Risk Management—Archived Article

Risk Control

August 2005

Once the directors' and officers' risks of loss have been identified, existing corporate policies and procedures must be evaluated to determine the extent of protection afforded against those risks. If necessary, changes in those policies and procedures should then be made to eliminate or reduce any remaining risks.

A brief discussion of several areas where D&O risk management practices should be applied is provided below. Also included are specific recommendations for reducing or eliminating some of the D&O liability exposure. At the end of the discussion, a checklist is provided which the reader may find useful in evaluating the corporation's current D&O risk management efforts and designing a more effective risk management program.

Managing Corporate Risk Management Policies and Procedures

Many D&O claims arise out of ignorance. This problem may be the result of inappropriate or outdated company policies and procedures or from those policies and procedures not being properly communicated to the board of directors. Because the board of directors has the ultimate responsibility for protecting the corporation's assets and managing its financial resources, it must ensure the corporation establishes a coherent risk management program along with clear guidelines for its implementation.

Clear written policies and procedures should be available for the purpose of resolving problems quickly. Even if a formal corporate policy manual exists, the contents of the manual must be periodically evaluated, revised and communicated to those who may be held liable for violations of those policies or procedures.

The risk management policies and procedures that the directors and officers must be knowledgeable about include the following:

·   Corporate charter and bylaw provisions

·   Channels of communication between the board and top management

·   The corporation's method of identifying risks and the systems in place to manage those risks

·   Corporate provisions for indemnification of directors and officers

·   Guidelines and procedures as respects selection, education, duties and monitoring of directors

·   Existing systems for the control of management information and records retention

·   Coverage provided by directors and officers liability insurance

Compliance with Corporate Charter and Bylaw Provisions

All corporations, whether for-profit or not-for-profit, are governed by the statutes of the state of incorporation, as well as the organization's own charter and bylaws. Black's Law Dictionary (6th Ed., 1991) defines “Charter” as “an instrument emanating from the sovereign power…to a corporation…assuring to them certain rights.” A charter is an act of a legislature creating a business corporation, or creating and defining the franchise of a corporation and is usually granted the state secretary of state. In most states, corporations have the authority to formulate reasonable rules and regulations to govern its actions and affairs, so long as those rules and regulations do not conflict with state or federal laws or the company's articles of incorporation. According to Black's Law Dictionary (ibid), the articles of incorporation contain information prescribed in the state's general incorporation statutes and serve as the basis for the state's issuance of a certificate of incorporation. While the specifics contained in the articles of incorporation can vary from state to state, they usually include a general description of the corporation, the corporate name, intended duration of the corporation, the purpose for which the corporation was formed, powers of the corporation, classes and authorized number of shares of stock, the number and term of founding board members, and other conditions of the company's operation.

A corporation's bylaws are the rules and regulations that are adopted by a corporation for its internal governance. Common bylaw provisions include:

·   Defining the rights and obligations of various officers, persons or groups within the corporate structure, including fiduciary responsibilities;

·   Describing officer positions and how officers are selected or elected;

·   Requiring the establishment of certain committees;

·   Setting forth the times and locations for various meetings affecting corporate activities, including regular board and shareholder meetings and quorum requirements;

·   Guidelines and procedures for indemnification of directors and officers;

·   The nature of business to be discussed at board meetings;

·   Voting and proxy provisions;

·   Procedures for filling board vacancies, resignation and removal of board members; and

·   The nature of the corporation's books and records, including how such records are to be prepared and maintained and who is responsible for preparation and maintenance.

Nonprofit corporations, while usually subject to many of the same general requirements as for-profit corporations, also may be subject to additional or different laws and regulations that govern the operations of the organization and the conduct of its board of directors.

It is the board's responsibility to ensure the company complies with the corporation's charter and bylaw provisions and that appropriate systems are in place to maintain that compliance.

Corporate Indemnification

Directors should be fully aware of, and understand, the nature and extent of any corporate indemnification that may potentially be available. The promise of indemnity can exist in the form of charter provision, a separate agreement with the corporation, or an adopted bylaw. Also see the “Other Protections Against Personal Liability” section.

The laws of the state of incorporation should be reviewed carefully to determine what, if any, affirmative action is required of the board of directors or shareholders in order to implement a limitation of liability, including indemnification of the directors and officers. If corporate action is required to obtain a statutory immunity from personal liability, directors should make sure the corporation takes the necessary steps. Where shareholder approval is required in order to adopt liability limiting provisions, a full disclosure must be made to the shareholders as to the effects of adopting such provisions.

Comprehensive indemnification provisions may:

·   Require, rather than permit the corporation to indemnify its directors and officers;

·   Require the advancement of legal defense costs, subject only to an unsecured obligation to repay the expenses if a court subsequently determines the indemnification was not permitted;

·   Require the corporation to prove that the director or officer is not entitled to the requested indemnification;

·   Require the corporation to reimburse the director and officer for any expenses incurred in a claim against the corporation for such indemnification if the director or officer is successful in whole or in part;

·   Give the director or officer the right to an appeal as to indemnification entitlement;

·   State that the indemnification right constitutes a contract, is intended to be retroactive to events occurring prior to its adoption and shall continue to exist after the rescission or restrictive modification of the provision with respect to events occurring prior to that rescission or modification; and

·   State that any director or officer who serves a subsidiary of the corporation or any employee benefit plan of the corporation or such subsidiary is deemed to be providing such service at the request of the corporation.

To avoid any argument that an expanded indemnification provision is unlawful or excessive, the corporation may obtain shareholder approval of the indemnification provision even if such approval is not required by law. It should be noted, however, that the Securities and Exchange Commission (SEC) considers indemnity for liabilities under securities laws to be contrary to public policy.

Keep in mind, too, that the protective features of even the most favorable indemnification provisions exist only to the extent that the corporation is financially able to provide the indemnification. A bankrupt or insolvent corporation may leave individual directors and offices with little or no protection regardless of what the corporation has promised to do.

Selection of Directors

Corporation bylaws usually prescribe the size and constituency of the board of directors. If the organization is to survive and flourish, effective director selection criteria must be established and observed. Desirable personal qualities of board members may include but are not limited to the following:

·   Appropriate intellect to comprehend problems facing the corporation

·   Awareness of the business and social environment in which the corporation operates, as well as the directors' obligation to protect shareholder interests by seeing that the corporation operates profitably

·   The ability to be a collaborative member of the directors' team and where warranted supportive of management, yet an inquiring and independent mind to question management's assumptions

·   Integrity, experience, good business judgment and an understanding of business fundamentals (finance, law, marketing, accounting, investments, etc.)

·   The ability to make decisions

·   The time to devote the necessary energies to the required job

A majority of board members should be from industries unrelated to the corporation's business and should have no personal interest in the corporation or any connection with significant shareholders. Obviously, major customers, suppliers, and competitors should not be asked to serve on the board to avoid a potential conflict of interest situation.

Education and Training

Unless the directors and officers receive education and training in the corporation's policies, rules and procedures, they should not be expected to miraculously know what they are. Initial and ongoing education and training makes the directors and officers better able to detect and prevent wrongful acts before they become a problem. In addition, a full and complete flow of information from management to board members is vital if the board is to make informed decisions. Board members therefore must have complete access to senior management. Conversely, management must feel free to properly disclose pertinent information about the company's policies, procedures and activities to board members.

An orientation should be provided for all new directors that includes a detailed description of the organization, the general and specific duties required of directors by applicable state and federal laws and an introduction to corporate management personnel. The orientation should also include making directors aware of any potential conflicts of interest between them and others with whom the corporation does business or as respects matters under consideration by the board.

Board members should also be required to continue their education as respects the company's operations and policies. Such education is particularly important for boards of corporations who issue securities or who may be subject to takeover actions.

Specific Duties of Directors

In addition to being aware of their statutory and corporate obligations to the corporation, directors should be aware of their specific duties as directors. Among the duties commonly required of board members by the states are:

·   Attend board meetings

·   Elect directors and officers of the company

·   Authorize important corporate actions

·   Provide advice and counsel to management, especially the CEO

·   Establish effective auditing procedures so that the board will be adequately informed of the corporation's financial status

·   Review corporate operations, including investments, at regular intervals to ensure compliance with all applicable provisions of the laws governing the operation of the organization

·   Monitor management's performance by setting objectives and measuring results against those objectives

Prospective board members must be aware of exactly what is expected of them. Generally, directors must keep up with the corporation's business activities on an ongoing basis, not just be updated at regular board meetings. They should be required to do, and document, sometimes extensive research before making decisions and should not blindly rely on corporate records, such as management memos, opinion letters, etc. In fulfilling their requirement of due diligence, board members should question information obtained from outside sources and make sure that any reports upon which decisions are based are adequate.

To limit their personal liability, directors should formally dissent, rather than simply abstain from voting as respects any board action that they feel is inappropriate. Most state corporation laws require a director to formally register a dissent from any resolution if he or she is not convinced that the proposed action is in the best interests of the corporation. Such dissent can be documented by the notation of such dissent in the board meeting minutes. Unless a dissent is formally recorded, however, many courts presume the director concurred with the resolution and may hold the director personally liable for any action taken by the board or the corporation.

If a potential conflict of interest exists as respects a particular director and the action being considered by the board, that director should refrain from voting on the issue and should be excused from any board discussion involving the proposed transaction. If the director must unavoidably participate in the discussion or in the decision, full disclosure of the conflict must be made not only to other persons involved in the decision-making process, but also to shareholders when appropriate.

In addition to the duties discussed above, directors also may have other duties prescribed by the corporate bylaws, such as:

·   Periodic assessment of the company's management, including adequacy of internal accounting controls;

·   Taking action to minimize potential exposures to liability as evidenced by past experience and problems faced by others in the same industry;

·   Preventing criminal conduct by employees, management, or individual directors by establishing guidelines and compliance standards;

·   Establishing and enforcing disciplinary programs by responding appropriately to any offense and taking steps to prevent reoccurrence; and

·   Reviewing the adequacy of employee benefit and compensation programs, including compliance with ERISA regulations.

The responsibilities of directors should be reviewed periodically and clearly communicated to ensure each director's compliance with corporate objectives and with state and federal laws governing the conduct of the board.

Although it may be easy to tell board members what they are required to do, it is somewhat more difficult to tell them how to do what is required. Additional guidelines for directors and information on how they can best perform their duties may be found in The Corporate Director's Guidebook. The Corporate Director's Guidebook is available at nominal cost from the American Bar Association. For information, call the ABA 's publication department at (312) 988-5000.

Board Committees

All state statutes allow for committees to be appointed by the corporation's board of directors. While an executive committee is specifically referred to in many state statutes, other committees also may be referred to. The three additional committees most often considered critical to the board's operations are an audit committee, a compensation committee and a nominating committee. State law also governs the delegation of board powers to committees; hence, the powers of each committee must be considered in the light of the particular state statutes under which the corporation exists. As a general rule, however, all such statutes will be interpreted to allow directors the right to rely on committee reports, unless they have knowledge that makes such reliance unwarranted.

The committees most commonly referred to in corporate bylaws are:

·   An executive committee that exercises some of the powers of the board of directors to ensure continuous supervision of management when the board is not in session. Some states permit the committee to exercise all of the boards powers as provided in the corporation's governing documents or other board resolutions, subject to restrictions that vary by state. The executive committee is typically composed of both directors and executive officers of the corporation.

·   An audit committee that is usually composed of three or four directors and serves as a liaison between the board, the corporation's independent auditors and shareholders. The audit committee reviews, monitors and provides recommendations as respects the corporation's internal financial data and controls.

·   A nominating committee that recommends qualified candidates for the board of directors. The nominating committee also may establish criteria for board membership, set the term of directorship and determine a mandatory retirement age for board members.

·   A compensation committee that reviews and approves the compensation of senior executives and board members. Compensation may include salaries, bonuses, stock options or other benefits.

Because of the increasing complexities of the matters board members must understand, discuss and decide upon, additional committees may be needed to address specific problems or concerns of the corporation. Examples of such additional committees are a public relations committee, a securities committee and a risk management committee.

Committees need not be composed solely of board members. Rather, where appropriate, outside experts or professionals should be included on board committees. In addition, board members should be periodically rotated between committees to broaden their experience and understanding of the organization. If a director has special qualifications in a particular area, that person could be retained on a committee for a longer period than directors without special qualifications.

Conduct of Board Meetings

Corporate bylaws usually contain provisions relating to the notice, conduct and recording of regular and special meetings of the board of directors, board committees and shareholders. Meetings should be scheduled on a regular basis and as frequently as prescribed in the bylaws or as deemed necessary.

Directors and committee members should be given an agenda and any relevant materials and information at least a week or two prior to each board meeting. Where specific board action is to be discussed, directors should be provided with written reports or memoranda describing the subject action and that set forth management's recommendations and the reasons therefore. Copies of documents such as merger agreements, contracts, letters of intent, and an executive summary of particularly long or complex reports from outside advisors should also be provided in advance of the meeting.

Ample time should be set aside at the meeting for both informal and formal discussion of the agenda. Because unchallenged reliance upon management's recommendations may subject directors to personal liability, board members should have the opportunity to actively question and challenge management and outside advisors in connections with transactions under consideration. Company officers, other key management personnel or legal counsel should be invited to attend the meeting when necessary.

Accurate and complete minutes of all board and committee meetings should be taken and retained. The minutes should describe the matters discussed and the authorities relied upon in reaching the board's decision. The minutes should clearly and concisely set forth exactly what action occurred during the meeting, including any limitations placed on the action taken or authority granted and any decision not to act. If a vote is taken, a dissenting director must affirmatively vote against a proposal if a legal defense based upon such dissent is to be established. Any documents referred to at the meeting should be described in or attached to the minutes. The minutes should then be reviewed prior to finalization by both the directors and by legal counsel.

All documents prepared by or relating to directors and officers should be prepared with the expectation that they will be closely scrutinized in the future for evidence of wrongdoing. Imprecise wording, inflammatory, vulgar or ambiguous language should be avoided.

Document Retention

Both the corporation and individual directors and officers should establish a document retention program. Typically retained documents include minutes of board and committee meetings, information related to issues and actions considered by the board, financial reports, etc. Retained documents should be periodically reviewed to determine which should continue to be retained and which may be destroyed. The determination of whether to retain a document should be made in light of state document retention laws, evidentiary rules that may apply, the degree to which the documents are superfluous or unnecessary, and the possibility that the documents may be misconstrued or confusing. If there is doubt, the document should be retained.

Managing Takeover and Acquisition Related Issues

Directors and officers may have an inherent conflict of interest in any potential takeover situation, whether such takeover is hostile or friendly. A takeover is the assumption of control or management of a company (called the “target”) by an outside corporation or group (called the “aggressor.”) Takeover attempts may involve the purchase of shares, a tender offer, a sale of assets or a proposal that the target company merge voluntarily with the aggressor company. As respects takeovers, the terms “hostile” or “friendly” describe whether the takeover is opposed or not opposed by the target company. Directors and officers may have at least the perceived self-interest of remaining in office and the desire to prevent an outsider from obtaining control of “their” corporation. In addition, employees who lose their jobs following a takeover or shareholders who find their share value is declining may sue the directors alleging that the board took improper action.

Directors must exercise great care and caution when evaluating and responding to any potential takeover. Directors should seek input from qualified experts to ensure that all areas of concern have been evaluated before taking action to defend against or accept a takeover bid. Legal counsel, investment bankers and other financial advisors should be consulted as necessary before any final response to the bidder.

If a group of management personnel is bidding for the company, the process must be handled in an especially evenhanded manner to avoid charges that the management group received preferential treatment. Outside opinions should be secured regarding both antitrust implications as well as the assessment of the fair market value of the organization's stock.

If the board considers acquisition of another company, employees and shareholders may again be concerned. Employees may lose their jobs and shareholders may find their investment declining in value if the acquisition does not achieve the anticipated financial results or if the corporation's assets are drained beyond repair. Once again, directors must exercise due diligence when evaluating a potential acquisition and should make use of qualified experts to ensure that all areas of concern have been evaluated before taking action.

Managing the Securities Exposure

It is important for directors to know when the company is actually dealing with transactions subject to requirements of state and federal securities laws. Because the courts are inconsistent in their application of securities laws, directors should not assume the transaction is too small or personal to attract SEC notice. Information disclosure, analyst communications, insider trading and periodic reporting requirements are all areas of concern that must be carefully addressed by the board of directors and the corporation's management. Clear guidelines and procedures for communicating with shareholders, governmental regulatory agencies and other parties that deal with the corporation are essential.

Information Disclosure

Liability for violation of federal securities laws governing information disclosure represents one of the greatest areas of exposure for directors and officers. The corporation should have well defined and well understood assignment of responsibilities with respect to securities laws and various disclosure issues. Top management should be involved in even routine communications to make sure that all “important factors” are “meaningfully” disclosed. Directors should personally review all important securities filings and disclosure statements and assure themselves that the corporation has taken reasonable steps to accurately and completely disclose all relevant material information. If the board of directors has established a securities committee, that committee should review all filings made to the Securities and Exchange Commission.

Institutional investors must be kept informed of and comfortable with the company's disclosure practices, as well as notified of significant developments. Care must be taken not to provide the selective disclosure of material non-public information, because such disclosure could be interpreted as illegal “tipping.”

The board should determine if the process of preparing, publicizing and issuing registration and offering materials complies with SEC requirements. All information must be truthful and properly presented, and any restrictions on offers prior to effective registrations must be carefully followed. The board should monitor carefully any statements or other activities that could be construed as an offer to sell the securities prior to the effective date of registrations. Since publicity of the offering is prohibited until the offering is registered, such publicity (advertising, press releases, etc.) should be avoided.

The board also should review carefully all materials associated with a potential or actual proxy solicitation for accuracy and completeness to make sure they comply with procedural requirements of securities laws and SEC regulations. Pending registration statements or prospectuses should be periodically updated to avoid misrepresentation and to make sure no material facts are omitted or misstated.

Companies also should make sure that all written and oral forward-looking statements include the statute-required information disclosure. Such disclosure can allow the company to qualify for safe harbor protection under the Private Securities Litigation Reform Act of 1995, even if the plaintiff alleges the company had actual knowledge of the falsity of any statements made.

In addition, The Sarbanes-Oxley Act of 2002 requires certification by the company's Chief Executive Officer (CEO) and Chief Financial Officer (CFO) of the accuracy of all company financial statements filed with the SEC after July 30, 2002, imposes strict guidelines as respects disclosure of insider trading, and mandates disclosure of off-balance sheet transactions and adjustments to financial reports. See the discussion of the Sarbanes-Oxley Act of 2002, in the Introduction for more information.

Analyst Communications

Many large stock brokerages and financial managers employ securities analysts to track, report on and forecast a company's stock performance. Companies frequently comment on such analyst's reports in their own annual reports, or in other published materials describing the company's financial status. When a company comments on an analyst's projections, those projections may become attributable to the company under federal securities laws. In a lawsuit, the plaintiff may argue that company officials knew, but failed to disclose, that performance would not meet the analyst's expectations and thus defrauded the market. Issues related to Initial public Offerings (IPOs) are discussed in more detail in the “Introduction” section.

The safest response to a securities analyst's inquiry is for the company to simply decline to release internal projections or not to comment at all on the analyst's projections. If the company chooses to release projections or comment on an analyst's projections, however, the following steps should be taken to help reduce the likelihood of securities fraud allegations:

·   In conjunction with the release or discussion of any estimates or projections, disclose any adverse risks, trends or uncertainties that might have a negative impact on expectations. This practice is sometimes referred to as “defensive disclosure.” “Defensive disclosure” is the strategy of communicating the known factors that might cause actual results to vary from projections. Factors affecting estimates or projections might include competitive or technological forces that could affect revenue, the uncertain needs of key customers, or anticipated regulatory or accounting changes that might affect the business or its financial results.

·   Have a sound basis for, and document, all comments or disclosures made. The documentation should include contrary opinions within the company as well as why the opinions were rejected.

·   Retain a copy of all documents released to analysts, as well as transcripts of all statements given or comments made. Such copies help avoid ambiguity over what information was actually communicated.

·   Prepare and release updated or revised projections as soon as previously published comments are no longer consistent with projections.

Insider Trading

A company's directors or officers may sell personal holdings in company securities or pass material non-public information to outsiders who subsequently sell their stock. If such sales precede a price drop, class-action plaintiffs may allege that the insider trading or tipping is proof that the company and its directors or officers intended to defraud investors. Even if the allegations are eventually disproved, the fact that insider trading or tipping may have occurred could prevent early dismissal of the lawsuit and instead result in expensive and protracted litigation.

Reasonable safeguards should be implemented and monitored to protect against the misuse of confidential information. Employees who have access to confidential information should be given a policy statement informing them of their obligation to safeguard that information and instructing them not to trade on the basis of the information. Availability of material non-public information should be limited only to those persons who need to know the information in order to participate in relevant discussions.

Documents containing confidential information should be carefully maintained and not left in plain sight for others to read. When draft documents must be given to others for typing, printing, etc., code names should be used to protect the identity of parties to the transaction.

A comprehensive insider trading policy with detailed procedures regarding trading in the company's stock should be adopted. At a minimum, the policy should incorporate the following elements:

·   A prohibition of any trading in the company's securities by insiders who are in possession of material non-public corporate information;

·   A central authority or compliance committee within senior management established for the purpose of monitoring insider-trading of company securities;

·   Clearly defined “trading windows,” periods when trading is permitted by insiders who are not in possession of material non-public information and who have obtained pre-trade approval by the designated internal authority; and

·   Clearly defined “blackout periods” during which all insider trading is strictly prohibited, such as immediately prior to and after the company's announcement of quarterly or annual results.

The policy also should conform to the provisions governing the conduct and disclose of insider trading as specified in the Sarbanes-Oxley Act of 2002. See the discussion of the Sarbanes-Oxley Act of 2002, later in this section, for more information.

Periodic Reporting

Persons within the company who are to be responsible for risk identification and disclosure as part of the company's periodic reporting process should be clearly identified in the reports. The reports should also include a separate “risk factor” section that contains a discussion of the risks, trends and uncertainties that the company faces. Factors a company may be required to disclose can include known uncertainties concerning future liquidity or credit; anticipated net sales, revenue or income declines; known changes in an important customer's orders; and known uncertainties surrounding new product development or release.

SEC filings and periodic reports are common vehicles for supplying meaningful disclosure as respects oral forward-looking statements. While SEC regulations have long required companies to disclose known risks, trends and uncertainties, few companies actually include such disclosure in their 10-K or 10-Q reports. Companies that want to have their oral forward-looking statements qualify for safe harbor protection under the Securities Reform Act should begin using the 10-Ks and 10-Qs to disclose the required information.

Complying with the Sarbanes-Oxley Act of 2002

The Sarbanes-Oxley Act of 2002 (“Act”) constitutes the most sweeping corporate governance legislation in decades. Although the Act does not create any new bases for civil lawsuits against directors and officers, it affects the legal environment in which D&Os must operate. The Act also offers directors and officers an opportunity to improve governance practices and to restore credibility in their company's financial and business disclosures.

The following are actions which D&Os should consider in response to various key provisions of the Act. By adopting and documenting these actions, companies can reduce the potential for litigation, can establish helpful evidence in defense of litigation and can potentially comfort D&O insurance underwriters in a difficult insurance market.

Develop procedures to support CEO/CFO certifications

The Act requires contemporaneous certification by the company's Chief Executive Officer (CEO) and Chief Financial Officer (CFO) of the accuracy of all company financial statements filed with the SEC after July 30, 2002. To ensure compliance with this provision:

•    Make sure the company's CEO and CFO receive drafts of all SEC reports with sufficient time to adequately review them before they are filed.

•    The CEO and CFO should both document their active involvement in revising and shaping such reports.

•    The CEO and CFO should consider delegating portions of the reporting process to appropriate subordinate individuals. These individuals should be given the responsibility to report, in writing, directly to the CEO or CFO, including the possible certification by that individual as to all facts and circumstances under that person's supervision that affect the applicable portion of the report.

•    The CEO and CFO should each retain independent financial and legal advisors (funded by the company) if significant issues arise regarding the content or accuracy of the certification or the due diligence related thereto.

•    The CEO and CFO should meet with the company's audit committee to allow for questions and answers on any issues that have come up during the report preparation, particularly questions about accounting practices and internal controls management.

Each CEO and CFO should maintain a comprehensive file containing all of the back-up information, reports and certifications relied upon in giving the CEO/CFO certification.

Take steps to timely report securities trading by company insiders

The Act requires insiders to disclose trading in the company's securities within two business days of the trade, and no longer allows insiders to defer certain transactions, such as qualifying stock option grants, in the company's securities. To ensure compliance with this provision, companies should:

·   Make sure the affected officers and directors have been given written material describing the revised reporting rules.

·   Review any automatic option grants to make certain the Act's provisions do not result in unintentional reporting violations.

·   Require “pre-clearance” of all insider trades with a specifically designated compliance officer.

·   Require insiders to conduct transactions with a single broker who is aware of the company's pre-clearance policies.

·   Have insiders grant the company a Power of Attorney to allow it to sign Section 16 reports on their behalf, giving the company the ability to quickly file such reports on their behalf.

·   Retain a complete list of insider EDGAR filing codes to allow for faster electronic filing.

·   Consider adopting a policy requiring all pre-established Rule 10b5-1 trading plans of its insiders be publicly disclosed. This is in anticipation of stricter disclosure requirements relating to such pre-established trading plans.

Develop guidelines for management and internal accounting staff to flag events or circumstances requiring immediate public disclosure

The Act requires a public company to disclose to the public, on a “rapid and current basis,” material changes in the company's financial condition or operations in accordance with specific rules to be developed and issued by the SEC. Until the SEC publishes regulations defining these new “real time” disclosure obligations, directors and officers should consider establishing a general policy on what items and events it considers to be “material” and therefore appropriate for immediate disclosure. These items and events include the following:

•    A specific list of events requiring disclosure. In this regard, it is good practice to examine the disclosure documents of similarly situated companies to determine how they are addressing common concerns. If other companies are disclosing a certain level of information, an implication may be created that such information is material and should be disclosed.

•   Categories of events to be brought to counsel and management's attention for determination of materiality. Dollar thresholds may be useful guides in some circumstances.

•    Items the SEC has indicated to be likely material, such as:

-    earnings information

-    new products or discoveries

-    changes in control or in management

-    calls of securities for redemption

-    adoption of repurchase plans

-    stock splits or changes in dividends or other changes to the rights of security holders

-    entering or terminating material agreements outside the ordinary course of business

-    terminating or reducing a material business relationship with a customer; or reaching a conclusion that security holders should no longer rely on the company's previously issued financial statements or any related audit report.

Determine if a conflict of interest exists sufficient to replace the company's independent auditor

The Act prohibits conflicts of interest between a company's independent auditor and certain of its executive officers. The Act also prohibits the same accounting firm from providing audit and non-audit services to public companies. To ensure compliance, public companies should:

•    Survey the company's directors and officers to determine if the accounting firm that currently serves as the company's independent auditor has previously employed any of them. Consider obtaining certifications from the accounting firm as deemed necessary.

•    Replace the company's independent auditor if the company's CEO, CFO, controller and/or chief accounting officer was previously employed by the independent auditor within the twelve months prior to the most recent audit year.

•    Consider replacing the independent auditor if any of the preceding individuals were employed by the independent auditor outside of this one-year period or if any other executive officer or a director has been employed by, or has a significant relationship with, the independent auditor.

•    Review all services that the company's independent auditor has provided to the company to determine if it has provided any non-audit services, including bookkeeping or accounting services; appraisal or valuation services, fairness opinions; actuarial services; internal audit outsourcing services; management or human resources functions, including compensation consulting; broker or dealer, investment adviser, or investment banking services; and legal services or other expert services unrelated to an audit. If so, consider whether to:

-    Appoint a new independent auditor and allow the existing firm to continue providing the non-audit services; or

-    Maintain the company's existing independent auditor and seek a separate accounting firm to provide it with the non-audit services.

Replace members of the company's audit committee who are not “independent” under the new SEC guidelines

The Act requires the Audit Committee to be composed entirely of independent directors. Public companies should:

•    Identify any member of the Audit Committee who has accepted any consulting, advisory or other compensatory fee from the company other than as a director.

•    Until the SEC adopts rules which further define “independence,” carefully consider whether any members of the Audit Committee have other relationships with the company that might call their independence into question.

•    Obtain resignations from directors who are not independent and appoint individuals to fill the resulting vacancies who qualify as independent.

Revise Audit Committee Charter

The Act imposes many additional requirements on a company's Audit Committee. By adopting the following requirements in an Audit Committee charter, the company can demonstrate its good faith attempt to comply with such rules. Such adoption also “institutionalizes” the new requirements into the audit review process.

•    Require pre-approval of all audit and non-audit services performed for the company by any accounting, auditing or other financial services company.

•    Require the audit committee to approve any transaction between an officer or director and the company, or any subsidiary or affiliate of the company, to ensure that such “related-party” transactions have been approved by an independent body as an “arm's-length” transaction that benefits the company.

•    Require independent auditors to report to the audit committee in writing all of the critical accounting policies to be used and all alternative treatments of financial information within GAAP that have been discussed with the company's management, including the treatment the independent auditor has recommended.

•    Provide the audit committee with the authority to directly appoint, supervise and compensate the company's independent auditors.

•    Require the audit committee to discuss annual and quarterly financial statements during one-on-one meetings with each of the company's auditors, management, internal accountants, and outside counsel.

•    Circulate a specific agenda for each meeting, prepare detailed records of each meeting, and consider having financial and legal advisors attend.

•    Require the review of any representation letter that management provides to the independent auditor.

•    Require periodic review of the company's risk management and risk assessment policies.

•    Establish procedures for the audit committee to receive, retain, investigate and respond to complaints relating to the company's accounting controls.

•    Establish procedures for the audit committee to receive submission of confidential and anonymous information about the company's financial controls from the company's employees.

•    Provide the audit committee with the authority and funds to engage independent counsel and other advisers regarding accounting or audit practices.

Take no action as a Board or as an individual director or officer that can be construed as interfering with the audit process

The Act prohibits any officer or director of a public company from fraudulently influencing, coercing, manipulating or misleading an independent auditor engaged in auditing the company. Directors and officers should therefore avoid any action that could be construed as an attempt to exert improper influence over the independent auditor, including:

•    ”Suggesting” to the company's independent auditors, either directly or indirectly, a “preferred” accounting treatment for any specific item or transaction;

•    Using the incentive of additional or increased use by the company of the independent auditor's services to induce the independent auditor to utilize a “preferred” accounting method in the company's financial audit; or

•    Providing any information to an independent auditor that is false or misleading in order to achieve a specific accounting result.

Determine if any member of the audit committee is a financial expert and if not, consider appointing one

The Act requires the SEC to adopt rules which will require that a company to disclose in its Exchange Act reports whether it has a “financial expert” serving on the company's audit committee, and if not, why. In anticipation of these rules, the following actions are recommended:

•    Determine if any of the audit committee members qualify as a “financial expert” based on (1) their understanding of GAAP and financial statements; (2) experience in preparing or auditing financial statements of similar companies and applying such principles in connection with accounting for estimates, accruals, and reserves; (3) experience with internal accounting controls; and (4) understanding of audit committee functions.

•    Appoint at least one financial expert if none is currently serving on the audit committee.

•    Require all members of the audit committee to possess a defined minimum level of financial skills.

Disclose all material off-balance sheet transactions and any material correcting adjustments

The Act requires disclosure of off-balance sheet transactions and accounting adjustments. It also directs the SEC to adopt specific requirements for the presentation of pro forma financial statements. Companies should therefore do the following:

•    Inform directors and officers of the need to disclose in the company's periodic Exchange Act reports whether the company has any off-balance sheet transactions, arrangements, obligations (including contingent obligations) or other relationships with unconsolidated entities or other persons that may have a material current or future effect on financial condition, changes in financial condition, results of operation, liquidity, capital expenditures or resources.

•    Inform directors and officers of the need to disclose in the company's periodic Exchange Act reports whether the independent auditor has informed the company of any material correcting adjustments in accordance with GAAP and the SEC rules.

•    Implement procedures to “flag” these types of transactions for review on an ongoing basis.

Ensure the directors and officers do not receive any impermissible extensions of credit from the company

The Act prohibits a public company from entering into certain credit arrangements with its directors and officers or otherwise renewing, extending or modifying the terms of any credit arrangement in place before July 3, 2002. It is recommended that companies do the following to ensure compliance:

•    Adopt and circulate to directors, officers and appropriate personnel clear policies and procedures that define and prohibit the proscribed extensions of credit.

•    Extend the credit ban to “arranging” or otherwise assisting the directors and officers in obtaining credit from unrelated third parties, family members and affiliates of directors and officers, as well as the providing of travel advances and use of company-supported credit cards “personal” uses.

•    Identify all outstanding loans or other extensions of credit made by the company or a company subsidiary to any officer or director. Establish procedures to prevent any modifications to existing credit agreements or further extensions of credit, even if future advances were contemplated by the original arrangement.

•    Do not forgive loans previously made to directors and officers without careful consideration whether such forgiveness will be viewed as a “modification” of an existing credit arrangement.

•    Review for compliance with the new rules any arrangements with directors or officers that have credit-like features, such as cashless exercise of stock options or procedures in stock option plans for loans to purchase option shares.

Review the company's document retention plan and revise if necessary

The Act prohibits document destruction in connection with a federal inquiry or investigation. Compliance with an appropriate pre-established document retention plan may be useful evidence to support an affirmative defense against a charge of improper document destruction. The following key points should be kept in mind when creating and maintaining a records retention policy:

•    Policies should be applied uniformly.

•    There must be legitimate reasons for the policy and a rationale for the way documents are slated for destruction.

•    Policies should take into account any administrative or regulatory record-keeping requirements.

•    Policies should not be adopted in bad faith or with the primary purpose to avoid preserving potential evidence.

•    When litigation is reasonably foreseeable, the policy should prohibit the destruction of potentially relevant documents even if the documents would otherwise be destroyed. Adequate safeguards should exist to assure documents are not inadvertently destroyed under those circumstances.

Some financial observers believe that, at least initially, the new rules may lead to more civil and criminal shareholder lawsuits and larger settlements involving public companies. In some cases, plaintiffs' attorneys may argue that the company failed to implement the new rules. In other cases, the attorneys may allege that the rules were improperly implemented, thereby resulting in the misstatement of company financial reports.

Coverage Issues

The insurance brokerage industry is divided regarding the effect of the new rules on D&O coverage for the activities of individual audit committee members. Some brokers are confident that most standard D&O policies already cover the added exposure, citing the fact that such policies usually contain severability clauses that state the wrongful acts of one insured cannot be imputed to another insured. Thus, if one audit committee member violates the new rules, coverage is still available for the other directors and committee members.

Other brokers, however, feel that policy severability is a moot issue because, under the new rules, all audit committee members must sign off on the company's financials. This may mean that any fraudulent misstatement in the financials will be attributed to all committee members even if some members were unaware of the erroneous information.

Policy Rescission Issues

Whether the new audit committee rules will result in more instances of policy rescission also is the subject of debate. “Rescission” means the voiding of the policy as of inception, with the result being that the policy is deemed to have never existed. Most D&O policies allow the insurer to rescind the policy or reject a claim if there is a material misrepresentation in the initial coverage application. If the audit committee recommends restatement of the company's financials, some brokers believe such restatement could make underwriters question the accuracy of financials that were provided with the initial coverage application. If underwriters are sufficiently uncomfortable with the restatement, they could attempt to rescind the policy.

Other brokers disagree, claiming that policy rescissions have declined in recent years and that the earnings restatement exposure is covered since there is no specific financial restatement exclusion in most standard D&O policies.

Because of the potential for bad-faith litigation, policy rescission is relatively rare and usually only a last resort for insurers. However, insureds concerned about the impact of the new rules on traditional D&O coverage for audit committees and the potential for policy rescission may wish to consider the purchase of supplemental coverage. At least one major broker is promoting an Audit Committee Liability Insurance policy that has been developed to specifically address the potentially heightened exposure of audit committee members. The policy provides non-cancelable coverage, applies if an existing D&O policy is cancelled or rescinded, and is intended to fill gaps in the underlying D&O policy.

The need for separate audit committee liability coverage is probably low for larger, Fortune 1,000 companies. Such companies typically have well-established governance procedures and are very familiar with the intricacies of D&O insurance coverage. But smaller companies may not have such sophisticated governance procedures in place and may be more vulnerable to coverage gaps or rescission because of their limited experience with D&O coverage.

Protection for Insureds

There are several measures that can be taken by public companies concerned about a gap in coverage or the possibility of D&O policy rescission. These measures, which may both help companies comply with the new rules and provide documentation needed to defend potential lawsuits, include, but are not limited to, the following:

•    Becoming informed about the new rules affecting audit committees and making sure that the committee is composed of the required number of financially literate independent directors.

•    Carefully documenting the process of selecting audit committee members.

•    Carefully drafting the audit committee's charter to accurately reflect the actual practices and responsibilities of the committee.

•    Closely monitoring the conduct of the audit committee and its members by the board of directors to ensure compliance with the new rules.

•    Reviewing existing D&O insurance to determine the scope of policy exclusions and the adequacy of the policy's severability provisions. It is important that the policy protects those board members who act in good faith. If the severability provisions are unclear or considered insufficiently broad, an attempt should be made to clarify the insurer's intent and to broaden the provisions by endorsement.

•    Considering purchase of additional coverage limits or coverage from a different insurer. An Audit Committee Liability policy or change of insurer may be required if the existing D&O policy's severability provisions are unfavorable and cannot be modified.

At a minimum, public companies should ask their broker or D&O insurer how the new rules affect existing coverage for innocent audit committee members if a lawsuit alleges fraudulent misstatement of earnings. Some brokers have suggested that such exposure may be now precluded, although the response may vary by insurer. If the broker or insurer confirms coverage, such confirmation should be obtained in writing.

By providing specific guidelines and procedures, the new rules should help ensure public companies take the necessary measures to prevent misstatement of financials and the resulting deception of investors. The actual effect of the new rules, however, remains to be seen.

Managing the Audit Committee Exposure

Previous audit committee rules were revised in 2000 and 2001 and the new rules have been adopted by the National Association of Securities Dealers and the Accounting Standards Boards. These new rules specify the responsibilities of audit committee members, prescribe qualification guidelines for those serving on audit panels, delineate audit committee functions, and require that corporate auditor reports be accompanied by written statements of approval by audit committee members.

Under the rules, audit committees must be made up of at least three (rather than the previous two) independent directors who are “financially literate.” The term “financially literate” means being able to read and understand financial statements. In addition, companies listed on the AMEX or NASDAQ must have at least one audit committee member with employment experience in finance or accounting, a professional certification in accounting, or comparable experience or background. The committee must provide details of all discussions held with outside auditors and must warrant that the company's financial statements have been discussed with management.

The new rules also require companies to have a written charter for their audit committee. (The NYSE continues to allow public companies with less than $25 million in revenue and market capitalization to have only two audit committee members, one of whom must be independent.) The charter must set forth the committee's structure and responsibilities as well as the procedure for submitting its reports to the board and, if necessary, replacing outside auditors.

Additionally, the Sarbanes-Oxley Act of 2002 created specific new requirements regarding the composition, responsibilities, and procedures of audit committees. Under the Act, audit committees must:

·   be directly responsible for the engagement and oversight of the corporation's auditors, including resolution of disagreements between management and auditors regarding financial reporting;

·   establish procedures for receiving and dealing with complaints and confidential, anonymous submissions by employees regarding accounting, internal controls, or auditing matters;

·   approve, in advance, all non-audit services (except certain specified “de minimis” services) provided by the corporation's independent auditors; and

·   receive reports directly from the corporation's auditors on issues related to the audit, such as alternative treatments of financial information under generally accepted accounting principles that were discussed with management and the treatment preferred by the auditors.

The Sarbanes-Oxley Act thus places a substantial burden on audit committee members to oversee the corporation's auditors, resolve conflicts between auditors and management, and deal with complaints or concerns about the corporation's accounting practices. Additional information about this is contained in the section on the Sarbanes-Oxley Act of 2002 in the “Introduction” section.

Managing the Outside Directorship Liability Exposure

When a corporation's directors and officers also serve as directors for outside entities, these shared relationships may create a significant exposure for the corporation. Outside directors often are targeted as “deep pockets” when there are insufficient corporate or individual assets to satisfy a judgment against the entity's “inside” directors and officers. It is therefore important to identify the outside entities to which the corporation's directors and officers belong.

Because outside directors owe the same fiduciary duties to the corporation and its shareholders as do inside directors, outside directors should be instructed not to attempt to substitute their judgment for the judgment of the entity's inside directors, nor should they constantly oppose the decisions of the entity's managers. However, to best protect their own individual liability, outside directors should be committed to act in the best interests of the corporation and its shareholders.

Outside-directorship positions often are with entities that have common business interests or other dealings with the corporation that has requested the outside-director service. These situations can be particularly problematic because of potential dual-loyalty conflict issues, such as those related to intercorporate transactions, maintaining confidences, and misuse of corporate opportunity. In addition, potential antitrust issues can result, particularly if the outside directorship is with an actual or potential competitor of the requesting corporation.

Outside directorship positions should be specifically evaluated and approved by a designated committee or person based on well-defined criteria so that the director or officer will qualify for corporate indemnification. The corporation's D&O insurance policies also should be reviewed to determine the extent of available coverage for outside-directorship liability. Some insurers do not provide any type of outside-directorship coverage; others provide this type of coverage only on an excess basis with specific qualifications or restrictions. When the coverage is provided by the D&O policy, it may apply either as double excess (i.e., the coverage applies excess of [1] the outside entity's indemnification, and [2] insurance), or as triple excess (i.e., the coverage applies excess of [1] the outside entity's indemnification, [2] insurance, and [3] excess to the requesting corporation's indemnification). Further, outside-directorship-liability coverage may apply subject to a limit of liability either included in, separate from, or as a sublimit of the policy's full limit of liability. In order to avoid potential defense and loss payment allocation issues, the language of the other-insurance clauses in both policies should be examined closely and modified where necessary to clarify that the outside entity's policy pays first.

Managing the Employee Benefits Exposure

A particularly sensitive area of potential liability exists when directors or officers also serve as plan fiduciaries for corporate employee benefit plans. Such individuals may be subject to inherent conflicts of interest when balancing the sometimes competing interests of the corporation and plan participants. For example, decisions relating to the timing and method of the corporation's funding of the plans and the investment of plan assets in the corporation's securities present clear conflicts which must be addressed from the standpoint of both the corporation and the plan.

Whenever a potential conflict exists, it should be fully disclosed to legal counsel and, where appropriate, to some or all board members. Where necessary, an appropriate response should be developed, including disqualification of the person involved with the conflict from voting and discussion, disclosure to shareholders or other remedial action. Whenever doubt about a potential conflict exists, advice from legal counsel should be obtained.

Employment Practices Liability Loss Prevention

Although the frequency of employment-related claims has increased dramatically in recent years, one encouraging aspect is that both frequency and severity of loss can be controlled through various prevention techniques, including but not limited to:

•    Developing and implementing concise, written employment policies and procedures

•    Sexual harassment, employee-awareness, and diversity management training

•    Specific policy and procedure to avoid wrongful discharge suits

•    Settlement agreements and claim releases

•    Alternative dispute resolution: arbitration and mediation

The goal of each of these techniques is to prevent employees from bringing a formal claim of wrongdoing or lawsuit against the employer in the first place. But even when a claim of wrongdoing is not prevented by such measures, the existence of sound employment policies and procedures can be important evidence of the employer's commitment to its workforce. Such evidence may help absolve the employer of any wrongdoing or help to mitigate damages or punitive awards when a claim is found to be meritorious.

Written Procedures

In today's increasingly regulated business environment, it is more important than ever that employers have clear, well-considered, comprehensive written strategies for the prevention of employment practices liability claims. It is equally important to document the implementation of such procedures through training and education programs.

Interviewing, Pre-Employment Screening, and Testing

A sound strategy to avoid employment-related claims should begin even before an employer hires an employee. Federal labor laws and the labor laws of many states place strict limitations on the pre-employment inquiries that a prospective employer may make of a job applicant. Within these parameters, however, there is much that an employer can do to protect itself against possible employment practices claims.

Interview Dos and Don'ts

Anyone who conducts an employment interview should use a written interview guide. Such a guide should contain a detailed script for conducting the interview, including all of the questions that are needed to enable the interviewer to obtain a complete and accurate overview of the applicant's skills and experience. An interview guide assures that applicants are handled in such a way as to make comparisons between applicants both valid and reliable. Remember, however, that an interview guide is just that, a guide. Effective interviewing obviously requires flexibility. Interview questions need not be asked in the order shown in the guide, and some may even be omitted as an interview progresses. Digression from the interview guide, both in order to retain spontaneity and to pursue particular inquiries about a given applicant, are always appropriate.

A structured interview should cover the following basic areas:

•    Background information about the applicant

     •    Questions about job-related behavior (for example, the applicant is asked to describe what decisions and/or actions he or she has made in situations similar to those that will be encountered on the sought-after job)

     •    Follow-up questions (such as questions concerning information that may be missing from the application form)

     •    Questions about the applicant's education history

     •    Questions relating to specialized training and skills

     •    Questions about intangible factors such as the applicant's goals and attitudes

     •    A description of the job being interviewed

     •    A description of the next step in the interview/hiring process

The Employment Application

An employer's application form should notify applicants that any material misrepresentation or omission will be grounds for refusal to hire them. It also should be made clear to applicants that even if they are hired, any later discovered misrepresentations or omissions on their application may result in discharge.

The application should require complete disclosure of the applicant's educational and work history. A request for references should also be included on the application. Overstated or falsified job applications are an endemic problem for employers. Before an offer of employment is made, the employer should independently confirm the information provided by the applicant. It is particularly important that the employer question the applicant about any time gaps in his or her educational or work history. References should be called and background information sought before an offer of employment is extended. An employer that fails to carefully review an employment application and check references might subsequently be the target of a claim if it becomes necessary to terminate the employment relationship at a later date.

The employment application also should include a clear, concise statement that employment is “at-will.” At-will means that the employment relationship may be terminated at any time, by either the employer or the employee, without notice and for any reason that is not otherwise illegal. Many courts have held that an at-will statement contained in the application protects an employer against claims of wrongful termination or termination without good cause in breach of an implied contract of employment. An at-will statement does not, however, prevent an employee from claiming discriminatory discharge in violation of Title VII, the ADEA, the ADA , or some other federal or state anti-discrimination statute.

Reference and Background Checks

Recent surveys suggest that anywhere between 25 and 35 percent of job applicants lie, misrepresent, and/or omit material information from their employment applications. These misrepresentations and omissions may relate to an applicant's educational qualifications, work experience, or other relevant matters. Therefore, it is important that an employer check an applicant's references in order to confirm at least basic information about the dates of employment and positions held, attendance, and performance at various schools.

Of course, personal references usually will present a favorable picture of the applicant, but they should be checked anyway. Many applicants will list as references the most important people that they know. These people often are particularly frank and objective.

When attempting to elicit meaningful information from a personal reference, it may be helpful to ask about some weakness in the applicant that the employer has already independently discovered. Normally, this will result in either a confirmation or a detailed denial.

If a reference does raise concerns about an applicant who has been tentatively chosen for employment, the employer should not automatically disqualify the applicant. If the unfavorable information is inconsistent with the information gathered from other reference checks, it may suggest a biased or mistaken reference. At minimum, another interview should be scheduled with the applicant so that the negative information can be explored.

Drug and Alcohol Testing

An employer may elect to have applicants undergo drug and alcohol testing (if the applicant is applying for a job as a driver that is covered by regulations of the Department of Transportation, a pre-employment drug screen is required). This type of testing often is an effective technique for screening out potential employees who may prove problematic if hired. Drug and alcohol tests may be done in conjunction with a pre-employment physical or they may be required by employers that do not make use of such physical examinations. In either case, the drug and alcohol test should be administered only by a medical facility using state-of-the-art equipment, such as a gas chromotographer. If the applicant does not pass the drug and alcohol test, a sufficient sample should be maintained so that a second, confirming test can be performed.

Some states, however, restrict or prohibit such testing altogether, and under the federal Americans with Disabilities Act, such testing can be conducted only after a conditional offer of employment has been extended. The test then must be uniformly given to all persons who are hired for a particular position. An employer that implements a drug and alcohol testing program in violation of law, or that implements a poorly designed program, runs the risk of a claim of unlawful discrimination by an applicant who is denied employment because he or she refused to take the test or did not pass it. In some states an employer's demand that an applicant take such a test may be a violation of statutorily protected privacy rights, giving rise to yet another possible claim against the employer.

Job Offers

In order to avoid misunderstanding and potential claims, all job offers to applicants should be clear and unambiguous. Job offers should address (1) compensation and benefits, (2) relocation requirements and benefits, if any, (3) working hours, (4) travel requirements, (5) starting date, (6) deadline for accepting the offer, and (7) any special job requirements. Job offers normally are based on certain conditions, such as passing a physical examination and/or drug and alcohol test, receipt and verification of references and academic degrees, and proof of citizenship or legal ability to work in this country. While most job offers are made orally, some employers may choose to confirm them in writing, particularly for senior employees.

Job Descriptions

An employer should develop written job descriptions for every position in the organization's work force. Job descriptions should set forth the educational, experiential, and physical requirements of each position. The essential functions of each job should be clearly defined. In addition, job descriptions should delineate each employee's supervisory and reporting roles.

Employee Handbooks

After an applicant has been hired, the employee needs to be made aware of what the employer expects of the employee and what the employee can expect from the employer as a part of the employment relationship. This information often is best provided by clearly stating the employer's policies, rules and procedures in an employee handbook or manual.

The possible topics to include in an employee handbook can be extensive, ranging from non-discrimination and hours of operation to sick leave and at-will employment. While the actual content of a handbook will depend upon the nature and size of the employer's operation, a listing of some of the policies that an employer might consider for inclusion is illustrated in Exhibit 3 of this section. An employee handbook also is an indispensable resource for orienting and training new employees. A handbook can serve as a readily available guide for personnel administration and can be used to instruct supervisors and managers who themselves may be unclear about the employer's policies, or who may otherwise commit unintentional violations of law.

For an employer, particularly one with a small or medium-sized workforce, effectively managing employees is an increasingly complicated and timeâ€'consuming task. Employers often find themselves without consistent or cohesive policies on a multitude of subjects, including proper hiring procedures, discipline rules, and termination techniques. Subsequently, the employer is forced to resort to managing its employees on an ad hoc basis. This situation arises for employers that are not large enough to employ an experienced personnel administrator.

Problems associated with the lack of formal and comprehensive policies and procedures on matters such as leaves of absence, absenteeism, and sick leave often lie dormant for long periods of time. Unfortunately, when such problems do surface, they often come in the form of a charge of discrimination, the denial of pregnancy or family-care leave, an administrative investigation, or a lawsuit alleging wrongful termination in breach of an implied contract of employment.

Frequently, the employer does not recognize the need for an employee handbook until it is too late. With carefully drafted and legally reviewed provisions in an employee handbook that clearly discuss issues such as non-discrimination, leaves of absence, and equal employment, the likelihood of disputes and litigation are greatly reduced. At minimum, a wellâ€'written employee handbook can significantly reduce the time, energy, and money that employers may be required to expend in the defense of judicial and administrative claims by their employees. For example, the EEOC will give great deference to properly written and implemented equal-employment and non-harassment policies.

 

Also, many federal and state labor laws, including FMLA and various state anti-discrimination statutes, now require that employees receive written notification of their statutory rights relating to employment. An employee handbook can help employers comply with these legislative mandates, while at the same time providing employees with a balanced and understandable explanation of their rights and benefits.

Sexual Harassment and Employee Awareness Training

Most employers will benefit by changing the way they think about sexual harassment and the way that their employees interact with one another. What used to be considered safe, consensual conduct often can be misconstrued and should be avoided entirely.

The Scope of Sexual Harassment Claims

Items as innocuous as birthday cards, Christmas gifts, or even supportive “hugs” can be taken out of context and used against employers. In such an environment, employers should counsel their employees to avoid sexual jokes or comments altogether. Countless cases involve employees who laughed at a joke and seemingly participated in the fun, only to later contend they simply felt too embarrassed to complain. The fact that an employee merely laughed at a joke, comment, or gesture does not insulate the employer from liability or bar the employee from later bringing a claim.

One of the most common complaints of sexual harassment involves the consensual relationship between employees. Often, a spurned lover later claims that he or she was pressured into granting sexual favors for the sake of keeping the job or advancing in the business. Other employees claim that when they have attempted to break off the relationship, the coworker refused to listen and continued to pressure the employee at work. Either scenario makes for the need to sort through the stories by way of messy, expensive, and often embarrassing depositions and written discovery in litigation. An employer's claim that the relationship was consensual will not make a lawsuit go away. It usually is left to a jury to decide whether the relationship was truly consensual. Some juries have decided that where a relationship involves a supervisor and a subordinate, an implied threat is inherent in the relationship.

Non-Fraternization Policies

Because of the increased exposure arising from sexual relationships among employees, many businesses are implementing non-fraternization policies by prohibiting sexual relationships between coworkers, especially in employee/supervisor relations. However, before implementing such a policy, employers should consult with expert counsel in their state, as some states prohibit employment policies that affect employees' activities outside the workplace.

Harassment Policies and Communication

The key to controlling sexual harassment in the workplace is communication. Employers must adopt strong and clear policies prohibiting such conduct and make their employees aware of these policies. At a minimum, a sexual harassment policy should describe and give examples of the various types of conduct that might be deemed as harassment. The policy also should make clear that the employer will not permit or condone sexual harassment in the workplace and that any such harassment will result in severe discipline, up to and including termination.

Diversity Management

As the frequency and severity of harassment and discrimination claims continue to rise in the U.S. , more companies and public agencies are attempting to reduce their exposure to such risks by investing in workplace diversity and awareness programs. However, without careful planning and a critical evaluation of the effectiveness of such programs, the risk of claims may not be reduced. Poorly executed programs may even increase the potential for claims.

Because media scrutiny increasingly focuses on high-profile sexual harassment and discrimination cases, such as publicized cases involving Texaco or Mitsubishi, some corporations are actively pursuing diversity management programs, betting that such initiatives can improve worker morale, improve productivity and ultimately reduce their exposure to potential lawsuits and claims. Other companies are implementing diversity programs simply for their perceived public relations value. However, critics of diversity management warn that companies may need to temper their enthusiasm and take a critical look at diversity initiatives that promise to manage or mitigate the risks of sexual harassment and racial discrimination.

Preventing Wrongful Discharge Suits

Specify the Rules

As noted previously, an employer should take care not to promise employees more than it can or is willing to deliver. For example, an employer should not talk about “permanent” or “lifetime employment” when it does not really mean that it will keep the employee forever, regardless of circumstances. Close attention should be paid to employee handbooks, employment applications, and other employment documentation that may suggest that an employee's employment is permanent or that discharge will occur only for “good cause.” Employers should avoid disciplinary policies that provide for termination only when an employee violates a specifically identified rule. Such a policy might be interpreted to mean that an employee cannot be terminated for any other reason, even something as serious as theft. Similarly, an employer should avoid creating a progressive discipline process that restricts the employer's ability to terminate an employee without taking every step in the process. It should be noted, however, that some employers, such as governmental bodies receiving federal funds, are required to afford certain classes of employees' due process rights prior to a demotion or termination. These employers, therefore, have limitations on their actions to terminate employees without following specified procedures.

An employer should consider expressly defining its employee-discharge policy as “at-will.” This can be accomplished by including a clear at-will employment statement as part of the employment application completed by prospective employees, or by having newly hired and existing employees sign an at-will employment agreement. However, since such a disclaimer may have a negative impact on employee morale, some employers prefer to adopt detailed rules advising employees of what conduct will result in discharge. On the other hand, such a list of rules may inadvertently omit some appropriate grounds for discharge. Each approach has its advantages and disadvantages, but in either case, the employer must take care that employees clearly understand the rules.

Many employers require a newly hired employee to serve a probationary period. Such a requirement is thought to give the employee a trial period during which the employer is free to discharge the employee for little or no reason. But many courts have found an implication that discharge may be made only for good cause when the employee successfully completes the probationary period. Also keep in mind that an employee discharged during a probationary period still can make a claim for unlawful discrimination. Employers should consider avoiding any reference to a probationary period. Use of the term trial period may help, but to avoid any misunderstanding of the intent of a trial period, the employer may choose to discontinue the practice of a formal probationary period and instead informally observe a new employee's performance and document deficiencies as needed. A waiting period still may be required for benefit eligibility, but without the negative implication that arises from a formal probationary period.

Be Candid with Employees

An employer should give employees regular, periodic written evaluations of their work performance. Unfortunately, many employers that evaluate employees seek to avoid the sometimes difficult task of informing an employee of less-than-adequate performance. The resulting inflated evaluation can be used against the employer at a later date. For example, an employee discharged because he or she did not get along with coworkers might point out that such a problem was never mentioned in any performance evaluations, and in fact he or she was always rated above average in their peer interactions. Where this occurs, a jury might be persuaded that the reason given by the employer for the discharge was actually a subterfuge and that the discharge was based on unlawful discrimination. Therefore, it is important that evaluations accurately and candidly reflect the employee's performance as compared with the employer's standards and expectations.

If an employee's performance is so poor that he or she is in danger of discharge, the evaluation should specify the areas of needed improvement, give a specific time frame within which the employee is to improve, and put the employee on notice as to the consequences of non-improvement.

Employees should be provided with a copy of their performance evaluations. They also should be given an opportunity to make comments. The employee should be asked to sign the evaluation form. If the employee chooses not to exercise this right, the employer should have that fact witnessed and documented. The employer should keep the signed evaluation, along with other employment documents, such as employment applications, warning notices, and termination reports, in readily identifiable and confidential employee personnel files. The most comprehensive employment documentation in the world is meaningless unless the employer can find it when needed.

Employee Discipline

Except in cases such as theft, intoxication at work, or gross misconduct, progressive discipline should precede discharge. In other words, an employee ought to be given one or more warnings or some other type of discipline, such as a suspension, demotion, or transfer prior to discharge.

In the case of employee evaluation, a disciplinary notice should be honest and direct. The employee should be informed as to the reason for the warning or discipline, accorded a specific period within which to meet the employer's standards of performance, and advised as to the consequences of non-performance. The employee, after having an opportunity to comment upon and sign the warning notice, should be given a copy, with the original being retained in the employee's personnel file.

Consider the Options

Discharge is not the only possible solution to the problem of an employee who performs unsatisfactorily or violates employer rules and policies. If the employee has a long record of good service but has recently been promoted to a job that is beyond his or her ability, an employer might consider demotion, possibly by return to a job in which the employee adequately performed. If the employee's problem arises from a personality conflict with peers, counseling might be considered. Other alternatives might consist of a referral to an employee-assistance program, a disciplinary suspension without pay, or the granting of outplacement assistance or other benefits in exchange for a written release of claims against the employer.

Discharge

In those situations where it becomes necessary for an employer to discharge an employee, the reasons for the discharge should be documented in writing. Care must be taken when stating the reasons for discharge. In any subsequent administrative or judicial proceedings, an employer may not be able to rely upon grounds other than those originally presented to the employee to support the discharge, even if there were other reasons. Additionally, care should be taken to avoid any implication that discharge was based on an illegal reason. For example, if an employer discharges a woman because of her inability to fulfill the aspects of a job that requires travel, the employer may be exposed to a claim of sex discrimination if she is unable to travel because of child care.

The discharge interview is not an appropriate time for the employer to try to avoid hurting an employee's feelings by being less than absolutely candid. This is not to say that the final meeting between the employer and the employee should degenerate into a name-calling session. On the contrary, the discharge interview should be handled as tactfully as possible, since in some states the manner and method of an employee's discharge may actually be the basis for a lawsuit. Therefore, the employer should have two representatives at the discharge meeting: one who conducts the meeting and one to witness the event. Both employer representatives should prepare a file memo immediately after the meeting, detailing what happened and what was said. These memos should be put into the employee's personnel file in case of any subsequent administrative or judicial claim. The discharge meeting should be conducted behind closed doors to avoid involving the entire company. While other employees ought to be informed of the discharge, it is usually best that they not be given detailed explanations. To avoid claims of defamation, such matters should be left between the employer and the employee. The discharged employee should be allowed to collect his or her personal belongings and leave the employer's premises without being humiliated.

Post-Termination References

Often, an employer will be approached by a discharged employee or their prospective employer for a reference. The employer may feel some obligation to give a positive reference to help the employee get a new position. Such a reference, however, may undermine the reason given for discharge and may be used against the employer in case of subsequent litigation. On the other hand, a negative reference, even if truthful, may provide fuel for a discharged and already disgruntled ex-employee to bring a claim against the former employer for defamation, blacklisting, or discrimination. To avoid this possibility, an employer should give a “neutral” job reference that includes only length of service, final position held, and rate-of-pay at termination.

Settlement Agreements and Release of Claims

If an employer is in the process of discharging an employee and believes that the employee may respond with some sort of administrative or judicial claim, the employer may consider the use of a settlement agreement and release of claims. Under such an agreement, the employee may receive severance pay, outplacement assistance, or an extension of benefits that he or she would not otherwise legally be entitled to. In return, the employee waives all claims relating to his or her discharge or any other aspect of the employment. Thus, the employer is protected from post-employment litigation.

However, there are some restrictions on the use of such settlement agreements. For example, an employee cannot give up an age-discrimination claim under the federal Age Discrimination in Employment Act unless he or she has been given twenty-one days to consider the waiver. Even then, the employee has a seven-day period to cancel the settlement agreement. Similarly, some states restrict the types of claims (such as workers' compensation and unemployment) that employees can waive. Employers also should be aware that employees sometimes claim that they were in a position of duress at the time of signing a release or waiver, and therefore such release or waiver is ineffective. The employer should take care to avoid placing undue pressure on an employee to sign a release or waiver agreement.

Arbitration and Mediation

In an effort to control the cost of litigation, employers increasingly are turning to arbitration agreements and mediation to resolve employment-related disputes. While arbitration and mediation generally are effective loss-control tools, some employers favor these alternative dispute-resolution procedures while others do not. Depending on how the arbitration or mediation agreements are structured, there may be a debate whether such agreements are just and fair for both the employer and the employee.

An increasing number of employers are requiring as a condition of employment that applicants and employees give up their right to pursue employment discrimination claims in court and agree to resolve disputes through binding arbitration. These agreements may be presented in the form of an employment contract or be included in an employee handbook or elsewhere. Some employers have even included such agreements in employment applications.

The use of such agreements is not limited to particular industries but can be found in various sectors of the workforce, including, for example, the securities industry, retail, restaurant and hotel chains, health care, broadcasting, and security services. Some individuals subject to mandatory arbitration agreements have challenged the enforceability of these agreements by bringing employment discrimination actions in the courts. The EEOC, while mindful of case law enforcing specific mandatory arbitration agreements,^[1] nonetheless believes that such agreements are inconsistent with the civil rights laws.

Other Considerations

While many employment-related disputes will continue to be resolved through formal litigation, arbitration and mediation appear to be the dispute-resolution models most likely to predominate in the future. If approached with a focus on fairness, an arbitrated or mediated resolution of employment problems often results in a less acrimonious and more productive workplace for all concerned. However, employers should give careful consideration to the benefits and possible pitfalls of arbitration and mediation before deciding if these procedures are right for the company. Employers also should consult with qualified counsel experienced in employment-related matters prior to developing and implementing any employment agreement that requires arbitration or mediation of employment disputes.

End Notes