Law Department Administration

By Joe Calve

Nine general counsel of non-insurance companies sent a letter to the American Law Institute on the eve of the organization’s annual meeting expressing “strong concern” over the direction taken in its proposed Restatement of Law, Liability Insurance. In response, ALI on May 23 postponed a final vote, noting that the draft’s Reporters needed another year to complete their work. Glenn Lammi, Chief Counsel, Legal Studies Division, of the Washington Legal Foundation, who has tracked this controversy, in an article posted to Forbes (bit.ly/2stN48x) called it “an especially troubling instance of where the American Law Institute (ALI), a private organization known for its ‘Restatements’ of common law in areas such as torts, products liability, and contracts, was instead revising the law. . . . ALI’s stated mission is to ‘clarify’ and ‘modernize’ the law. . . . With projects like the Restatement of the Law, Copyright (which we criticized in a 2015 post) and now the liability insurance Restatement, the organization has been blurring the line between restating and revising.” The following excerpts from the GCs’ letter have been edited for length and style.

As general counsel of major corporations, we fully appreciate that no other private organization of practicing attorneys, judges, and law professors has had more influence on the development of American law than the ALI. Nevertheless, the approach taken in several pending Restatements risks causing irreparable harm to the organization’s reputation in the legal community. . . .

As you know, the ALI membership is scheduled to vote on whether to give final approval to the Restatement of the Law of Liability Insurance. The membership is also scheduled to discuss the Restatement of the Law of Consumer Contracts. Fundamental concerns exist with respect to both projects which go to the heart of the integrity of ALI Restatements of Law.

The Restatement of the Law of Liability Insurance is the ALI’s first venture into the highly complex field of liability insurance. This fact alone warrants extra caution and attention in developing recommended “black letter” common law rules. As you are aware, this project began as a Principles of Law project which allowed the Reporters greater leeway in fulfilling academic aspirations. Restatements, in comparison, are supposed to be based on existing law and comport with the ALI Style Manual’s enumerated “elements” for a Restatement. The Proposed Final Draft of the Restatement of the Law of Liability Insurance, however, appears to contain vestiges from when the work product was a Principles project, as well as numerous subsequent provisions which do not satisfy the traditional elements of a Restatement.

For example, all of the undersigned seek to use words in our contracts that are clear and coherent. We expect courts will follow the “plain meaning” of these words. The Restatement of the Law of Liability Insurance departs from this most basic “plain meaning rule” to allow extrinsic evidence to be considered even when a contract is clear. This provision would set a troubling precedent with respect to the interpretation of insurance policy terms, and possibly terms in other types of contracts.

In addition, this Restatement includes an unprecedented endorsement of one-way attorney fee shifting that departs from the traditional “American Rule” that each party is responsible for his or her own attorney’s fees. The project, in multiple contexts, recommends that an insurer that loses a dispute with a policyholder would have to pay that policyholder’s legal fees, but if the insurer prevailed, it would have to pay its own attorney’s fees. Although we, the undersigned, might benefit from such a provision in our capacity as corporate policyholders, it is wholly inappropriate to address the very controversial issue of one-way attorney fee shifting in the context of a Restatement on the topic of liability insurance where attorney fee shifting is not inherently an insurance law issue. Rather, this issue reflects a broader public policy matter most often determined by state legislatures, not common law judges. The Restatement’s approach to attorney fee shifting, similar to the project’s approach to the “plain meaning rule,” could set a troubling precedent in contexts outside of insurance.

These examples represent only a small sampling of the concerns about this Restatement. Our understanding is that a number of motions have been submitted by ALI members addressing other specific ongoing project concerns, including an overarching request to postpone the scheduled final project vote or recommit specific provisions that do not comport with the elements of a Restatement. We agree with the underlying objective of these motions: the ALI should not finalize this project at the Annual Meeting.

Many of the same basic concerns with the Restatement of the Law of Liability Insurance exist with respect to the proposed Restatement of the Law of Consumer Contracts. Although this Restatement will not be voted on at the Annual Meeting, the idea that the ALI is even considering this project as a Restatement is deeply troubling. As general counsel, we address a multiplicity of legal issues every day. In our collective experience, we do not believe that so-called “consumer contracts” represents a separate body of law from the general law of contracts.

It is our understanding that the ALI has never before followed a path of creating separate legal rules for “consumers” versus any other entity. We are also unaware of any courts making such a distinction and applying the law differently based solely on whether a party is a business or an individual “consumer.”

Of equal importance, this Restatement attempts to create separate “consumer contract” rules that are not grounded in existing case law. It relies on a patchwork of other laws, most notably state consumer protection statutes. As you are aware, such statutory law was designed to prevent deceptive marketing practices; it is not a basis for the development of contract law. Yet, this Restatement proposes to give consumers broad new legal remedies to challenge virtually any contract involving consumers, and appears to empower judges to exert broad new authority to change contracts absent existing common law precedent.

Both of these Restatement projects demonstrate that the ALI has reached a key decision point between allowing Restatements of Law to reflect a Reporter’s subjective and aspirational views of what a common law rule “should be” versus the ALI’s governing directive of clarifying and simplifying prevailing common law rules. We respectfully submit that the ALI should pursue the latter approach to preserve the credibility and reliability of its body of work.

Article by: Michael W. Peregrine

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

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

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

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

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

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

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

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

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

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

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

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

Michael W. Peregrine, a partner in McDermott Will & Emery, advises corporations, officers and directors on matters relating to corporate governance, fiduciary duties and officer/director liability issues. His views do not necessarily reflect those of his firm or its clients. He can be reached at mperegrine@mwe.com.

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