Tone at the top
07/06/2019
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A US company is attempting to use “tone at the top” as the basis to claw back former executives’ pay.

Regulators around the world, including ASIC, have exhorted companies to improve their  “tone at the top”, as a requirement for governance, despite not being able to explain exactly what this is, and what a good or bad “tone” looks like  (see HERE and HERE) .

In March 2019, the Hertz Corporation, filed two complaints 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). The litigation between Hertz and its former executives raises novel questions about whether executives have a legal duty to set the right “tone at the top” and the consequences if they fail to do so.

Background

In May 2014, Hertz 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.

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 .

Claims against the Former Executives

Hertz’s complaints are notable both for what they allege and what they do not allege and raise interesting questions regarding the responsibilities of corporate officers and the consequences if they fail to satisfy those responsibilities.

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 instil 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 “fulfil 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 “streamline[e] [Hertz’s] hierarchy and ensure[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 wilful gross neglect or wilful gross misconduct.

Questions Raised Regarding “Tone at the Top”

Though Hertz’s complaint has yet to be sustained, it raises several questions that are novel­ and 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? Related questions implicated by the complaints include:

  • Does an officer have a duty 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 duties of care for 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?

“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.

There are many interesting side aspects to this case that may serve to set a precedent for what are unacceptable tones from the top.

See more notes on this case HERE .

© Guerdon Associates 2021
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