I am frequently asked about the safety of director service. Below is the text of a short article I wrote for a forthcoming issue of a business publication.
Although the article is short and non-technical, I decided it was a good opportunity to start a discussion here on director service. I would enjoy a dialogue with readers on these issues, so please post comments or email or call me. I may write follow-up blog posts on issues that generate discussion.
D&O insurance is an essential component of the analysis of the safety of director service. “The ‘Nuts and Bolts’ of D&O Insurance,” by Kevin LaCroix, author of The D&O Diary, is an excellent primer on the subject.
Here is the text of my article:
Disclosure dilemmas and legal problems are a reality of business, and shareholder lawsuits often follow.
So, is it safe to serve on a public company board of directors? The answer is easy: yes, it indeed is safe, as long as the director is conscientious and has appropriate corporate protections against personal liability.
Shareholder lawsuits are frequent, but outside director liability is rare. Shareholder litigation almost never affects the personal finances of outside directors, due to a combination of factors.
- Shareholder litigation rarely goes to trial. This is true for many reasons, including potential exceptions under corporate indemnification and Directors’ & Officers’ (“D&O”) liability insurance contracts if a defendant were to lose at trial.
- Nearly all shareholder cases are settled with D&O insurance proceeds and/or a payment by the company. Only in exceptional cases have outside directors ever made any significant financial contribution toward the settlement of public company shareholder litigation.
- Outside directors are not the target defendants in securities class actions. They are often sued in shareholder derivative actions challenging the directors’ oversight of the company, but plaintiffs face high hurdles to establish liability. They also are often named as defendants in shareholder challenges to mergers, but such cases almost always settle for modest amounts.
Yet, no director wants to be sued, so prevention of problems is key — the fewer problems, the less risk of litigation, and preventive measures actually establish substantive defenses to liability. In simple terms, the law expects directors to make sure that their companies have systems in place to prevent and detect problems, and to follow up on indications of a lack of compliance. Attention is essential. The Sargent Schultz defense (“I know nothing!”) doesn’t work.
Sarbanes-Oxley’s certification requirements are central to a company’s systems for compliance with the securities laws. Because of Sarbanes-Oxley, more work goes into internal controls, financial reporting, and other public disclosures than ever before, and more issues bubble-up and are addressed at the senior management and board level. Even though the burdens that these requirements have imposed are onerous, they have made outside directors’ compliance with their oversight duties easier.
Legal compliance on matters other than disclosures is highly company-specific. In a nutshell, directors need to understand the company’s legal risks, implement the appropriate compliance and reporting systems, and act to address problems as they are identified. Directors can easily satisfy their oversight duty if they understand their responsibility, ask the right questions and engage the right legal advisors.
If problems and litigation arise, directors have several protections against personal liability.
The most fundamental protection is an “exculpation,” or “raincoat” protection in the company’s corporate charter or articles of incorporation. In general terms, such a provision provides that directors shall not be liable to the corporation for money damages unless they acted disloyally, intentionally or in bad faith.
Corporate indemnification is a director’s primary financial protection. Directors should ensure that the company’s indemnification provisions are well-crafted and provide the maximum protection the law allows, and should ask a securities litigator to review them from time to time.
D&O insurance, of course, also provides important protections. Three points are important to keep in mind:
- Engage a broker who is a specialist in D&O insurance coverage and claims. Such a broker will best know what coverage provisions are possible and at what price, and will know the right structure and amount of insurance.
- Focus on protections for outside directors. Ensure that the insolvency provisions are state-of-the-art, and there is sufficient Side A coverage.
- From time to time, ask a securities litigator to review your D&O insurance program.