A Guide to Director Independence
an interview with Bruce F. Dravis of Downey Brand, LLP

James Hazlehurst - University of California, Davis, School of Law
Vol. 7
December 2006
Page

Bruce F. Dravis is a partner at the Sacramento law firm, Downey Brand LLP. He specializes in business representation, with an emphasis on public and private securities transactions, regulatory compliance, and corporate finance and operation. Mr. Dravis is a graduate of Boston University School of Law.

Q: Bruce, the American Bar Association has just published your you are in the process of writing a book on the subject of director independence, "Independent Directors Guidebook". What developments led to the writing of this book and what is its goal or purpose?

A: Multiple elements in my background led me to create this book. While serving as general counsel for a publicly traded semi-conductor company in Sacramento, I found that when I consulted treatises, I would get someone's description of what the law was and maybe a citation to the law.

However, I could not instantaneously get my hands on the source material. So, this book has been developed as a solution to that problem.

In addition to the hard copy, the book is being published with an accompanying CD-ROM. The CD-ROM will provide a link to the source material. For example, where the book references Sarbanes-Oxley Section 303, you can select a link in the CD-ROM and get the full text of Sarbanes-Oxley Section 303. Where the book references a Securities Exchange Commission ("SEC") Release, you will have access to that release through the CD-ROM. Altogether there will baree about 10,000 pages of material on the CD-ROM. It will beis a miniature law library. This format flows out of my own experience and desire to have this type of resource in my own practice. Hopefully it will be a useful tool to other people.

In terms of the specific subject matter, which is corporate governance and the role of independent directors, the book grows out my having been involved with corporate securities law for twenty years.

One of the striking things to arise out of the Sarbanes-Oxley Act is the primary role given to independent directors in the Act's statutory structure. Over the past five years, there has been increasing refinement of what it is independent directors should and should not do. For example, there's been an increased itemization of what independent directors should do. And so now you have a level of specificity that never before existed for independent directors.

Until now, there has not been an existing resource that says if you're an independent director, these are the things you need to be aware of. I have identified six key areas that independent directors need to have an understanding of and be familiar with before they can even begin to work. It is essential that independent directors have some understanding of the six separate legal doctrines not only because the doctrines are complex, but also because the directors may be affected by them even before they start doing the job that they were hired to do.

The six legal issues are: the definition of independence, the fiduciary duties of directors, the specific roles of committees, the relationship with shareholders, the SEC's enforcement regime which uses independent directors as the gate keepers of information for public disclosure purposes, and issues relating to the purchase and sale of company securities, including stock options.

Each of these is a small area of law in itself and thus a lot for directors to take on.

Q: So your book will make it easier for directors to get the information they need?

Well, at least the information will all be all in one place. This book will be marketed toward attorneys (it is being published by the American Bar Association), and also to directors. I tried not to write it in "legalese", but when you are a lawyer, it i's very hard not to write for other lawyers.

Q: When will your book be available?

A: It went to typesetting about two weeks ago. Hopefully it will be available by the end of the year.

Q: How long was the process in getting this book to publication?

I put in the proposal about a year ago. I finished the first draft of the manuscript about nine months later. Then, I completed a sample chapter a few months after the proposal was accepted. Now it's been in different phases of the production cycle for about three months.

Q: Why is director independence important and how has the definition of director independence changed over time?

A: Director independence is an interesting development in corporate law. Traditional corporate law doctrines relating to director independence applied to related party transactions. For example, in a building lease, if management or one of the other directors owned the building, the doctrine held that those people with financial interests in the transaction should not take part in decisions relating to the transaction. Director independence was designed to make sure that shareholders are protected in terms of fairness and other facets of the transaction.

This concept of independence in the face of perceived or real conflict of interest carries over and mutates into different applications in the corporate context. So, by the time of the Enron and World Com scandals in early 2000, where gigantic corporations were destroyed by accounting fraud, public policy analysts had a slightly different take on the role of independent directors. Since the accounting frauds were either directed by management or done with the complicity of management, public policy critics began to ask why independent directors failed to sufficiently act as a check and balance over management.

Thus, there became a push for a separation of powers in the boardroom between board members and management. Whereas directors were historically chosen by management to be friendly, collegial, and cooperative with corporate managers, the idea arose that the format should be changed to create a board of directors independent from management with the role of overseeing management.

Q: You recently wrote an article where you commented on the potential suitability of attorneys to serve on boards, The Attorney As Corporate Director (NACD Directors Monthly, March 2005). When an attorney serves on a board, does that create other problems? For example, might an attorney expose herself to greater liability because she's more sensitive to the legal issues facing the board?

A: That is an interesting question that is not yet at the forefront of current practice, but may surface in four or five years. My article was prompted by certain SEC rulemaking which itself was prompted by specific provisions in the Sarbanes-Oxley Act aimed at insuring the independence of attorneys.

Sarbanes-Oxley not only set certain independence standards for directors, but also set standards for financial analysts, accountants, and attorneys. Each group received a certain amount of scrutiny. Though accountants received the brunt of the scrutiny, attorneys received some as well. There was some concern about whether the legal advice provided to management from some of these companies enmeshed in scandals was sufficiently independent, professional, and aimed at the interests of the true client, the corporation, as opposed to serving the interests of the management which had retained the law firm.

The SEC's rulemaking response to the statutory provision in Sarbanes-Oxley was to come up with a structure in which the SEC proposed that attorneys notify the SEC if they found violations by their clients. That proposal, called the "Reporting Out" provision, was not adopted. There is a provision that was adopted that is in the act itself-called "Reporting Up"-where if the attorney finds a legal issue, reports it to the chief legal officer or to the chief executive officer, and does not believe that those individuals make an appropriate response, then the attorney is charged with elevating that up to the board or a committee of the board.

As a result, the SEC created the concept of a qualified legal compliance committee ("QLCC"). The SEC's concept was that the QLCC would take responsibility for the legal decisions so that if the attorney reported the conflict up to the QLCC, the attorney would be off the hook. The QLCC has not played out in fact and unless the SEC adopts some version of the Rreporting Outup requirement, companies are going to be slow to adopt the QLCC. Still, some companies have adopted the idea and I believe the QLCC has some utility.

As to whether an attorney would have increased liability exposure if the attorney is on the board as opposed to anyone else without a legal background, the short answer is likely no. One can analogize to the financial expert on the audit committee. The rules relating to financial experts are intended to specifically immunize those individuals from having special liability associated with their level of expertise.

However, there are cases under Delaware law where if you have special expertise, and you think you're entitled to act like an idiotdisregard your expertise, the courts will disagree with you. So it is entirely possible that an attorney would have a higher standard than another director without a legal background depending on the particular facts and the particular subject, but in general directors are intended to be held to a unified fiduciary standard.

Q: So the main duty of the attorney on the board would be to notify the QLCC of the legal issues?

A: No. , the idea would be-and this hearkens to the old chestnut about the lawyer's job Lawyers learn how the law creates as creating categories and relationships among categories, and they learn how to analyze analyzing responsibilities or duties among parties, so one value an attorney could bring to a board would be and having the ability to speak that language. -that there could very well be contexts where being able to bring that language to bear in deliberations are inherently valuable especially because there are legal duties that attach to boards. It would not be the case, for example, that an attorney would i's not that you know everything about environmental law, but that you an attorney could know enough about affirmative defenses and how the appellate process works, for example, that he or she you might say, "Gee, it sure seems to me that this case should be structured this way. Can we have counsel look at this?" That would be the role of the attorney on the board.

Q: To what extent has the role of legal counsel to board members changed in recent years?

A: If you look at anyone who has been consulted about stock options, back dating, or to deal with any executives in the Hewlett Packard scandal, involving Wilson Sonsini , it turns out that advising boards is more complex than it has been in the past.

Q: And that i's primarily grown out of the scandals with Enron and Worldcom?

A: Well, it grew out of Sarbanes-Oxley in significant part in that there are more specific rules to deal with. The Hewlett Packard situation, for example, grew out of the culture relating to corporate governance.

The event that started everything at HP was that a board member leaked information to the press. This board member was speaking out of turn and was not authorized to speak on behalf of the company. So in trying to investigate the leak, Hewlett Packard adopted some means that ultimately proved problematic. However, investigating the leak was exactly the right thing to do. You want the company to speak with one voice; you want your individual directors to fulfill their fiduciary duties, including their duty to maintain confidentiality. So if you find someone who is breaching that duty, you can not turn a blind eye.

Q: Was it just the policies used to police the board that brought about the Hewlett Packard scandal?

A: Perhaps. I do not know the specifics of the situation. My speculation is that if If Hewlett Packard executives had instead gone to the board and said, "We want authorization to use your personal information and we want you to sign an affidavit that you have nott talked to any of these reporters," then the executives would be on a very different footing. I think such statements would have decreasedYou might not have seen the level of cloak and dagger activity the company wound up using and got in so much trouble for.

Q: What has been the impact of the compliance costs of Sarbanes-Oxley?

A: There are numerous costs that have been associated with Sarbanes-Oxley. One of the costs that is not a board related cost is the internal financial control compliance-the so called Section § 404 compliance. It is horrendously expensive and no-one in Congress had any idea how expensive it was going to be.

It's a bit late to reconsider now because so many companies have everybody has spent the money to comply with Section 404, although there are some efforts to see if y are looking at whether there are better ways to achieve that particular objective. requirement.

There are increased compliance costs that are associated with every other level of board function for public companies. SEC reporting is on a shorter time frame and there are costs associated with the internal processes that corporations want to put in place to ensure good reporting. This leads to increased internal costs at a company level in addition to external costs from bringing in counsel.

What this signifies today is that the type of companies with good operating businesses that went public in the 1990s nineties now might would probably not make enough profit to be able to pay the costs associated with accessing the capital market. Companies more than ever are faced with weighing the benefit of capital market access against the dollar cost of securitiesy fraud law compliance.

Citation
7 U.C. Davis Bus. L.J. 9 (2006)