Risk Management For Prospective Outside Directors

Thursday, June 1, 2006 - 00:00

Corporate counsel are often invited to serve as directors of company boards or asked to advise executives who have been invited to join a board. An informed decision requires understanding the obligations and risks of directorship and minimizing the risks to the greatest extent possible. This article highlights the risks facing a prospective director and suggests some critical protections they should require before agreeing to serve on a board.

Expanding Liability. Every prospective director has seen the headlines: the Sarbanes-Oxley Act of 2002 has resulted in unprecedented scrutiny of the conduct of public companies' officers and directors, and as a consequence the Department of Justice and the Securities and Exchange Commission appear to be engaged in endless investigations. Shareholder suits have routinely followed these investigations. Further, as corporate counsel may know, since 2003 DOJ has taken the position that corporations can demonstrate cooperation with investigations (and thus attempt to avoid indictment) by cutting off the advancement of legal fees to officers and directors whom the government believes may be "culpable." At times, serving as a director may seem like a greater headache than it's worth.

Navigating the Risks. The current regulatory and legal climate should not necessarily dissuade prospective directors from accepting the honor of serving on a board. Careful consideration of a number of factors should allow prospective directors to minimize, if not eliminate, many risks.

Be Informed. First, it is critical to know the organization. The prospective director should know and feel comfortable with management, the other directors, and the company's counsel and auditors, and should research the company, its board, and its management through publicly available information, including all SEC filings, paying special attention to whether the company has received clean auditors' opinions regarding its accounting and internal controls. The prospective director also should know the members of the company's audit committee and its independent directors sufficiently well to know whether they can be relied on to make strong and independent decisions, or whether management so dominates the board that the audit committee and independent directors may not be able to effectively respond to a crisis.

Second, the prospective director should determine whether she can serve effectively and without conflicts. Corporate directors owe two fundamental fiduciary duties to the corporation: the duty of care, requiring directors to be diligent and informed about the company's governance and management; and the duty of loyalty - requiring the director to always act in the company's best interests, not her own or those interests to which she is loyal.

These fundamental fiduciary duties require a prospective director to first consider whether she is able to devote the time and energy necessary to fulfill these responsibilities. A director cannot rely on others to do the work; she must be committed to attend directors' and committee meetings and do the work and study required to be informed and meaningfully participate in deliberations and decisions.

The prospective director also must evaluate whether her other positions or business interests present conflicts with the corporation on whose board she may serve. Does the director or her employer do business with the organization? Does the director serve on other boards that compete or whose interests intersect with the organization? Does the prospective director hold or will she learn confidential information that will put her in a conflict position?

Conflicts of interest do not necessarily preclude serving as a director. But fiduciary responsibility, as well as liability avoidance, require that conflicts be recognized and addressed, most often by disclosure and recusal from relevant board decisions.

Look for Maximum Liability Protection. The prospective director who wants to serve needs to consider how she will be protected from liability.

Two fundamental protections should be in place. First, the corporation's bylaws and other articles should provide for indemnification of directors to the maximum extent provided by the law of the state of incorporation. The laws of every state allow for the corporation to indemnify its directors for expenses incurred in the defense of claims and for judgments or settlements. Even bylaws providing for mandatory indemnification, however, will not serve to indemnify a director found to have breached her fiduciary duties or acted in bad faith. To provide additional protection, a corporation's bylaw may provide that the right of indemnification is contractual, allowing the corporation to enter into separate indemnification agreements with directors that may not be altered without the consent of the indemnified director. Finally, the bylaws should provide for the advancement of expenses, so that legal fees and expenses can be reimbursed as they are incurred, rather than at the conclusion of litigation.

Second, the company should have comprehensive directors and officers insurance in place. Except for intentional misconduct, D&O insurance can insure what is not indemnifiable. However, a D&O insurance policy with a multi-million dollar limit may actually provide illusory protection for a director. For example, protection provided by D&O insurance can vanish if a bankruptcy trustee succeeds in the argument that the policy is the property of the bankrupt debtor's estate and the directors have no or limited rights to the policy. Coverage also can be impaired where individual director and officer insureds compete for portions of the policy limits to be used to pay for their own defense expenses or for settlements they wish to make. Insurers also may argue that the application for D&O insurance submitted by a company officer, but of which the independent directors had no knowledge, contains a fraudulent misrepresentation that completely invalidates coverage. Finally, a management director's criminal or fraudulent act could void coverage even for directors who did not participate in the act and had no knowledge of it. Each of these nightmare scenarios has occurred.

As a result of the demand for reliable protection, the insurance industry has responded by offering policy terms that minimize the risk of coverage of operating in the face of a claim. In a D&O policy, insuring Agreement A provides coverage for the directors and officers individually for "loss" arising from "wrongful acts" alleged to have been committed in their capacity as directors or officers. Insuring Agreement B provides coverage for the corporation to the extent of its responsibility to indemnify its directors and officers for expenses of defense in claims. Many D&O policies also have an Insuring Agreement C, which provides direct insurance for the corporation for claims against it. This is so-called "entity" coverage. Thus, in a typical shareholders class action case where the directors are named as defendants along with the corporation, the D&O insurance policy pays for the defense of the corporation, as well as the directors and officers.

Following the insuring agreements come the exclusions, which often seem to take back most of the insurance that the insuring agreements provide. It is critical to understand the exclusions. For example, loss arising from intentional wrongful acts is always excluded. But are wrongful acts of one insured imputed to other insureds to take away their insurance? Does the wrongful act need to be established by a final adjudication or is it sufficient for the insurer simply to conclude that a wrongful act took place? Does the exclusion exclude loss based on certain acts or is it broader excluding loss based on a claim "alleging" certain acts? An exclusion in the latter form excludes even the defense for such a claim.

A hidden danger lurks outside the policy terms in the policy application. Some D&O insurance applications incorporate the company's SEC filings and require the applicant to warrant the accuracy of the representations in the filings. An insurer faced with a large claim will flyspeck the application to find deviations from the warranted facts. An even worse situation is if the application was completed by a CFO who knows the company has problems but discloses nothing about them in the application. This may completely invalidate the insurance.

While insurance policies with this structure described above have successfully resolved many significant claims, the structure itself creates two problems in a catastrophic situation. First, if the corporation is in bankruptcy, the debtor in bankruptcy (or a trustee) may assert that the entity coverage renders the policy the property of a bankrupt estate, and the individual and the individual insureds have limited rights or no rights to the protection the policy provides. Second, the existence of multiple insureds, i.e ., officers, management directors, the company itself and the independent directors may create a competition for use of insuring insurance limits. Independent directors, for example, might want to enter into a settlement using a substantial portion of the policy limits and the other insureds may object.

These circumstances have led to the development and use of:

1. policies that provide only coverage for individuals and no entity coverage;

2. policies that provide limits reserved solely for independent directors; and

3. policies that provide separate stand-alone "side A" coverage for independent directors only.

Stand-alone coverage for the independent directors is the ultimate protection. These policies are applied for separately and are written on a so-called DIC (difference in conditions) basis, so that if payment of company indemnification is not forthcoming and the main D&O policy fails to cover the claim or fails to pay, the DIC policy will pay. The only issue is one of cost. This coverage is not expensive, compared to ordinary D&O premiums, but whether the protection is actually worth the cost is a matter on which opinions may vary.

Armed with the knowledge of these potential insurance pitfalls, a prospective director should review the insurance coverage available for independent directors along with the application and, unless she is expert on these issues, should consult with the company's risk management department, the company's insurance broker, or independent counsel.

In sum, it is important for good people to serve as directors. The work can be fascinating and professionally rewarding and need not impose undue risk if the issues are considered and resolved ahead of time.

Robert McL. Boote is a Partner in Ballard Spahr's Litigation Department and a member of the Insurance Group and the Health Care Group. Justin P. Klein is a Partner of Ballard Spahr Andrews & Ingersoll, LLP, in the Business & Finance Department, Partner-in-Charge of the Securities Group, and a Member of the Mergers and Acquisitions Group, Securitization Group, Transactional Finance Group, Technology and Emerging Companies Group and of the Insurance Group. John C. Grugan is an Associate in the firm's Litigation Department and a Member of the White Collar Litigation Group and the Insurance Group.

Please email the authors at booter@ballardspahr.com, kleinj@ballardspahr.com or gruganj@ballardspahr.com with questions about this article.