Global Warming: Congress, The SEC And Shareholder-Plaintiffs Turn Up The Heat On Corporate Directors

Thursday, July 1, 2004 - 01:00

Protect Your Personal Assets

These are challenging times to serve as a director of a public company, particularly as a member of the Board's audit committee or compensation committee. Investor confidence has been shaken by corporate scandals where the "bad guys" appear to have been CEOs, CFOs and other senior management. To the SEC and the investing public, both the directors and auditors appear to have been either "asleep at the switch" or intentionally looking the other way. What followed was: (a) a legislative reaction in the form of the Sarbanes-Oxley Act of 2002; and (b) a sea of new regulations by the SEC and the stock exchanges, coupled with increased investigation, oversight and enforcement. More claims are being filed against officers and directors, and the cost to resolve those claims has increased by over 400%. Average settlements have tripled from $8.6million to $27million through June of last year, and there are now many settlements that exceed $100million. "Red flag" subjects that demand extra careful scrutiny by directors include: earnings restatements, executive compensation packages, pension plan changes, valuing stock options, mergers, sales and acquisitions; and managing intellectual property.

Directors can no longer rely upon indemnification from the company in order to protect their personal assets. Because corporate indemnity generally requires that the claims be resolved favorably, funds may be available only at the end of the case. Corporations will not necessarily advance monies to pay for a director's legal defense to achieve a favorable outcome. In addition, broad corporate indemnity that may be permitted under state law may be severely limited by corporate documents. Corporate indemnity may even disappear or become severely limited if:

• The company becomes insolvent and files for bankruptcy; or

• Governmental agencies refuse to settle claims against directors unless they waive their right to corporate indemnity - an increasingly common occurrence.

D&O Insurance

One answer to increased director protection lies in D&O insurance. However, a traditional D&O policy may not be sufficient to protect a director's personal assets because:

• D&O insurers may rescind the policies due to misstatements in the application process, including in financial statements that are a part of that process.

• Conduct-based exclusions may preclude coverage for "innocent" directors if other insureds (officers or directors) have participated in dishonesty, fraud or other wrongful conduct.

• If the D&O policy limit has not been increased in the last few years, the policy limit is possibly inadequate.

• Even a D&O policy with a high limit may be insufficient to cover all insureds (officers, directors and perhaps the company as well), which will necessitate allocating the coverage among the various insureds.

• Traditional D&O insurance may not kick-in until charges are filed; it may not cover informal government and regulatory investigations, but the vast majority of defense costs are usually incurred before charges are filed.

• If a company becomes insolvent or declares bankruptcy, the proceeds of the D&O policy may become part of the bankrupt estate, making the proceeds unavailable to pay directors' defense costs.

• D&O policies can exclude coverage for likely subjects of claims against directors, including securities fraud.

Directors do have some recourse. They must urge their companies to provide increased protection through D&O insurance products now on the market. These include:

• Side A excess coverage [to increase the amount of available coverage];

• Side A excess "executive" coverage with "full severability" and "anti-rescission language" [protects innocent directors against rescission or denial of coverage based upon alleged wrongful conduct by other insureds (officers or directors)].

• Side A coverage with "difference in conditions" [becomes primary coverage for directors when the D&O policy does not respond because of some exclusion].

• Separating coverage for directors from coverage for the company.

• Allocating in advance a substantial portion of the D&O coverage to directors or particular groups of directors (e.g., independent directors).

There is a dynamic tension and potential conflict of interest between the individual directors and the company and its senior management. Individual directors need more comprehensive D&O coverage, the advice of independent counsel, and increased access to independent consultants at company expense. It will cost the company money to reduce the level of risk to individual directors. But the company and senior management will likely prefer to cut costs by limiting D&O coverage and having corporate counsel represent and advise both the company and its directors.

Each director should consider his or her insurance needs independently from those of the company. Directors should ask for a complete explanation of all existing D&O coverage and, if appropriate, engage independent consultants to advise whether the coverage is adequate.

The Need For Independent Advice And Counsel

The key is to recognize that corporate counsel represents the corporation, not individual officers, directors or employees.

• There may be conflicts of interest between individual directors and the corporation.

• There may be conflicts of interest between some directors and others (e.g., independent v. inside directors).

• There may be no attorney/client privilege for communications from directors to corporate counsel.

• Government agencies and regulators encourage corporations to waive attorney/client and work product privileges with respect to communications between corporate counsel and directors, officers and employees.

Directors should get separate counsel whenever necessary to protect their interests.

Practical Suggestions

Four essential elements for discharging your fiduciary duty as a director are: (1) being well-informed about the company and the issues; (2) honest action by directors without hidden conflicts of interest or personal gain; (3) good faith belief that the actions you take are in the best interests of the company; and (4) probing questions of management. Here are some practical suggestions for Board meetings:

• Recruit directors with diverse expertise to serve on the Board.

• Regular director "education" at company expense - ongoing professional development and training in areas such as accounting and new legislation.

• Insist that directors receive all materials to be discussed at a meeting sufficiently in advance to permit adequate study.

• Directors should get both executive summaries and full documents.

• Schedule enough time to discuss important subjects and don't cut off discussion.

• Get independent advice from consultants, experts, and outside counsel where appropriate.

• Have one meeting for discussion and then defer important decisions until a second meeting, affording time for individual consideration.

• Hold executive sessions to discuss some issues outside of the presence of CEO/CFO.

• Scrutinize all issues for potential conflicts of interest involving Board or management.

• Document what is done at meetings but keep minutes concise and factual.

• Ask for follow-up to ensure that Board directions have been implemented.

The following ideas and suggestions have been publicly aired by a variety of scholars to "raise the bar" of our corporate business culture beyond the technical requirements of current legislation. These suggestions are increasingly being implemented in order to minimize the risk of both corporate and D&O liability:

• CEO should not be Chairman of the Board.

• Expand the role of the audit committee (all independent directors) beyond financial reporting and audit process to add responsibility for (i) conflicts of interest; (ii) codes of conduct; (iii) payments to/financial transactions with insiders; (iv) insider trading.

• Increase support for audit committees, including direct access to internal auditors and heads of business units, and financial support for independent consultants.

• Limit the number of Boards on which directors sit.

• Limit the number of interested directors (i.e., 1/3) on the Board and gradually evolve Board make-up to all independent directors.

• Eliminate director stock options, but offer tenure and retirement benefits.

Jeffrey W. Lorell is a Partner in the firm's litigation department. He has more than three decades of experience in sophisticated complex, multi-party civil litigation, arbitration, and mediation. Emphasis has been in all aspects of corporate litigation, antitrust, directors and officers' defense, fraud, securities, lender liability, trademark and unfair competition and business disputes of all types. He has extensive experience handling litigation and ADR proceedings involving disputes arising from the dissolution of professional partnerships and corporations, as well as employment related matters concerning restrictive covenants, client solicitation, improper use and disclosure of proprietary and confidential information, and related matters. For additional information write to: