Business ethics 88.
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There is a growing trend to increase the amount of personal responsibility borne by company directors, as exemplified by the recent case of Feuchtwanger Investments.
Feuchtwanger Investments was a veteran investment company with a reputation for stability. In 2001, it was taken over by the Peled-Givoni Group, which replaced the old directors with new ones, many of whom were inexperienced. Within days after being installed, the new directors were asked to approve a series of huge and complicated deals, whose cost exceeded the assets of the company. The directors approved the deals, which then failed, leading to the collapse of the company in 2002.
When the company failed, its assets were passed to a receiver, Shlomo Ness. In a relatively rare step, Ness concluded that the directors were culpably negligent and sued them for NIS 250 million. He claimed that their actions were rash and unreasonable.
Recently, a compromise was reached according to which the directors will pay NIS 33m., and charges against them will be dropped.
These cases are rare because directors are doubly insulated from questionable management practices. The first firewall is that granted to managers. Courts are properly reluctant to second-guess the judgment of managers. When an investment goes sour, it may seem obvious, with hindsight, that bad judgment was involved. But it could be that, initially, it seemed like an attractive investment, and managers are paid to take risks, not to flee them. Business decisions have to be pretty irrational before courts will decide that the managers are legally accountable. In the case of Peled Givoni, its managers were indicted.
The second firewall is that directors are responsible only for oversight, not for execution. In other words, they don't necessarily have to conclude that a particular deal is in the best interests of the company; they only have to conclude that the business judgment of the managers is reasonable. Obviously they cannot take the hands-off position of the courts, insofar as they are the representatives of the owners. But their legal responsibility is basically to make sure the company has capable management - and not to personally take responsibility for everyday business decisions.
So a high degree of negligence is required before a director can be considered liable. The Feuchtwanger case is particularly noteworthy because in many cases where directors are sued, they are accused of self-dealing or favoring their cronies. Based on my experience, accusations of naked negligence are the exception. Directors have been held liable in Israel in only a handful of cases.
One interesting wrinkle in this case is the role of the Clal insurance company, which will now have to pay the entire sum, because Feuchtwanger, like most companies, had an insurance policy protecting directors against such suits. Clal was an investor in the original Feuchtwanger Investments, and the company itself accused the directors of negligence. The company is now paying the price of its own vindication.
Since director negligence, or at least nonchalance, was implicated in the failure of Enron, legislation in the United States (Sarbanes-Oxley Act of 2002) and worldwide has sought to increase the degree of responsibility of directors. One result has been that directors cost more, in terms of salary and liability insurance; another is that many public companies have been taken private to avoid the provisions of the laws.
It is also possible that directors have begun to err on the side of caution. These costs are undoubtedly very large. But that doesn't mean that legislation such as Sarbanes-Oxley is necessarily flawed. It may be that the majority of companies are better managed with the directors knowing that they could be held responsible for major missteps.
Asher Meir is research director at the Business Ethics Center of Jerusalem (www.besr.org), an independent institute in the Jerusalem Institute of Technology.