Countering Corporate Inner Circles

\\server05\productn\O\ORE\83-2\ORE202.txt unknown Seq: 1 18-FEB-05 9:16 JAMES FANTO* Whistleblowing and the Public Director: Countering Corporate Inner Circles here have been startling cases of corporate fraud, self-deal- Ting, and mismanagement, particularly among Chief Execu- tive Officers (“CEOs”), Chief Financial Officers (“CFOs”), and other top executives of publicly traded firms. The scandals in- clude executives at Enron, WorldCom, Global Crossing, Qwest, Adelphia, Dynergy, Tyco, Xerox, Vivendi, Sprint, and Health- South.1 In these cases rarely, if ever, did a member of a company’s board of directors, even an independent director (the director with no ties to the company, who has long been touted as the panacea for corporate governance reform),2 identify the * Professor of Law, Brooklyn Law School. I would like to thank my colleagues Dana Brakman-Reiser, Ted Janger, Roberta Karmel, Arthur Pinto, Norman Poser, Tony Sebok, Larry Solan and Spencer Waller for offering comments on this Article, and Clara Mack (class of 2003) for her valuable research assistance. I would also like to thank participants in faculty forums at Brooklyn Law School and Pace Law School, and at the 2004 AALS meeting of the Section on Business Associations, where a paper based on the Article was presented, for giving me additional sugges- tions. The Article was prepared with the assistance of two summer research stipends from Brooklyn Law School, for which I thank Dean Joan Wexler. 1 See, e.g., Task Force on Corp. Resp., Am. B. Ass’n, Preliminary Report of the American Bar Association Task Force on Corporate Responsibility, 58 BUS. LAW 189 (Nov. 2002) (listing various corporate scandals) [hereinafter ABA Report]; John A. Byrne, Restoring Trust in Corporate America, BUS. WK., June 24, 2002, at 30; Capi- talism and its Troubles, THE ECONOMIST, May 18, 2002 (special insert dealing with scandals in U.S. corporations). For a harsh summary of the scandals and those who profited from them, by a securities lawyer who often represents shareholders, see William S. Lerach, Plundering America: How American Investors Got Taken for Tril- lions by Corporate Insiders, the Rise of a New Corporate Kleptocracy, 8 STAN. J.L. BUS. & FIN. 69 (2002). 2 See generally Laura Lin, The Effectiveness of Outside Directors as a Corporate Governance Mechanism: Theories and Evidence, 90 NW. U. L. REV. 898 (1996). In discussing the implications of Enron, Vice Chancellor Strine of the Delaware Chan- cery Court observes that the scandal has greatly undermined the legal basis for the role of independent directors in corporate governance by showing how hollow that [435] \\server05\productn\O\ORE\83-2\ORE202.txt unknown Seq: 2 18-FEB-05 9:16 436 OREGON LAW REVIEW [Vol. 83, 2004] wrongdoers at an early stage. Rather, many board members, if not active or indirect participants in a scandal, passively went along with the wrongdoing, were blind to it, resisted its uncover- ing, or intervened only when disaster had already struck their firm.3 The outside advisors of the scandal-ridden firms performed no better. Investment bankers, stock analysts, accountants, and lawyers, as well as corporate service professionals such as proxy and publicity firms, did little to detect problems or call executives to account for questionable transactions.4 Instead, as sycophantic concept is, given all the ties that these directors have with management and how little time they give to their position. See Leo E. Strine, Jr., Derivative Impact? Some Early Reflections on the Corporation Law Implications of the Enron Debacle, 57 BUS. LAW . 1371, 1374-95 (2002). 3 A good example of passiveness is Enron’s board. See STAFF OF S. PERMANENT SUBCOMM. ON INVESTIGATIONS OF THE S. COMM. ON GOV’T AFF., 107TH CONG., THE ROLE OF THE BOARD OF DIRECTORS IN ENRON’S COLLAPSE (Comm. Print 2002), available at http://news.findlaw.wm/hdocs/docs/enron/senpsi70802rpt.pdf. The Subcommittee investigation did not substantiate the claims that the Enron Board members challenged management and asked tough questions. Instead, the investigation found a Board that routinely relied on En- ron management and Andersen representations with little or no effort to verify the information provided, that readily approved new business ven- tures and complex transactions, and that exercised weak oversight of company operations. The investigation also identified a number of financial ties between Board members and Enron which, collectively, raise questions about Board member independence and willingness to challenge management. Id. at 14. See also William C. Symonds, Tyco: How Did They Miss a Scam So Big?, BUS. WK., Sept. 30, 2002, at 40 (describing “seemingly willful blindness” of Tyco board members in failing to discover Tyco’s accounting scandal). 4 The U.S. Senate noted that the Enron fraud was the work of highly educated professionals such as accountants and lawyers. The alleged activity Enron used to mislead investors was not the work of novices. It was the work of highly educated professionals, spinning an in- tricate spider’s web of deceit. The partnerships—with names like Jedi, Chewco, Rawhide, Ponderosa and Sundance—were used essentially to cook the books and trick both the public and federal regulators about how well Enron was doing financially. The actions of Enron’s executives, accountants, and lawyers exhibit a “Wild West” attitude which valued profit over honesty. S. REP. NO. 107-146, at 2-3 (2002); see also ABA Report, supra note 1, at 7 (“[I]t is a clear failure of corporate responsibility when outside directors, auditors and lawyers, who have important roles in our system of independent checks on the corporation’s management, fail to avert or even discover—and sometimes actually condone or contribute toward the creation of—the grossest of financial manipulations and fraud.”). To this list of the culpably inactive should be added corporate compensation consultants, who invariably justified the high pay packages for the CEO and other top executives in a given company. See Lucian Ayre Bebchuk et al., Manage- rial Power and Rent Extraction in the Design of Executive Compensation, 69 U. CHI. \\server05\productn\O\ORE\83-2\ORE202.txt unknown Seq: 3 18-FEB-05 9:16 Whistleblowing and the Public Director 437 cheerleaders of top executives and companies during the bubble of the late 1990s, they were often active participants in the fraud- ulent behavior or acquiesced in it. Moreover, they generally de- nied responsibility and blamed others when a scandal emerged.5 L. REV. 751, 789-91 (2002). But see Brian J. Hall & Kevin J. Murphy, The Trouble with Stock Options, 17 J. ECON. PERSP. 49, 61-67 (2003) (disagreeing that rent seek- ing by managers resulted in the high managerial stock options and attributing this to board misperception of the true economic costs of options). 5 Professor Hrishikesh D. Vinod amusingly summarizes how so many individuals involved in Enron deny responsibility for the scandal. See Hrishikesh D. Vinod, Winners and Losers in Multiple Failures at Enron and Some Policy Changes (Apr. 9, 2002), available at http://www.ssrn.com. For example, David Bushnell, Citigroup Managing Director, said the following: But, let me be clear, while we regret our relationship with Enron, we acted in good faith at all times. Our employees, including the bankers who are here today, are honest people doing honest business. They did transactions that were common throughout Wall Street, and they believed those transactions were entirely appropriate. Hearings on the Role of the Financial Institutions in Enron’s Collapse: Hearing Before the Permanent Subcomm. on Investigations of the S. Comm. on Gov’t Aff., 107th Cong. 3 (2002) (statement of David Bushnell). Similarly, the Managing Direc- tor of J.P. Morgan Chase stated, It is our understanding that Enron recorded these transactions on its balance sheet; in other words, they were not “off balance sheet” transactions. As stated earlier, however, the manner in which Enron accounted for these transactions on its books of account and in its financial statements was a matter for Enron and its management and auditors. Hearings on the Role of the Financial Institutions in Enron’s Collapse: Hearing Before the Permanent Subcomm. on Investigations of the S. Comm. on Gov’t Aff., 107th Cong. (2002) (statement of Jeffrey W. Dellapina, Managing Director, J.P. Morgan Chase Bank). Of course, the denials do not always prove accurate, as the conviction and bankruptcy of Enron’s outside accounting firm, Arthur Andersen, has shown. See Jonathan Weil et al., Auditor’s Ruling: Andersen Win Lifts U.S. Enron Case—Shredding Wasn’t Factor in Verdict, Jurors Say, A Single E-Mail Was, WALL ST. J., June 17, 2002, at A1. For example, Robert Roach stated, Numerous major financial institutions, both here and abroad, engaged in extensive and complex financial transactions with Enron. The evidence we reviewed showed that, in some cases, the financial institutions were aware that Enron was using questionable accounting. Some financial institutions not only knew, they actively aided Enron in return for fees and favorable consideration in other business dealings. The evidence indicates that En- ron would not have been able to engage in the extent of the accounting deceptions it did, involving billions of dollars, were it not for the active participation of major financial institutions willing to go along with and even expand upon Enron’s activities. The evidence also indicates that some of these financial institutions knowingly allowed investors to rely on Enron financial statements that they knew or should have known were misleading. Statement of Robert Roach, Chief Investigator, Hearings on the Role of the Finan- cial Institutions in Enron’s Collapse Before the Permanent Subcomm. on Investiga- tions of the S.

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