Veeco's Code Of Ethics Case Summary

♣ Seven months later, the same employee reported more export violations. The Audit Committee allegedly “permitted additional violations to occur, either by completely disregarding the first report, or by establishing procedures that were wholly inadequate and ineffective and that failed to protect the Company from potentially enormous liability” [p. 278].

♣ Responsibilities and the Charter. According to the complaint, Veeco’s Audit Committee is responsible, among other things, for

o “reviewing the scope and results of the audit and other services provided by Veeco’s independent auditors, and overseeing Veeco’s Code of Ethics” [p. 276]. o “Additionally the Audit Committee’s charter sets forth the following responsibilities of the Committee:
a) Whistleblower—In complaint [sic] with SEC and NASDAQ rules, the Committee shall establish procedures for the receipt, retention and treatment of complaints or concerns, including confidential and anonymous submissions received by the Company regarding accounting, internal accounting controls or audited matters ...
(c) Legal Compliance—The Committee shall review with the Company’s internal legal counsel any legal and regulatory matters that could have a significant impact on the Company’s financial statements, the Company’s compliance with applicable laws and regulations pertaining to financial disclosure, and any correspondence with regulators or governmental agencies that raise material issues regarding the Company’s financial statements or accounting polices” [p. 276].

The Legal Test. The court in this decision was asked to decide whether the shareholders first had to make a demand on the board to pursue this litigation, or whether a demand on the board would be futile because most directors were not disinterested in the outcome. Since the directors manage the affairs of the corporation, and not the shareholders, the plaintiffs needed to show that a demand on the board would have been futile. Because Veeco was incorporated in the State of Delaware, the law of Delaware controlled [p. 273].

According to a prior Delaware decision, when a board fails to take action, director liability may arise from “an unconsidered failure of the board to act in circumstances in which due attention would, arguably, have prevented the loss” [In re Caremark Int’l Inc. Derivative Litig., 698 A.2d 959, 967 (Del.Ch.1996)]. The court in this case elaborated on what this means, quoting from other Delaware cases:

“[I]n the context of a so-called Caremark-case, ‘A court must determine whether or not the particularized factual allegations of a derivative stockholder complaint create a reasonable doubt that, as of the time the complaint is filed, the board of directors could have properly exercised its independent and disinterested business judgement in responding to a demand’” [p. 274; citations omitted].

Under Delaware law a “director is interested if he will be materially affected, either to his benefit or detriment, by a decision of the board, in a manner not shared by the corporation and the stockholders” [p.
274 citation omitted]. In other words, the plaintiffs claimed the defendants could not make an impartial decision as to whether to prosecute this action on behalf of the corporation since the defendants would face substantial personal liability if the shareholders were to prevail.

Here, plaintiffs alleged that, “Defendants’ reckless stewardship of Veeco, particularly their failure to institute appropriate controls and oversight of all areas of the Company’s business, has exposed the Company to potentially significant fines and legal liability, has substantially impaired the Company’s market capitalization, has eroded the Company’s goodwill and trust in the market place, and has threatened the Company’s overseas sales” [pp. 274-275].

Outcome. Under Delaware law the plaintiffs had to create a reasonable doubt about the disinterestedness or independence of a majority of the board. The court decided that the shareholder derivative suit could proceed without a demand on the board because the allegations raised a reasonable doubt as to the disinterestedness of six of the ten directors (five members of the Audit Committee plus one board member who was also the CEO).

The court reasoned that the Audit Committee members were interested
because

“The significance of the TurboDisc division—both in terms of the money expended to acquire it and the value it purportedly added the Company—coupled with the Audit Committee’s role in reviewing matters that significantly impact on the Company’s financial disclosures, suggest that the Committee was duty-bound to ensure that Veeco implemented an adequate system of internal controls when integrating the TurboDisc division. Nevertheless, plaintiffs contend that [Audit Committee members] breached their duty to Veeco by recklessly ignoring red flags signaling TurboDisc’s inadequate system of internal controls.” [p. 277]

“Additionally, plaintiffs allege that the Audit Committee abdicated its responsibility to monitor legal compliance and investigate whistleblower claims relating to the Company’s allegedly flagrant, systematic and repeated violations of export control laws.” [pp. 277-278]

Per the court, “If true, plaintiffs’ allegations that the Committee failed to exercise appropriate attention to potentially illegal corporate activities would constitute a breach of loyalty, subjecting [the Audit Committee members] to a substantial likelihood of liability. Thus, plaintiffs’ allegations raise a reasonable doubt that these Director-Committee members were disinterested and capable objectively deciding whether to prosecute this litigation on the corporation’s behalf.” [p. 278]

This ruling does not indicate whether the audit committee was ultimately held responsible since the court was only considering the plaintiffs’ allegations in a motion to dismiss for failure to first make a demand on the board to pursue the litigation. It does illustrate that the duties outlined in the charter will be carefully reviewed in litigation. It also exemplifies, in a broader sense, the serious role of the audit committee in monitoring internal controls, including compliance issues such as export controls.

Case 2: The General Motors Case - Faulty Ignition Switches and Transfer of Risk Duties to the Audit Committee.

In the following case, the responsibilities for risk management were shifted to the audit committee which was, allegedly, already overburdened when the transfer was made.
The case highlights the need to review and reassess the audit committee’s duties, especially considering its existing workload. Plaintiffs also claimed the transfer did not cover all the risk responsibilities from the prior risk committee. In addition, it reveals the need to have in place a process to receive information that may have a significant impact on financial reporting – in this case arising from a defective product. Finally, the case raises the question of corporate culture and the role it plays in the effectiveness of a complaint process in a large multifaceted
organization.

Background. Following revelations of faulty ignition switches which failed to keep the car powered on and which could, in turn, cause the airbag not to deploy in a crash, approximately 13 million General Motors (GM) vehicles were recalled beginning in February 2014 resulting in a cost of approximately $1.5 billion against earnings through the first and second quarters of 2014. GM disclosed that certain engineers and others within the company had known about the ignition switch defect for many years. GM paid $35 million in fines - the “maximum civil fine and highest in history, for its violation of the National Traffic and Motor Vehicle Safety Act of 1996 (the “Safety Act”)” ([In re Gen. Motors Co. Derivative Litig. 2015 WL 3958724, (Ch.Del.) (In re GM)]. Several personal injury and class action lawsuits ensued, as well as Congressional and criminal investigations.

The GM Board did not know about the defects until February 2014. However, shareholders alleged the GM Board of Directors should be held personally liable for the faulty ignition switches, “not because the Board was complicit in the defect, but because it did not know about it until February 2014. Specifically, the Plaintiffs allege that the Board lacked a process by which it would be advised of National Highway Traffic Safety Administration (“NHTSA”) inquiries and the responses thereto. More generally, they argue that the Board lacked a mechanism by which it received information about safety risks and the risk of punitive damages in pending litigation” [p. 2].

At the request of the Board to investigate the circumstances leading up to the recall, Anton Valukas, a partner in the law firm of Jenner & Block, investigated and produced a report in which he concluded that “no single committee of the Board was responsible for all vehicle safety-related issues,” and that “the system put in place by the Board did not require that serious defects detected by GM’s legal department, its engineering department, consumer protection organization, or law enforcement agencies be reported to the Board.” Furthermore, “Valukas concluded that the Board ‘did not discuss individual safety issues or individual recalls except in rare circumstances,’ though it did receive ‘a wide variety of reports,’ and that the litigation reports to the Board did not mention ignition switch or airbag issues” [p. 4].

In addition, GM is required to adhere to the “Early Warning” requirements of the Transportation Recall Enhancement, Accountability and Documentation Act (the “TREAD Act”), or face monetary or criminal penalties. These requirements allow “NHTSA to collect data, notice trends, and warn consumers of potential defects in vehicles.” [p. 5] GM maintained a TREAD database, but Valukas concluded that “until 2014, the TREAD Reporting team did not have sufficient resources to obtain any of the advanced data mining software programs available in the industry to better identify and understand potential defects” [p. 8].

The plaintiffs claimed that GM’s in-house legal department knew from outside counsel as early as 2010 about litigation involving the failure of the airbags to deploy and the potential for punitive damages. In 2012, one firm made the connection to the ignition switch. These and other reports from various lawsuits and exposure to punitive damages apparently were not elevated to GM’s General Counsel or to the Board [p. 8].