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CORPORATE GOVERNANCE

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The Jack Wright Series # 2 – Legal Obligations of Directors

Introduction

As Jack Wright weighed the invitation to join the Mega Corporation board, he reflected
on how his personal career had flourished and the ways in which his stature in the community

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had risen steadily over the years. As a result, he had been asked several years previously to
become an organizer/director of a de novo community bank, the shares of which would be listed
on NASDAQ after its charter was granted by the Federal Reserve. This was Jack’s first
opportunity to become a director of a publicly held company, and he had readily agreed to join
the organizers, a prestigious group of successful, civic-minded people. Jack knew most of the
organizers, though not all of them. He was currently facing an unexpected and difficult problem
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in connection with that attachment.

After the charter was granted, the organizers formally constituted themselves as a board of
directors and set about establishing their committee structures. Jack was asked by the board
chair if he would head the Governance & Nominations Committee, a flattering assignment which
Jack accepted graciously and seriously. After all, in the highly regulated banking industry,
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effective governance was absolutely essential and would likely have a direct bearing on the
financial success of the institution.

From the beginning, the bank prospered, propelled by a skilled management team and an
energetic and highly engaged board. The bank’s rapid and profitable growth, however, soon
required that it raise additional equity capital to ensure that it remained solidly in the ranks of
“well-capitalized” banks, as defined by the Federal Reserve and the other regulatory agencies
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with oversight over its operations.

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This case was prepared by Wallace Stettinius, George Logan, Visiting Lecturers, and John L. Colley, Jr., Almand R.
Coleman Professor of Business Administration both at the University of Virginia Darden School of Business. This
case was written as a basis for class discussion rather than to illustrate effective or ineffective handling of an
administrative situation. Copyright  2003 by the University of Virginia Darden School Foundation,
Charlottesville, VA. All rights reserved. To order copies, send an e-mail to sales@dardenpublishing.com. No part
of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any
form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of
the Darden School Foundation. Rev. 11/2/05.

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An Unfortunate Lapse

In the months just preceding John Rock’s Mega invitation, Jack had encountered a deeply
unsettling situation. A prominent and extremely wealthy local investor had approached the
bank’s board chair and stated his strong interest in investing in the bank through a purchase of

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authorized, but un-issued shares. This investor had been impressed by the bank’s performance
since its formation, and the timing of his interest coincided perfectly with the bank’s need for
additional capital. A share price would have to be negotiated, to be sure, but there was little
doubt in any director’s mind that public knowledge of this particular investor’s purchase would
boost the price of the bank’s shares, notwithstanding the extent to which issuing the additional
shares would dilute the ownership of the existing shareholders.

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Strategically, this investment would put the “gold seal” of approval on the institution and
open many new avenues of profitable business for the bank. Furthermore, this sale of shares,
along with a debt instrument that the Federal Reserve permitted to be counted as Tier 1 Capital,
would substantially strengthen the bank’s balance sheet and enable it to continue on its historical
growth trajectory, a 30%+ compound increase in annual earnings. This was one of those rare
and positive situations where the internal rate of capital generation could not keep pace with
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strong, high quality loan demand. In fact, contrary to investor expectations, the bank had not
begun paying a dividend because the leverage effect of retained earnings was producing a far
greater shareholder return, reflected in the share price.

The board decided, unanimously, to go forward with negotiations of the equity purchase,
subject to its obtaining a fairness opinion. The bank’s legal counsel admonished the group in the
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strongest possible terms that the impending transaction was a highly confidential matter. Even
more importantly, no member of the board, senior management, nor any related parties, could
either buy or sell company shares until the transaction was completed and knowledge of it was in
the public realm, unless the proposed deal had been terminated. Counsel further made clear that
this prohibition specifically extended to members of the directors’ immediate families.

Just weeks after this board meeting, the wife of one of the founding directors made a
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major purchase of the bank’s stock through a privately negotiated transaction. These shares were
registered in street name, at the suggestion of the broker involved in both sides of the trade. As a
result of a recent inheritance, she had the means to make the purchase and was inspired to do it in
part as an act of financial independence. She was not aware of the private investor negotiations
since her husband had been careful to maintain confidentiality and had spoken to no one about it,
including his wife. Neither counsel nor other board members, including Jack as chair of the
Governance & Nominations Committee, were aware of this purchase until the director learned of
his wife’s purchase, and reported it to them. He waited almost two weeks before filing the
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legally required SEC Form S-4, notice of insider purchase or sale, long after the newly required
48 hour legal filing window had passed. As soon as they learned of this filing, the other directors
and senior management were in a state of disbelief. The prospective equity purchaser was also

This document is authorized for educator review use only by MUHAMMAD SHOAIB ABDULLAH, International Islamic University Islamabad until Apr 2020. Copying or posting is an
infringement of copyright. Permissions@hbsp.harvard.edu or 617.783.7860
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surprised, and this major insider purchase was immediately noticed by the investing public. The
share price quickly rose almost 20% overnight. Word travels fast in a small community.
The Aftermath

The board chair asked Jack and his committee to investigate the circumstances under

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which this purchase had taken place, and then to report back to the board’s executive committee
with the facts and with a recommendation for how to deal with this situation. Meanwhile, for
this and other reasons, the potential investor politely terminated purchase discussions, a turn of
events which distressed the entire board deeply, including the director in question. This was a
major setback for the heretofore greatly successful bank.

As Jack contemplated this bizarre and troubling situation, he wondered if it were even

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possible to ensure beyond any doubt the proper and legal conduct of each director of any board
of directors. It seemed to him impossible to absolutely eliminate any and all risk, though he had
thought that the board formation process of the bank had come as close as was humanly possible
to achieving this goal. As he launched his inquiry, Jack hoped the facts could somehow
exonerate the director in question.
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From the very earliest days of the bank’s formation, Jack, along with the other directors,
had worked hand-in-glove with the “offending” director. Jack and the other directors had only
the highest regard for this person. In fact, of all the directors, this one was among those who had
worked the hardest, and the most effectively, to make the bank a success in the community. In
addition, this director had an impeccable reputation within the community. Jack simply could
not imagine his fellow director and personal friend making such an ill-considered move in the
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face of unambiguous, stern advice from the bank’s legal counsel. But, he clearly had, or rather,
his wife had.

When Jack approached the director, the latter readily admitted to knowing of the family
member’s purchase after the fact and well before the filing. But, he stoutly maintained that she
had absolutely no knowledge of the other potential transaction, and had thus made the purchase
in “good faith.” Furthermore, he emphatically contended that he had simply “drawn a blank”
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when Jack reminded him of counsel’s admonitions about related parties. He pleaded with Jack
that there had been no intent whatsoever to either deceive or reap so-called ill-gotten gains. He
further stated unequivocally that he would have his wife either sell the entire purchase on the
open market or transfer any gains to the original selling shareholder, if this would be what it took
to restore his credibility with his fellow directors. While seemingly noble gestures, in Jack’s
opinion the genie was already out of the bottle.

When Jack learned of the transaction, he promptly called a meeting of the Governance
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and Nominating Committee. He presented the director’s explanation of the situation, which they
discussed at great length. They thought it was plausible that he did not know of his wife’s
purchase. While he certainly knew of her inheritance, he probably didn’t know of her act of
independence. Why hadn’t he informed her that she shouldn’t trade in the bank’s stock without

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his knowledge, per the lawyer’s instructions? The answer was because he did not anticipate
circumstances where she would have an opportunity to do such a thing. This, too, seemed
plausible. But, then should he have anticipated the possibility, given the inheritance? Perhaps
most damning was the fact that after he knew of the transaction, he waited so long to inform the
board of it. He said that he had forgotten the new deadline, and had reported within the old

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deadlines.

The discussion came down to four issues. The first was the director’s credibility. The
committee to a person felt that he was an honest man, and there was no intent to commit an
inappropriate act. There was, in their view, poor judgment, which could be explained by
inexperience in the operations of a public corporation, or by embarrassment when he found out
about the transaction. But, did the committee have clear cut evidence of intentional wrong

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doing?

The second issue was the effect of any actions that they might take on the bank, itself, in
a small community. The director had many friends in the community, and any action taken to
punish him would undoubtedly have a negative effect on the bank. At best, it would split the
community. In short, this was a case where there was nothing to be gained and the risk of a great
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deal of potential harm if he were to be removed from the board.

On the other hand, the stockholders had been harmed, and if they found out, many might
want to know why no action was taken. This suggested that the board should try to keep the
problem confidential if they took no action. But, was this forthright and ethical, even if it was
legal, as advised by counsel?
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The third issue that was discussed was whether the other members of the board could
ever feel the same towards him? Could they see it as a lesson learned for all, then forgive and
forget?

Finally, the committee recognized that the bank and its shareholders had been
significantly damaged by the actions of the director’s wife, and perhaps, by his failure to report
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the transaction promptly. There was no practical way for the director to make restitution.

The committee struggled with balancing the need for an appropriate punishment, together
with the potential damaging consequences of taking or not taking action.
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This document is authorized for educator review use only by MUHAMMAD SHOAIB ABDULLAH, International Islamic University Islamabad until Apr 2020. Copying or posting is an
infringement of copyright. Permissions@hbsp.harvard.edu or 617.783.7860