Q 7Q 7
Every now and then, scandals in the business world rock the nation. Certainly, this was true in the fi rst decade of the 2000s when the activities of Enron Corporation, AIG, and a number of other companies came to light. As noted in several chapters in this unit, Congress responded to public outcry in 2002 by passing the Sarbanes-Oxley Act, which imposed stricter requirements on corporations with respect to accounting practices and statements made in documents fi led with the Securities and Exchange Commission (SEC). The lesson for the business world is, of course, that if business leaders do not behave ethically (and legally), the government will create new laws and regulations that force them to do so. We offered suggestions on how business decision makers can create an ethical workplace in Chapter 5. Here, we look at selected areas in which the relationships within specific business organizational forms may raise ethical issues.
The Emergence of Corporate Governance
The well-publicized corporate abuses of recent years provided the impetus for businesspersons to create their own internal rules for corporate governance (discussed in Chapter 42). Examples of these abuses make it clear why such rules are needed. In a few situations, officers have blatantly stolen from the corporation and its shareholders. More frequently, though, officers have received excessive benefits, or "perks," because of their position. To illustrate: Tyco International bought a $6,000 shower curtain and a $15,000 umbrella stand for its chief executive officer's apartment.
Corporate officers may be given numerous benefits, which they may or may not deserve. On several occasions, a leading corporate officer has received compensation of $50 million or more in a year when the company's share price actually declined. Even if corporate officers are scrupulously honest and have modest personal tastes, their behavior may still raise concerns: they may not be good managers, and they may make incompetent corporate decisions. They may be a little lazy and fail to do the hard work necessary to investigate the corporation's alternatives. Sometimes, officers may simply fail to appreciate the concerns of shareholders on certain matters, such as maximizing short-term versus long-term results.
Corporate governance controls are meant to ensure that officers receive only the benefits they earn. Governance monitors the actions taken by officers to make sure they are wise and in the best interests of the company. In this way, the corporation can be confident that it is acting ethically toward its shareholders.
Fiduciary Duties Revisited
The law of agency, as outlined in Chapters 32 and 33, permeates nearly all relationships within any partnership or corporation. An important duty that arises in the law of agency, and applies to all partners and corporate directors, officers, and management personnel, is the duty of loyalty. As caretakers of the shareholders' wealth, corporate directors and officers also have a fiduciary duty to exercise care when making decisions affecting the corporate enterprise.
The Duty of Loyalty Every individual has his or her own personal interests, which may at times conflict with the interests of the partnership or corporation with which he or she is affiliated. In particular, a partner or a corporate director may face a conflict between personal interests and the interests of the business entity. Corporate officers and directors may find themselves in a position to acquire assets that would also benefit the corporation if acquired in the corporation's name. If an officer does purchase the asset without offering the opportunity to the corporation, however, she or he may be liable for usurping a corporate opportunity.1
Most courts also hold that a corporate officer or director has a fiduciary duty to disclose improper conduct to the corporation. The Supreme Court of Arkansas weighed in on this issue in 2007. Thomas Coughlin was a top executive in theft prevention at Wal-Mart who held several other high-level positions prior to becoming a member of the corporation's board of directors. He retired in 2005 and entered into a retirement agreement and release of claims with Wal-Mart under which he was to receive millions of dollars in benefits over the years.
Then Wal-Mart discovered that Coughlin, before his retirement, had abused his position of authority and conspired with subordinates to misappropriate hundreds of thousands of dollars in property and cash through various fraudulent schemes. Wal-Mart fi led a lawsuit alleging that Coughlin had breached his fiduciary duty of loyalty by failing to disclose his misconduct before entering a self-dealing contract. Ultimately, the state's highest court agreed and held that the director's fiduciary duty obligated him to divulge material facts of past fraud to the corporation before entering the contract. The court stated, "We are persuaded, in addition, that the majority view is correct, which is that the failure of a fiduciary to disclose material facts of his fraudulent conduct to his corporation prior to entering into a self-dealing contract with that corporation will void that contract."2
The Duty of Care In addition to the duty of loyalty, every corporate director or officer owes a duty of care. Due care means that officers and directors must keep themselves informed and make businesslike judgments. Officers have a duty to disclose material information that shareholders need for competent decision making. Some courts have even suggested that corporate directors have a duty to detect and "ferret out" wrongdoing within the corporation. 3 In fact, a number of courts applying Delaware law have recognized that directors may be held liable for failing to exercise proper oversight.4 For example, in 2009 a Delaware court held that shareholders of Citigroup, Inc., could sue the directors and officers for failure to exercise due care to adequately protect the corporation from exposure to the subprime lending market.5 Corporate law also creates other structures to protect shareholder interests, such as the right to inspect books and records.
Although traditionally the duty of care did not require directors to monitor the behavior of corporate employees to detect and prevent wrongdoing, the tide may be changing. Since the corporate sentencing guidelines were issued in 1991, courts have had the power to impose substantial penalties on corporations and corporate directors for criminal wrongdoing. The guidelines allow these penalties to be mitigated, though, if a company can show that it has an effective compliance program in place to detect and prevent wrongdoing by corporate personnel. Since the Sarbanes-Oxley Act of 2002 required the sentencing commission to revise these guidelines, the penalties for white-collar crimes, such as federal mail and wire fraud, have increased dramatically.
Fiduciary Duties to Creditors It is a long-standing principle that corporate directors ordinarily owe fiduciary duties only to a corporation's shareholders. Directors who favor the interests of other corporate "stakeholders," such as creditors, over those of the shareholders have been held liable for breaching these duties. The picture changes, however, when a corporation approaches insolvency. At this point, the shareholders' equity interests in the corporation may be worthless, while the interests of creditors become paramount. In this situation, do the fiduciary duties of loyalty and care extend to the corporation's creditors as well as to the shareholders? The answer to this question, according to some courts, is yes. In a leading case on this issue, a Delaware court noted that "the possibility of insolvency can do curious things to incentives, exposing creditors to risks of opportunistic behavior and creating complexities for directors." The court held that when a corporation is on the brink of insolvency, the directors assume a fiduciary duty to other stakeholders that sustain the corporate entity, including creditors.6 When a corporation is insolvent, courts often require directors to consider the best interests of the whole corporate enterprise-including all its constituent groups-and not to give preference to the interests of any one group.7
Corporate Blogs and Tweets and Securities Fraud
In the fast-paced world of securities trading, there is a great demand for the latest information about companies, earnings, and market conditions. Corporations have adapted to technology by establishing Web sites and blogs, and using other interactive online media, such as Twitter and online shareholder forums. Nearly 20 percent of Fortune 500 companies sponsor blogs. Corporations that use the Internet to distribute information about the company to investors, however, need to make sure that they comply with the regulations issued by the SEC. The SEC treats statements by employees in online media, such as blogs and Twitter, the same as any other company statements for purposes of federal securities laws.
Tweets That Contain Financial Information Some corporate blogs include links to corporate employees' Twitter accounts so that readers can communicate directly with, and get updates from, the individual who posted the information. For example, eBay, Inc., launched its corporate blog in 2008. A few months later, Richard Brewer-Hay, a seasoned blogger that eBay hired to report online, began tweeting (posting updates on Twitter) about eBay's quarterly earnings and what took place at Silicon Valley technology conferences. Brewer- Hay's tweets gained him a following, but then eBay's lawyers required him to include a regulatory disclaimer with certain posts to avoid problems with the SEC. Many of his followers were disappointed by the company's oversight, which put an end to his spontaneous, personal, and informal style. Brewer-Hay is now much more reserved in his tweets on financial matters and often simply repeats eBay executives' statements verbatim.8
A 2008 SEC Release Provides Guidance The reaction of eBay's lawyers to Brewer-Hay's tweets was prompted in part by an interpretive release issued by the SEC in August 2008. The SEC generally embraces new technology and encourages companies to use electronic communication methods. The SEC noted that "the use of the Internet has grown such that, for some companies in certain circumstances, posting of the information on the company's Web site, in and of itself, may be a sufficient method of public disclosure."
The release also addressed company-sponsored blogs, electronic shareholders' forums, and other "interactive Web site features." The SEC acknowledged that blogs and other interactive Web features are a useful means of ongoing communications among companies, their clients, investors, shareholders, and stakeholders. The SEC cautioned, though, that all communications made by or on behalf of a company are subject to the antifraud provisions of federal securities laws. "While blogs or forums can be informal and conversational in nature, statements made there... will not be treated differently from other company statements." In addition, the release stated that companies cannot require investors to waive protections under federal securities laws as a condition of participating in a blog or forum. (The release also cautioned companies that they can, in some situations, be liable for providing hyperlinks to third party information or inaccurate summaries of financial information on their Web sites.)9
The Sarbanes-Oxley Act and Insider Trading
The attorney-client privilege generally prevents lawyers from disclosing confidential client information-even when the client has committed an unlawful act. The idea is to encourage clients to be open and honest with their attorneys to ensure competent representation. The Sarbanes-Oxley Act of 2002, however, requires attorneys to report any material violations of securities laws to the corporation's highest authority.10 The act does not require that the lawyer break client confidences, though, because the lawyer is still reporting to officials within the corporation.
In August 2003, the SEC went one step further than the Sarbanes-Oxley Act to permit attorneys to disclose confidential information to the SEC without the corporate client's consent in certain circumstances.11 Although the American Bar Association modified its ethics rules to allow attorneys to break confidence with a client to report possible corporate fraud, not all state ethics codes allow attorneys to disclose client information to the SEC. Thus, by reporting possible violations of securities law to the SEC, corporate lawyers may violate the state ethics code of their profession.
When a company's executives offer opinions about the firm's financial status and future business prospects through blogs, Twitter, and other Internet forums, the SEC can hold the company liable for violating securities laws. Is this fair to investors who want to hear the straight scoop from the firm's executives? What arguments can you make in favor of this restriction? What arguments can you make against it?