Management Duty to Set the Right “Tone at the Top”

David Lopez and Arthur H. Kohn are partners and Margot G. Mooney is an associate Cleary Gottlieb Steen & Hamilton LLP. This post is based on their Cleary memorandum.

In late March 2019, the Hertz Corporation and Hertz Global Holdings, Inc. (collectively, “Hertz”), filed two complaints (the “Damages Proceedings”) against its former CEO, CFO, General Counsel and a group president seeking recovery of $70 million in incentive payments and $200 million in consequential damages resulting from Hertz’s 2015 decision to restate its financial statements and an ensuing SEC settlement against Hertz and federal class action lawsuit (which was dismissed). At the same time, the defendants in those actions each filed separate complaints (which have been consolidated in the Delaware Chancery Court) demanding advancement of their legal fees in the Damages Proceedings (the “Advancement Proceedings”). The litigation between Hertz and its former executives raises novel questions about whether executives have a legally cognizable duty to set the right “tone at the top” and the consequences if they fail to do so. The litigation also raises important and interesting questions regarding clawbacks and indemnification.

Background

In May 2014, Hertz announced that it would be unable to file its Form 10-Q for the first quarter of 2014 because of prior period errors it had identified and in September 2014 (after previously announcing the departure of its lead independent director) it announced the departure and replacement of its CEO, Mark Frissora. In July 2015, Hertz announced that it would restate its financial statements for the 2011, 2012, and 2013 fiscal years (the “Restatements”) and disclosed a series of material weaknesses including “an inconsistent and sometimes inappropriate tone at the top [that] was present under the then existing senior management.” The Restatements stemmed principally from two accounting decisions made in the 2012 and 2013 time frame when the company was under financial pressure: it reduced the allowance on its books for recoveries for vehicle damage from renters and other third parties with the result that its expenses were decreased and income increased and it extended the planned holding periods for its fleet of U.S. rental cars with the result of improving its depreciation expense.

On December 31, 2018, the predictable SEC settlement followed imposing a cease-and-desist order on Hertz for negligent violations of the securities laws. (Hertz’s officers were not charged.) A federal securities class action lawsuit also was filed.

The Complaints seek to hold Hertz’s former CEO as well as its former CFO, former General Counsel and former Group President for Rent-A-Car Americas (the “Defendants”), accountable—at least in part—for the damage caused to Hertz as a result of the Restatements and ensuing SEC and class action settlements. They came in two filings: a New Jersey state complaint against CEO, Frissora; CFO, Elyse Douglas; and General Counsel, Jeffrey Zimmerman (the “New Jersey Complaint” ) and an almost identical complaint in a Circuit Court in Florida against Scott Sider, the former Group President for Rent-A-Car Americas (the “Sider Complaint” and, together with the New Jersey Complaint, the “Complaints”).

Claims against the Former Executives

Hertz’s complaints are notable both for what they allege and what they do not allege and raise important and interesting questions regarding the legal responsibilities of corporate officers and the consequences if they fail to satisfy those responsibilities. Hertz does not allege that the officers violated their fiduciary duties; presumably those claims would be covered by D&O insurance. Nor do they claim that the officers committed fraud against the company. Rather, the Complaints assert claims arising out of Hertz’s clawback policies and for breach of defendants’ separation agreements and also seek to deny the Defendants the funds typically advanced to officers to defends themselves in such lawsuits.

Specifically, Hertz seeks recovery of $70 million in incentive payments under Hertz’s compensation clawback policy, and $200 million in consequential damages from representations made by the Defendants in agreements entered into by them in connection with the termination of their employment with Hertz that they had not “engaged in any conduct that constitutes willful gross neglect or willful gross misconduct with respect to [their] employment duties with [Hertz] which has resulted or will result in material economic harm” to Hertz, and that [they] had not “facilitated…and ha[ve] no knowledge of, any financial or accounting improprieties or irregularities.”

Relying on Hertz’s findings with respect to internal controls (similar to those made by other companies who have announced restatements and determined there was an improper tone at the top), Hertz alleges that “Defendants’ wrongful ‘tone at the top’ was a form of misconduct and gross negligence.” The allegations generally challenge the former executives’ business decisions: Defendants “push[ed] a counterproductive aggressive agenda, doing so despite knowing full well that Hertz was in a difficult and taxing period of corporate upheaval [on account of a major acquisition and relocation of the corporate headquarters] that strained the Company’s already inadequate internal controls.” Hertz’s allegations with respect to each of the former executives are worth summarizing individually:

  • Former CEO, Mark Frissora: “management style and temperament” “created a pressurized operating environment at the company,” “demand[ed] mandatory team-wide calls and continuous weekend meetings” when told Hertz might miss a financial target and “berate[d] subordinates” who did not come up with enough “‘paradigm-busting’ accounting strategies to fill the gaps,” and “took direct and intimidating and/or demeaning steps to instill an aggressively pro-growth culture within Hertz.”
  • Former CFO, Elyse Douglas: “failed to stop, effectively counterbalance or otherwise offset or report to Hertz’s board of directors . . . Frissora’s inappropriately forceful tone, in breach of [her] duties owed to Hertz,” “wrongfully failed to counterbalance the obvious pressure [Frissora] was putting on subordinates to meet financial targets,” did not “fulfill her obligation to inform the Audit Committee or the Board of any of that misconduct,” and “promoted and approved” financial and accounting changes such as extending the amortization period of Hertz’s vehicles and retaining vehicles for longer periods of time.
  • Former General Counsel, Jeffrey Zimmerman: “failed to stop, effectively counterbalance or otherwise offset or report to Hertz’s board of directors . . . Frissora’s inappropriately forceful tone, in breach of [his] duties owed to Hertz;” “failed to disclose what he knew of [possible improper payments to Brazilian government officials] to the Board,” and failed to “inform the Board and take corrective action” where Frissora and Douglas approved certain financial and accounting changes.
  • Former Group President for Rent-A-Car Americas, Scott Sider: “failed to stop, effectively counterbalance or otherwise offset or report to Hertz’s board of directors . . . Frissora’s inappropriately forceful tone, in breach of his duties owed to Hertz,” “played a direct role in approving several key accounting changes which contributed to the need for the Restatement,” “failed to correct” “frequent issues with authority and jurisdiction between [the various accounting] groups,” and failed to “streamlin[e] [Hertz’s] hierarchy and ensur[e] the appropriate review of accounting changes.”

These allegations are made to support clawback claims under a policy that gives the compensation committee sole discretion to determine whether the Defendants’ conduct amounted to gross negligence. They are also made to support contract claims that certain of the defendants falsely represented in separation agreements that they had not engaged in willful gross neglect or willful gross misconduct.

Questions Raised Regarding “Tone at the Top”

Though Hertz’s complaint has yet to be sustained, it raises several questions that—though novel­—are important. The essence of the complaint appears to be that the former officers failed to maintain an appropriate tone at the top with the result that the company made accounting errors that resulted in a Restatement, SEC settlement, and class action lawsuit. Specific attributes that are alleged to illustrate this inappropriate tone include: “management style and temperament,” “inappropriately forceful tone,” “aggressively pro-growth culture,” and “weekend meetings”. In many cases, these attributes can be evidence of an effective management team that drives their employees hard in the service of shareholder value. The Complaints raise the question at what point do those attributes cross the line from permissible (even if perhaps offensive or of questionable effectiveness) to a tort or violation? Related questions implicated by the Complaints include:

  • Does an officer have a duty, that is legally cognizable, to set a particular tone at the top?
  • To the extent that such a duty exists, what is the source of that duty and what is its content?
  • How does the nature of that duty compare, for example, to the Caremark duties of directors?
  • Does failure to satisfy that duty amount to gross negligence as a matter of contract?
  • Does the duty vary between different officers and does a General Counsel’s duty include the obligation to report to the board on tone at the top?
  • What obligations, in turn, does the board have with respect to tone at the top?

The phrase “tone at the top” encapsulates the amorphous concept of a company’s proclivity for compliance. However, the ambit of the phrase, including what is an appropriate versus inappropriate tone, has not been defined as a legal concept. The phrase itself was originally used in the audit context and is part of the Committee of Sponsoring Organizations of the Treadway Commission’s (“COSO”) Internal Control—Integrated Framework for internal controls over financial reporting. The COSO framework sets forth five integrated components that make up an effective internal control system, one of which is the “control environment,” or the set of standards, processes and structures that form the basis for implementing internal controls at the organization, and which includes the responsibility of the board and senior management to establish the “tone at the top” with respect to the importance of internal control, expected standards of conduct, and the ethical values of the organization. Companies that have restated their financials, or that have found weaknesses in their internal controls over financial reporting, have referenced “tone at the top” issues as having contributed to material weaknesses in their management report on internal control over financial reporting included in their annual reports on Form 10-K but without giving much content to that phrase other than whatever was said was inappropriate and led to inappropriate decisions being made.

Likewise, it does not appear that any court has recognized a legally-cognizable duty to provide a particular tone at the top. The issue has arisen in federal securities fraud cases where courts have considered whether a company’s finding that there was an inappropriate tone at the top gives rise to an inference of scienter, defined to include severe recklessness. In that context, courts have found that the failure to maintain an appropriate tone at the top does not in and of itself amount to severe recklessness, in part because of the difficulty of distinguishing between an aggressive business strategy and an inappropriate tone at the top.

“Gross negligence” is commonly defined as “a high, though unspecified degree of negligence.” It represents: (i) an extreme departure from the ordinary standard of care, sometimes referred to as the failure to use even slight care or (ii) something closer to recklessness or intentional misconduct. But those definitions, applied here, simply raise the question whether there is a particular tone at the top that is ordinary and what tone is a departure from the ordinary standard of care.

Duty of the General Counsel

Hertz seeks to clawback compensation from the General Counsel and to deprive him of the fees necessary to defend against that action on the theory, in part, that he failed to report the inappropriate tone to the board and failed to restrain the CEO in his gatekeeper role. But that raises still further questions for every general counsel to consider. Ordinarily, and in the case of Hertz, the general counsel is an officer of the corporation with duties to the shareholders through the board of directors. There are well-established rules with respect to up the ladder reporting including where there is evidence of a material violation of securities laws or a breach of fiduciary duty or similar violation. But those rules have not been applied previously to failure to report an improper tone. At what point does such a duty attach? Senior management surely has responsibility to manage the affairs of the corporation and to drive performance and is entitled—by virtue of her or his appointment to be an officer—to exercise those responsibilities. At the same time, prudent general counsel will raise issues (at least to the Audit Committee) that raise a significant risk of a control violation. When does the failure to make those reports give rise to a legal violation permitting a clawback? The New Jersey case raises that question, and may answer it.

Personal Financial Exposure

Notably, certain of the protections available to officers and directors in respect of claims arising in their capacity as officers or directors may not be available to the Defendants. Specifically, since the claims are contractual, and not fiduciary, claims, any D&O insurance may not be relevant, and the cases raise the question whether the Defendants would be entitled to indemnification or expense advancement.

Key Takeaways

Although the outcome of the Hertz proceedings is unclear, there are several practical implications of which to be aware.

  • Having the wrong “tone at the top” could potentially lead to claims for gross negligence and resulting damages.
  • General counsel will be in a better position by reporting up to the board or, as a gatekeeper, in instances where there is potential misconduct even if it does not rise to the level of a material violation of the securities laws, but as a practical matter this may pose difficult issues as the general counsel typically reports directly to the CEO.
  • Officers and companies should consider potential liability on account of breach of contract claims when negotiating D&O, compensation and advancement policies and exculpation clauses.

The complete publication, including footnotes, is available here.

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