Delaware and the Responsibility for SOX: The Case of Loans to Management

As discussed in a prior post, SOX included a prohibition on loans to executive officers and directors. See Section 402 of SOX.  The provision engendered considerable criticism and not without good reason.  It prevents the board from engaging in transactions that will sometimes benefit the company. 

But the provision did not arise in a vacuum.  Under state law, the standard of review for transactions between the company and executive officers became meaningless as long at the transaction was approved by a majority of independent directors.  In those circumstances, courts presume the transaction valid and make no resort to fairness.  Thus, loans approved by independent directors could be in extraordinary amounts or on terms that no bank would make.    

Let's look at the poster child example.  Bernie Ebbers, as CEO of Worldcom, found himself incurring margin calls as the price of WorldCom dropped.  Rather than sell his shares, he borrowed from his own company. The loan and guarantees ultimately climbed to over $400 million. How much was that to Worldcom? See Restoring Trust, Report Prepared by Former SEC Chairman Richard Breeden,  August 2003, at 28 (Breeden Report)  (“ Ultimately the program of loans and guarantees grew to more than $400 million, representing a substantial portion of WorldCom’s cash reserves and its net worth, had its balance sheet been accurately reported.”).

And the terms?  Apparently the loans weren't properly collateralized.  See Report of Investigation by the Special Investigative Committee of the Board of Directors of Worldcom, Inc., Dennis R. Beresford, Nicholas deB. Katzenbach, C.B. Rogers, Jr., March 31, 2003 (“The Company did not have a perfected security interest in any collateral for the loans for most of the time period during which they were outstanding.”); or subject to standard repayment terms; see Id. (“Ebbers was not required to make regular payments; rather, payments were required only on the Company's demand, and no payments were demanded."); or market interest rates.  See Id. ("The promissory notes provided that the interest charged to Ebbers would be equal to the fluctuating rate of interest charged under a WorldCom credit facility, almost always the lowest rate available to WorldCom at the time, and a rate of interest lower than that of Ebbers' other outside loans. Moreover, this rate was lower than the average rate WorldCom paid on its other debt.”).   As the Study concluded:  The loans were involved an assumption of risk “that no financial institution was willing to assume.”

The Ebbers loans are widely known.  But given the terms and amount, how could they have happened, consistent with state law fiduciary obligations?   As long as the loans were subject to some type of independent approval process, the terms didn't matter.  The loans were approved by the compensation committee, a committee that "seemed to spend most of its efforts finding ways to enrich Ebbers, and it certainly did not act as a serious outside watchdog against excessive payments or dangerous incentives.”  See Breeden Report.  The three directors on the compensation committee were apparently independent, at least under the reigning, inadequate definitions. As the Breeden Report noted:

• "Both [Stiles] Kellett and [Max] Bobbitt appeared to satisfy the “independence” standards for directors of the time, and might well satisfy current definitions used by the New York Stock Exchange (“NYSE”) and NASDAQ. However, both men had received millions of dollars worth of WorldCom stock when Ebbers acquired predecessor companies. Both men had been involved in business with Ebbers for years, and both owed a substantial portion of their net worth to his actions. This made them uniquely poor choices to represent the interests of WorldCom’s shareholders in exercising oversight responsibilities over Ebbers. As demonstrated by their actions in extending stockholder loans to bail out Ebbers’ personal debts, both men seemed to be more solicitous of Ebbers’ wishes than shareholder interests."

Moreover, it turns out that Kellett had leased a plane from Worldcom, with the terms later determined by Breeden to be “below fair market value.”

Nonetheless, so long as the loans were approved by directors who met the requisite definition of independent under state law and were otherwise informed, a decidedly low standard, the loans were beyond challenge, irrespective of the amount or terms. As one report concluded: “We do not understand how the Compensation Committee or the Board could have concluded that these loans were in the best interests of the Company or an acceptable use of more than $400 million of the shareholders’ money.” Report of Special Investigative Committee.  

Had the board retained the obligation to show fairness, the loans probably never would have occurred.  At a minimum, fairness would have required commercially reasonable terms. With the decision subject to the business judgment rule, the terms and fairness of the transaction hardly mattered.  It was this void that Congress entered in banning executive loans by public companies.

Thus, the issue is not whether the prohibition in SOX results in inefficiencies or additional costs but whether these consequences are more costly and inefficient than the approach employed under Delaware common law.  We will explore this aspect of Delaware law in later posts.