Recognizing the Contours of a Warning Sign: General counsel should ensure that their boards know a red flag when they see one

Thursday, August 3, 2017 - 11:18

The challenges associated with board oversight duties in "crisis situations," and related expectations regarding director attentiveness, are highlighted in a recent Wall Street Journal article concerning Theranos. It serves as a reminder of the valuable role that general counsel can play in supporting the ability of directors to satisfy these duties and expectations.

Two former Theranos directors were criticized in the article, which ran on May 30. They were taken to task for their lax oversight of corporate operations. Based on a review of depositions given by the directors, the article suggested that they had failed to follow up on public allegations that the company was using standard technology in its blood testing operations, rather than its touted proprietary technology. The inference (fairly or unfairly) was that these allegations were a significant warning sign of the company's emerging financial, regulatory and reputational problems.

The article included specific excerpts from the directors' respective depositions in which they seemingly acknowledge that, the public allegations notwithstanding, they made no separate inquiry of the CEO as to whether the proprietary technology was working as planned. One of the directors was quoted as testifying that he “didn’t probe into” that issue: “It didn’t occur to me.” He was further quoted as adding, “Since I didn’t know, I didn’t have anything to look into.”

The clear theme of the article was that the two directors were deficient in the exercise of their oversight obligations, and that the public allegations were "red flags" of corporate or executive misconduct that they missed, to the detriment of the company and its investors. To buttress this theme, the article included criticism from a law professor who noted that it is “a board’s fiduciary duty to find out what was going on.” 

Media stories questioning whether directors have satisfied their fiduciary obligations are nothing new, especially in highly public corporate controversies. And it's never fair to draw conclusions of director culpability from media reports – there are always two sides. But what is unusual about this matter – what could make many directors pause for a deep breath – is that these allegations implicated directors of exceptional national prominence and credibility. These are two individuals who by their life's work could be expected to be the most competent of fiduciaries (and may well have been in this case, the article notwithstanding).

One is former U.S. Secretary of State George Shultz, an enormously respected adviser who has dedicated much of his life to Cabinet-level public service. The other is the former chief of naval operations, Adm. Gary Roughead. These are serious people who have dedicated their lives to public service.

When such credible and capable individuals can be publicly criticized for lack of attentiveness, it's reasonable to expect a ripple effect in the boardroom. The typical director can be excused for having some concerns about his or her liability exposure. “If this kind of guy can't do the job,” a director may think, “how can I be expected to do it?”

And that's a concern that should not go unaddressed, for the sake of both board effectiveness and director retention. The Theranos story could serve as a useful teaching moment that an attentive general counsel can use to bridge the "confusion gap" and give the board an understanding of what might reasonably constitute a red flag that requires some form of response.

Step one is for the general counsel to review the basics: namely, that the oversight obligation requires the board to have a thorough knowledge of corporate affairs. The board is not expected to ferret out corporate wrongdoing or risk, absent a particular warning sign that a cause for suspicion exists. Board action is not required until it is presented with extraordinary facts or circumstances. But when it is, that's the point at which the board has a known duty to act, and must do so proactively. 

But here's the rub: There's no one-size-fits-all legally binding definition of "red flag" that a director can keep in his or her pocket and periodically refer to in times of controversy. So the general counsel who aims to guide directors might start with a hypothetical involving something that, on its own, is innocuous, but when combined with other information of which the board is already aware, would require an immediate board response. In other words, a red flag is more than just bad news. It's the kind of thing that would make a director want to raise his or her hand high, and hold it there until an adequate answer is provided.

If this is not clear enough, the general counsel can then offer examples of what courts – including those outside of Delaware – have found to constitute red flags. And those fall within a wide range of circumstances, including but not limited to financial discrepancies, governmental inquiries, credible whistleblower reports, serious conflicts of interest, sudden executive departures, notable swings in operational results and unusual executive conduct. And it can include omissions as well as commissions, such as the continuing failure to recruit top talent; persistent director absences at board meetings; notable departures from traditional quality of management reporting; excessive qualifications in legal or accounting opinions; etc.

The general counsel could also offer examples of what courts have found to be proper board responses to red flags. The GC’s goal is not to deliver an all-inclusive list of red flags to which directors can refer in times of trouble. It’s to provide value by sketching, in practical and understandable terms, the contours of a warning sign. You want them to be comfortable that they'll know it when they see it. And that can't help but contribute to the effectiveness of a director's oversight duties, even if the director isn't a former Cabinet officer or a renowned military leader.