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Special Section—2007 CICA International Conference CAPTIVES AND CORPORATE RESPONSIBILITY Captive boards need to establish SOX-related guidelines for conflicts of interest Over the past couple of years, life has changed for corporate officers and directors. The failures of Enron and a host of other public corporations have caused U.S. investors to take a critical look at the job that corporate directors and officers are doing. These high-profile corporate failures also prompted Congress to take quick action to reestablish investor trust, by passing one of the most sweeping financial accountability laws. The regulation, Sarbanes & Oxley Act of 2002 (SOX), spells out specific requirements for all officers and directors of listed public companies. However, it is important to note that while the legislation deals with “publicly held” organizations only, outside auditors have begun to make these requirements a “standard of care” for all organizations, so in reality the law extends far beyond public companies. As many organizations have found, SOX implementation has required radical modification to a company’s standard operating procedures. Everything from accounting methods to financial reporting and risk management has required revised approaches for officers and directors. SOX has left little doubt that regulators, in addition to investors, will no longer tolerate corporate officers and directors who are not working in the shareholder’s best interest. Captives as a microcosm Obviously, if a parent corporation has begun to be more aggressive with its overall corporate responsibility measures, it is only natural that it will take a similar position with regard to its various subsidiaries as well. One of the subsidiaries that is receiving its share of attention in many organizations is the captive insurance company. Robert W. Stocker II of Dickinson Wright, PLLC, provides some valuable insight into this increased emphasis on the directors and officers of the captive at the Fall 2006 CICA meetings. He discussed the role of the captive’s officers and directors in this new age of corporate management responsibility. Stocker noted the special relation-ship that fiduciaries (i.e., the captive’s officers and directors) have with regard to the captive. He pointed out that all fiduciaries share a common group of duties that include good faith, trust, confidence, and candor. The duties are based on the fact that the directors and officers are required to act for the benefit of the captive owners. Much of this formal responsibility is based on common law, which specifically imposes two fiduciary duties on directors—the duty of care and the duty of loyalty. State laws, Stocker notes, codify the common law fiduciary duties. For the most part, these laws affirm that a director should discharge his or her duties in good faith. Further, they should be done with that degree of diligence, care, and skill that an ordinarily prudent person would exercise under similar circumstances in a similar position. Duty of care The duty of care requires that a director be reasonably well informed about the organization and exercise independent judgment. It also requests that directors participate in decisions and, according to Stocker, do the above in good faith, with the care of the ordinary prudent person. In order to be informed and exercise independent judgment, a director should attend meetings. The director should also exercise independent judgment on all business entity decisions. In addition, Stocker says, directors should collect and understand all information that is supplied, and if they determine that information is inadequate to make a reasoned decision, they should request additional information. The concept of the “prudent person,” commonly referred to as the “business judgment rule,” has been used for many years and, as a result, has stood the test of time. In essence, the rule provides guidance with respect to whether the conduct of a director amounts to a breach of the duty of care. Thus, Stocker points out that the business judgment rule can serve as a defense to an allegation of a breach of the duty of care. In essence, he says, “the rule protects directors from liability when they act on an informed basis, act in good faith, and in an honest belief the action taken was in the best interest of the corporation.” Duty of loyalty In general, the duty of loyalty requires directors to exercise their power in the interest of the business entity—in this case, the captive—as opposed to their own interest or the interest of another entity or person. The duty of loyalty is made up of three components, according to Stocker. These include: • “Protect the confidences of the corporation.” • “Deal fairly with the corporation and avoid conflicts of interest.” • “Not exploit business opportuni-ties that rightfully belong to the corpora-tion for the director’s own benefit.” Recently, this conflict of interest issue has come to the forefront. This is due in large part to the fact that a director may have interests that could potentially be in conflict with those of the captive. This can easily happen when various third-party vendors serve as directors for the captive. In this case, Stocker says, the duty of loyalty requires that a director be conscious of the potential for such conflicts and act with candor and care in dealing with the captive and fully disclose such situations. For example, should a director have an interest in a transaction that is being considered by the board, the director should disclose the conflict before the board takes action on any matter. A necessary step that each captive board should take is to establish a conflict of interest policy statement. Once the policy statement is in effect, each director serving on the board should be required annually to disclose any potential or ongoing conflicts of interest via a specific questionnaire. This “full disclosure” questionnaire should be designed to identify potential problem areas. It is important to note that a contract or other transaction between the captive and one or more of the directors is not void or voidable solely because a conflict of interest exists. The key, according to Stocker, “is that the contract is fair and reasonable when approved and that all material facts as to the director’s relationship or interest are disclosed and known to the other board members.” The contract must then be approved or ratified by a vote sufficient for the purpose without counting the vote of any interested director. Stocker says that most states recognize the “business competition doctrine” which allows a director to engage in a competing business, provided the director acts in good faith. One step further As noted earlier, SOX has added greater oversight, disclosure, and reporting duties to officers and directors of publicly held companies. Currently, there are two main SOX-related disclosure duties that are imposed on officers and directors. The first one is Section 302 which obligates the chief executive officer (CEO) and chief financial officer (CFO) to personally certify all annual and quarterly reports. They must certify that the reports fairly present the company’s financial condition and results of operations, and they do not contain any untrue statements or omissions of material fact. Stocker notes that the CEO and CFO are subject to criminal liability for falsely, knowingly, or willfully making any inaccurate Section 302 certifications. The second area of concern from SOX is the Section 404 requirements. This section requires that corporations establish and maintain adequate internal control procedures to permit accurate financial reporting. Corporate officers and directors must report on the effectiveness of the internal control procedures, and the organization’s auditors must also provide information on the effectiveness of management’s internal control procedures for accurate financial reporting. Proactive compliance New U.S. Sentencing Guidelines have been established that dovetail with SOX compliance. For the most part, the Sentencing Guidelines set forth a formula for assessing the range of minimum/maximum fines for corporate criminal wrongdoing. One of the major factors in the guidelines is the concept of “culpability,” which can significantly enhance the minimum and maximum fine range. According to Stocker, culpability is determined by two factors that mitigate the ultimate punishment of the organization. The first factor is the existence of an effective compliance program; the second factor is self-reporting, cooperation, and acceptance of responsibility. For these reasons, it is critical for organizations to establish proactive compliance programs. The Sentencing Guidelines use broad parameters in determining an effective compliance program. These include: Exercise due diligence to prevent and detect violations, and otherwise promote an organizational culture that encourages ethical conduct and a commitment to compliance with the law. Stocker says that several necessary steps must be incorporated in the compliance program. Among the most important are: • A corporation must establish standards and procedures to prevent and detect criminal conduct. • The board shall have knowledge of the content and operation of the compliance program and must exercise reasonable oversight over the implementation and compliance with the program. • The board should receive periodic communications regarding the status of the program. • Program compliance should include a formal monitoring and audit-ing system to detect criminal conduct. • After the discovery of criminal conduct, organizations must take reasonable steps to appropriately respond and prevent similar actions in the future. Proactive involvement via the establishment and implementation of a SOX-compliant program should be an important part of any captive’s strategic iniatives. SOX has altered the landscape for all corporate officers and directors including those who serve on captive boards. Stocker’s comments were directed at the value of a proactive approach to compliance, and any captive board would be well advised to consider his suggestions. * |
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