"Spending Time with Family" and the Antifraud Provisions

It is a time honored practice to explain a CEO's resignation as motivated by family concerns.  It might be to spend more time with family or something a bit more generic (family reasons, which presumably could, for example, include such things as repairing relations with a spouse). 

When the CEO of Pfizer resigned in 2010, the press release indicated he wanted to “recharge my batteries, spend some rare time with my family and prepare for the next challenge in my career.”  The departing CEO of Restuarant.com likewise wanted to spend time with family.  So did Dick Notebart when he stepped down as CEO of Qwest.  The same was true at Red Roof Inn and Kellogg

With respect to the recent resignation of the CEO at Stryker, the press release indicated that he resigned "for family reasons".  According to the WSJ

The 48-year-old executive resigned Feb. 8 after apparently losing the confidence of some key board members at the medical-device maker, according to a person familiar with the matter.  Those board members became bothered after learning of [the CEO's] purported affair while he was involved in divorce proceedings, this person said. The divorce isn't final, according to Michigan court documents. The alleged affair couldn't be independently confirmed.

We have no idea whether any of this is true.  Nor do we know whether the resignation was prompted by anything other than family reasons.  Indeed, romantic involvement with a former employee by a CEO going through a divorce, to the extent it even occurred, doesn't seem to raise the types of concerns that typically result in a CEO being pressured to leave. 

Nonetheless, it got us thinking about whether a company could be successfully sued under the antifraud provisions (the infamous Rule 10b-5) when using the "family" explanation for a CEO's departure.  The practice may be widespread.  As the WSJ noted:

Boards force out a CEO over what they consider unethical behavior more often than commonly believed but rarely divulge that's the reason, according to experts. Many directors want their leader to live by high standards, and will replace the CEO if they believe he or she "has shown bad judgment in personal life,'' a succession-planning specialist said.

We start with the assumption that the motivation is true.  Officers commonly depart for family reasons.  So the issue under the antifraud provisions is not whether the family explanation is false but whether, having disclosed one motivation, the company is required to reveal any other significant motivation for the departure. 

This arises from the obligation under the antifraud provisions to ensure that all statements to the market are accurate and complete, an obligation that, by the way, also arises under state law.  See Sherwood v. Ngon, 2011 Del. Ch. LEXIS 202 (Del. Ch. Dec, 11, 2011) (statement may have been misleading by implying that motivation given for removing director " was the only reason that motivated the board to remove him from the Company's slate.").  

Resolution of the disclosure issue for the most part depends upon the materiality of any omitted motivations.    Materiality, in turn, depends upon the context. 

In many cases, there is an argument that omitted motivations won't be material either because they are unimportant to reasonable investors or because the market already knows the truth.  Thus, shareholders in a company where earnings or stock prices have performed poorly will know that these were factors likely played a role in the resignation, even if they were unstated. See Zahid Iqbal & Dan French, Executive share ownership, trading behavior, and corporate control, 59 J. of Economics and Business 298, 299 (2007) (noting that while companies often attribute executive departure to "early retirement" or "personal reasons," at least one study  concluded that "whatever the reason stated [for an executive's departure], the majority of executive turnover during financial distress is associated with the financial condition of the company."). 

Moreover, in those circumstances, share prices sometimes actually go up.  Shareholders do not care about the reason for the departure, only that the departure occurred.  In other cases, the departure of the CEO may matter but the reasons do not. 

Motivations that have the strongest chance of crossing the materiality threshold are those that reflect not so much on the CEO but on the company.  Thus, for example, a "resignation" of a CEO as part of an interenal investigation into financial fraud or a departure arising out of criminal investigation of the company may well be material.  These motivations suggest problems inside the company that shareholders and investors would want to know about. 

What about allegations of unethical behavior?  For one thing, that concept is extremely broad with no automatic content.  Moreover, context clearly matters.  Ethical issues in the context of a CEO who remains at the helm may be very material (and therefore subject to disclosure).  Investors would want to know about the unethical behavior in assessing their trust in management when buying shares.  Shareholders would presumably weight the factor when voting for directors. 

In the context of a CEO's resignation, however, departures as a result of "ethical" concerns would generally seem to add little to the total mix.  The trust issue is not particularly important since the CEO is departing.  Materiality might be a concern if the CEO's behavior somehow results in substantial exposure to the company (say the loss of all government contracts).  But this would likely not be the case in most instances.  

Returning to the Stryker situation, the company disclosed that the CEO departed for "family reasons."  The share prices hardly changed.  When the WSJ published an article hinting at other possible motivations, the share prices again hardly changed.  Perhaps the market did not believe the hints.  Or, perhaps the market didn't care.  In other words, perhaps the motivations for the resignation were not material. 

The materiality of omitted motivations in the context of a resigning CEO will depend on each specific set of circumstances.  Nonetheless, as a general rule, it will often be a difficulty case to maintain. 

J Robert Brown Jr.