Risk Management

When Restating Causes a Furor

In a California business judgment ruling, a court backs a board trying to correct the CEO's perceived ethical mistake – but the case leaves questions.
Roy HarrisSeptember 30, 2010

Like many court opinions hinging on the business judgment rule, last week’s case of California-based Nara Bancorp ended in a simple finding that masks a complex story — and carries potential lessons for future companies facing a tough decision.

Reduced to basics, the Los Angeles County state judge’s ruling backed defendants at Nara and its board with a summary-judgment dismissal of a derivative complaint brought by former chairman Thomas Chung. Chung, who resigned in 2005 in an ethical dispute that the board thought required a restatement of 2002 financial statements, claimed that restating was wrong, and knocked nearly $55 million from the market capital of Nara, a banking concern that serves a largely Korean-American community.

Judge Carl J. West found, however, that Chung failed to show a breach under the rule —based on legal principles largely honed in the courts of Delaware, where Nara and many other companies are incorporated — that protects good-faith business decisions made in keeping with directors’ so-called duty of care and duty of loyalty. It is that business judgment rule, the judge noted, that “reflects judicial reluctance to ‘second-guess’ directors’ business decision, given the courts’ limited expertise in business matters.”

The Nara board had sought Chung’s 2005 resignation after a new CEO learned of the agreement he had signed three years earlier with then-CEO Benjamin Hong, relinquishing $600,000 of Hong’s profit-sharing rights toward “helping the bank’s smoother earnings curve in the future” — in exchange for monetary compensation in the future. Against a background of corporate accounting abuses from Enron to WorldCom to Adelphia, and stricter enforcement, Nara’s board consulted attorneys about what to do. The lawyers recommended audit-committee attention to the matter, which led to an investigation of whether the Hong agreement had been reflected accurately in financial statements covering 2002.

Based on the legal advice, and with auditor Crowe Chizek’s agreement, Nara and the board restated 2002 results to accrue the $600,000 from Hong as a liability; asked Chung and Hong to resign; and one year later began an arbitration proceeding against Hong for damages they believed had reflected Hong’s misconduct. Hong cross-complained, seeking compensation that he said was owed him.

In a twist that eventually gave rise to Chung’s lawsuit, Nara lost its arbitration case, in which Hong also won a determination that the 2005 restatement was, in fact, not required. When Nara then decided to let the restatement stand, without revision, and to take no action against those who advised it to restate, Chung made his own demands, seeking $2.5 million in damages and bringing the shareholder derivative suit.

What makes this business judgment case noteworthy, according to Perrie M. Weiner of law firm DLA Piper, who represented Nara and the board, is that “it really tested the boundaries of what would be acceptable to a court” in considering a board’s and an audit committee’s actions “when confronted by accounting irregularities [involving] the two highest officers in the company.” Weiner tells CFO that “law firms or boards have for a number of years been advised that if they face a situation like this, the best practice is to do a thorough investigation and leave no stone unturned. This vindicates that this is the proper thing to do.”

Many states, including California, adopt a standard following Delaware’s business judgment rule, he says, and in litigating “the big question is, will the court properly apply the rule,” as Weiner believes it did in this case.

“It’s not that they’re vindicated; it’s that they’re immune” because of the judge’s business judgment ruling, responds plaintiff’s attorney Steven M. Goldberg of law firm Russ, August & Kabat. “The legal defense [by Nara] was that the business judgment rule is like an absolute shield,” says Goldberg, who says he has been authorized by the 83-year-old Chung to appeal the case in California. Goldberg believes that “gross negligence” by Nara’s board should have been found to outweigh the rule’s protections — or at least warrant jury consideration, rather than a summary dismissal.

Among other things, Goldberg argues that before the restatement in 2005, the board never determined whether there was a quid pro quo for Hong’s “altruistic” surrender of his $600,000. Further, he tells CFO, “The decision [to restate] was so obviously a mistake, and caused so much damage, the question is, were the board members who did that to be held accountable?”

In this case, the answer is no. “The fact that the arbitrators found the restatement unnecessary is irrelevant,” the judge ruled, adding that “it is the process which led up to the board’s decisions that is relevant.”