Damage claims against management on the rise

There has previously been strong resistance by members of the supervisory board to assert damage claims against long-standing and respected members of their company’s management.

This no longer holds true as supervisory boards are conscious about their fiduciary roles and responsibilities to act in the best interest of the company, and potential personal liability risk if they fail to act.

The change in overall sentiment in recent years is a direct result of increased regulatory enforcement on a global level, extensive press coverage and ensuing pressure from stakeholders, customers and the general public to recover a company’s economic losses.

Supervisory boards now routinely retain external counsel to conduct internal investigations to help evaluate damage claims against company management in connection with acts of corruption, fraud, breach of trust or tax evasion.

What is expected from management when it comes to corruption prevention?

Outlawing bribery and corruption by way of a Code of Conduct or introducing a compliance program to prevent corruption is not enough unless implemented, monitored and enforced consistently to ensure it is working in in practice. Employees involved in corrupt acts must face disciplinary actions, and in sufficiently severe cases may be asked to leave the company.

Violations of fiduciary duties by the members of the management board that result in personal liability can range from a failure to take notice of growing indications of bribery at group level, to creating a corrupt culture where making sales take precedence over ethical business.

  • Some examples of damage claims against management in connection with bribery practices are: failure to set up a competent, independent and adequately staffed Compliance and/or Legal organization;
  • presenting events and occurrences to the members of the supervisory board or the Audit Committee in a misleading manner; and
  • failure to consider corruption or regulatory risks and conduct a risk assessment when investing or conducting business in higher risk countries or industries.

Has the pendulum swung too far?

In a recent case, a member of the management board of a German listed company responsible for the technical function was sued for damages together with his fellow management board members for the amount of EUR 90 million. The supervisory board pursued this board member despite the fact that it had reappointed him to the management board after an internal investigation cleared him of personal wrongdoing.

This unusual sequence of events is hard to explain, and it is suggested in the press that his unanimous reappointment by the supervisory board may have been the result of political factors. According to a company statement, the litigation was necessary for legal reasons to preserve damage claims against the fellow management board members. Another explanation for the management board member being re-appointed and sued at the same time could be that the real objective was to gain access to payments under an existing D&O insurance rather than from the management board member personally.

Legal framework in Germany for asserting damage claims and liability settlements

The supervisory board is the controlling body tasked to supervise and control the actions of the management (Sec. 111 German Stock Corporation Act). As part of this controlling function, once it becomes aware of problematic business practices or materializing regulatory risk, it must assess the existence of any damage claims against members of company management for violations of their fiduciary duties.

If the supervisory board comes after a diligent and informed analysis to the conclusion that claims for damages exist against members of the company management, it is legally obligated to assert such damage claims - and there is no room for discretion.

Failure to act can constitute a breach of its own fiduciary duties to act in the best interest of the company and may in a worst case scenario subject the supervisory board members to criminal liability for breach of trust.

The statute of limitations pursuant to German stock corporation law is ten years for companies, listed at a stock exchange at the time of the violation of the fiduciary duty, and five years for not public stock corporations.

Ultimate decision over settlement with management by shareholder resolution

The supervisory board represents the company vis-a-vis its management in and out of court. It negotiates the settlement terms with former and current members of the management, taking into account litigation risks, adverse publicity or negative consequences for the company’s business. It must be guided by the best interest of the company and may only consider other factors such as the past contributions and long-standing service of a management board member in exceptional circumstances.

But the final decision whether or not to accept the settlement proposal is for the shareholder meeting to resolve, not for the supervisory board or any other corporate functions. If the company and the managing board member agree on a mutual termination of the employment relationship, a valid waiver of the right to bring damage claims in connection with acts of corruption would require a shareholder resolution.

In accordance with German corporate law, a stock corporation can only waive or settle claims against managing board members if three years have passed since the claim came into existence, the shareholder meeting approves the decision and provided a minority representing at least 10% of the stock capital does not file a written objection.

The supervisory board in practice informs the shareholders in a written report about the context of the settlement, and sometimes the complete wording of the liability settlements with the members of the management board is attached as an Annex to the invitation to the shareholder meeting.

Settlement amounts in connection with acts of corruption are on the lower end when compared to the original claims.

Companies bring damage claims against (former) management for the economic loss suffered in connection with the corrupt acts. This amount comprises of fines and penalties imposed, total amount of questionable payments made, tax losses incurred, costs of external consultants and in recent cases the estimated disgorged profits.

Often the quantifiable economic loss to the company by far exceeds the financial means of the individual management board member with the potential to wipe out their economic existence. This is sometimes seen as unfair in particular when considering the management board members’ longstanding service for the company and the contributions these individuals made over their tenure.

For example, the supervisory board of a listed German industrial group demanded from its former CEO EUR 237 Mio compensation of economic loss for violating his supervisory and monitoring obligations in connection with acts of corruption.

A criminal probe was opened in September 2012 by the Munich prosecutor after the former head of the audit department testified in a related trial that he had informed the CEO in a meeting about possible corrupt practices regarding business in an eastern European country. In the summer of 2013, the criminal investigation against the former CEO was settled by paying EUR 500,000 (USD 668,000) to charity.

At the same time, the company announced that it negotiated a settlement with its former CEO in the amount of EUR 1.2 Mio.

Pursuant to German law, this settlement will only become binding if approved in next year’s annual shareholder meeting. We will continue to follow this case and provide an update on the outcome of the shareholders’ meeting next year.

How can such a discrepancy between the original demand and the ultimate settlement amount be explained?

For a variety of reasons, most importantly litigation risks and fear of further adverse publicity, companies tend to settle with management board members for far less, often in connection with a settlement with the D&O insurers.

But in today’s challenging economic environment, despite limited public information available in this regard, it appears that middle sized and businesses and smaller enterprises are less likely than DAX 30 stock corporations to forego the opportunity to fully recoup economic losses from former management, and often vigorously proceed with the collection under settlements or judgements.

This is a particular risk where the D&O insurance does not cover (all) the damages incurred due to claims being time barred or exemptions under the policy clauses. The D&O insurers may dispute their obligations to cover the damages incurred and in light of litigation risks (for example the company needs to establish the liability of the board members in a court case), it may be in the best interests of the company to reach a settlement with the D & O insurers and collect other economic losses directly from (former) management.