Enron’s legacies and directors’ and officers’ risk

Shortly after former Enron CEO Jeffrey Skilling’s Oct. 23, 2006, sentencing, the Enron Task Force said it was closing down, with its mission mostly complete. Yet did that event really signal an endpoint in the Enron criminal scandal? Perhaps it’s time to take a look at the scandal’s lasting impact and effect on directors’ and officers’ risk.

The end of an era?

While Skilling’s sentencing had the air of a culminating event, a fresh wave of scandals suggests that white collar criminal prosecutions will remain part of the legal landscape. Indeed, the same week as Skilling’s sentencing, Comverse Technology’s former chief financial officer became the first corporate official to plead guilty to criminal charges in connection with the options backdating scandal. Also that same week, Refco’s former CFO was indicted for accounting allegations raised following the company’s ill-fated initial public offering. Those are signs that white collar crime prosecutions will remain a prosecutorial priority.

Furthermore, there are a number of Enron-related prosecutions in the pipeline. Three British bankers who were extradited to the United States will stand trial in 2007 on allegations that they stole from their former employer in connection with an Enron-related transaction. There may be new trials for several former Enron executives whose earlier proceedings ended in mistrials. Key Enron defendants have not yet been sentenced. And the civil lawsuit against Enron’s investment banks (the ones not yet settled) is pending.

Even when the book is closed on Enron, the assault on corporate fraud is likely to continue.

Enron’s legacies

“Enron” has moved into our language, both as a reference to the company and the scandals that followed its demise, and as a shorthand expression for the corporate scandals that were uncovered earlier this decade. Here are a few of Enron’s legacies.

1. New corporate culture of governance: The most important of Enron’s legacies is the new culture of corporate governance. Now, no corporation can ignore the implementation of serious internal compliance systems to detect and deter corruption. The role and functioning of corporate boards also have been dramatically altered.

Boards are now active, independent and involved, and are providing meaningful oversight of corporate management. There is increased emphasis on independent board composition. According to the National Association of Corporate Directors, 83 percent of boards say more than half of their directors are independent, up from 54 percent in 2000.

The changes hold out the intriguing possibility that improved corporate governance will result in reduced D&O risk. Some believe that improved governance explains the reduction in securities fraud lawsuits filed in 2006. Stanford Law Professor Joseph Grundfest stated that “extensive and expensive corporate efforts to improve governance and accounting have reduced plaintiffs’ ability to allege fraud.”

Governance reforms have improved corporate officials’ sensitivity to potential wrongdoing. But even allowing for this heightened vigilance, other commentators remain skeptical that reforms alone can explain the reduced number of lawsuits. As D&O authority Dan Bailey wrote about the impact of corporate governance reform on securities lawsuits, “it appears unlikely that this is a major contributing factor to the reduced filings.”

Increased board independence and oversight has, in some cases, led to boardroom turmoil that, in turn, has resulted in claims against, between and among directors and officers. Events involving Hewlett-Packard’s board are the most prominent example. The overly zealous efforts of HP’s board chair to identify the source of leaked confidential board information led to board resignations, shareholder litigation and, ultimately, to the criminal indictment of the board chair herself.

Yet the positive significance of Enron’s legacy in terms of D&O risk remains uncertain. In addition, there are movements afoot that could potentially alter that legacy.

2. Whistleblower protection: The new culture of oversight is not limited to the boardroom. Internal compliance programs, combined with Sarbanes-Oxley Act provisions that provide corporate whistleblower protection, encourage employees to report conduct they believe may have crossed the line.

The existence of whistleblower provisions could translate to increased D&O risk, in light of the possibility of claims based on the whistleblower’s disclosures. Yet the cases to emerge have been bogged down in procedural delays that could deter future whistleblowers. There have been no dramatic cases in which a whistleblower’s revelations have resulted in significant claims against corporate officials. So far, the provisions have not had a significant impact on D&O claims activity.

3. CEOs in the hotseat: With improved corporate governance procedures has come increased scrutiny of senior corporate management. Following Enron and other corporate scandals, CEOs’ hold on their jobs is more precarious. Since early 2005, the boards of some of the country’s largest companies — Bristol-Myers Squibb, Fannie Mae, Pfizer, Merck and American International Group — have ousted their CEOs. Additionally, executive compensation has been scrutinized. More active boards, a greater willingness to challenge management and a changed regulatory environment contributed to that.

Significant turnover at the most senior levels of management creates a volatile environment in which accusations of wrongdoing may more easily arise. Recurring questions about executive compensation add to the atmosphere of increased tension. The recent lawsuits involving options backdating allegations illustrate how quickly questions about compensation and management performance can lead to executive departures and D&O claims. The scrutiny under which management now operate is a source of D&O risk.

4. White collar crime enforcement: One of Enron’s most durable legacies is the creation of a prosecutorial police force to identify and punish corporate crime. The Corporate Fraud Task Force continues to find activities to investigate and prosecute. The picture of a permanent white collar fraud police force was illustrated in the recent remarks of Timothy J. Coleman. A former U.S. Justice Department official, Coleman was responsible for the Corporate Fraud Task Force and supervised the Enron Task Force and the Criminal Fraud Section. A Washington Post article attributed to Coleman the statement that:

The investigators hired by securities regulators, federal prosecutors and the FBI will pay lasting dividends because they will become a “standing army” ready to target business wrongdoing. That army will inevitably find offenses to investigate, prosecute and punish, whether its’ stock options, mutual funds or something else, he indicated. The likelihood of a series of major corporate crime investigations is one of Enron’s most tangible legacies.

With the increased prospect of prosecutorial scrutiny comes the increased possibility of D&O claims. Just as the major corporate criminal scandals involved parallel civil claims, and just as the options backdating investigations meant a wave of shareholder lawsuits, so too will future criminal investigations lead to civil claims against Ds&Os. The threat of claims arising from corporate criminal investigations is perhaps the most important way that Enron has affected D&O risk.

5. Increased severity of civil securities fraud lawsuits: Enron and other corporate scandals have changed the environment for civil securities fraud lawsuits. The changes have important implications for D&O carriers and their insureds. Average settlements in securities fraud lawsuits have escalated enormously due to the civil cases arising from the corporate scandals.

It may be that the egregiousness of those cases drove an increase in average severity that will diminish once the worst cases have played through the system. Yet the rough idea of “what cases like this settle for” has been ratcheted upward in a way that is unlikely to completely go away. This heightened severity standard affects D&O carriers’ average expected severity — particularly for excess carriers — and D&O insurance buyers’ limits selection. Carriers and policyholders must be prepared for more expensive outcomes.

How permanent are Enron’s legacies?

Shortly before the Enron Task Force disbanded, the Committee on Capital Markets Regulation formed to examine the effect of regulatory burdens on the competitiveness of the U.S securities markets in the global economy. The committee became known as the Paulson Committee because of the support Treasury Secretary Henry Paulson has given it.

The Paulson Committee is reviewing whether SOX represented an overreaction, and whether there are revisions that might swing the regulatory pendulum back to the middle. The committee’s work has been accompanied by statements from President Bush and Vice President Cheney that perhaps SOX went too far. Changes might not follow. But the extent of the recommendations and the regulatory reforms that could follow might affect the permanency of some of Enron’s significant legacies.

Corporate governance changed forever

Ultimately, there may yet be more of the Enron story to be told, and the current scandals (such as the options backdating investigations) will impact corporate culture. The Paulson Committee also may affect the post-Enron regulatory environment. Nevertheless, Enron has wrought enormous, categorical changes. Principles and practices of corporate governance are changed forever.

Corporate compliance programs are now an important part of every company’s internal operations. White collar fraud prosecution is empowered and an important component of the contemporary legal landscape. And D&O insurers and their policyholders face a changed claims environment characterized by increased risk and heightened severity expectations.

By any measure, Enron’s demise was a milestone in the history of American corporate culture, and its ramifications will affect companies for decades to come.

Topics Lawsuits Fraud Legislation Claims Directors Officers