Whether or not a candidate chooses to take the job as a corporate director or officer at a particular company may be significantly affected by his or her potential exposure to personal liability. After all, in recent years, personal liability for directors and officers has expanded into issues of wages, taxes, employee actions, environmental damage, regulatory matters and disclosure or misrepresentation of company information. And although the number of claims for directors’ and officers’ (D&O) insurance coverage changed little from 2000 to 2001, according to the Tillinghast-Towers Perrin 2001 D&O Liability Survey, the average payment increased by 75 percent in 2001 reaching $5.65 million.
To recruit and retain talented personnel, companies try to provide top management with maximum protection from personal liability for corporate action. Potential exposure can be limited by statute, charter provisions or contracts, and insurance.
The Sources of D&O Liability
Shareholders can sue directors and officers over breach of fiduciary duty (see sidebar on right) or for violations of securities laws (see sidebar below). Third parties (including company employees) can sue directors and officers for injuries allegedly resulting from executive conduct.
Overall, according to the Tillinghast-Towers Perrin survey, 25 percent of D&O claims in 2001 consisted of employment discrimination actions (the most common third-party action). Another 9 percent were financial disclosure claims (the most common shareholder action).
State Lawmakers Reduce Liability
Responding to a perceived D&O liability crisis in the mid-eighties, the Delaware general corporation law was amended to allow a corporation’s certificate of incorporation to contain a provision “eliminating or limiting the personal liability of a director to the corporation or its stockholders for monetary damages for breach of fiduciary duty as a director.”
The only exceptions are for liability arising from (1) breach of duty of loyalty, (2) conduct not in good faith or involving knowing violation of the law, (3) unlawful dividends or stock repurchases and (4) a transaction in which the director derives an improper personal benefit. In essence, the Delaware law allows directors to be shielded from monetary liability for negligence or gross negligence. (This protects only officers, however, not officer-directors in their capacity as officers.)
Delaware’s example was widely followed, with variations. In some states the exculpation is automatic—no special charter provision is necessary. The exception for breach of loyalty is omitted by many state corporate codes, which also eliminates the duty of disclosure.
Corporate statutes do expressly impose personal liability on directors for taking certain actions that threaten the corporation’s solvency, such as paying dividends or repurchasing stock when the corporation faces a capital shortage, distributing assets in dissolution to stockholders ahead of creditors, or making unauthorized loans to insiders. A director’s reliance on reports from officers or others regarding financial condition or other corporate matters, however, generally will absolve him or her of liability.
Indemnification
Corporations generally are empowered to indemnify their directors and officers for claims made against them as a result of their service to the company. These claims can be categorized as made either by or on behalf of the corporation (commonly known as derivative claims) or by a third party, such as those made under Rule 10b-5 of the Securities Exchange Act of 1934 and employment discrimination claims.
Statutory Rules. The corporate codes of California, Delaware and New York, and the Model Business Corporation Act (MBCA) require indemnification of an officer or director for expenses incurred in the successful defense of either kind of claim mentioned above. (The legal expense of enforcing an indemnification claim is normally included in an officer’s or director’s indemnification right under Delaware law, but is excluded in New York.)
These codes also authorize a corporation to indemnify an officer or director for incurred expenses and judgments, fines or settlements paid in a third-party action. Under these laws, the director or officer must have acted in good faith and in a manner he or she reasonably believed to be in the corporation’s best interest. In a criminal proceeding, the executive must have had no reasonable basis to believe his or her conduct was unlawful.
For a derivative claim, if the director or officer is found to have acted in good faith and in a manner he or she reasonably believed to be in the corporation’s best interests, indemnification for expenses incurred in settling a claim is permitted under each of these codes. (In New York and California, court approval is needed—judgment costs in a derivative claim, however, are not covered.) If the director or officer is found liable to the corporation, indemnification is allowed only as determined by the court.
Each of the state statutes also specifies circumstances under which defense costs may be advanced to a director or officer pending final determination of his or her entitlement.
Corporate Enhancements to Indemnification. As an incentive to entice new directors and officers, companies often indemnify directors and officers even if corporate statutes do not require them to do so. These obligations are created by charter, bylaw or contract, but are limited to the authority vested in the corporation by statute. Therefore, whether a director or officer can be indemnified must be determined on a case-by-case basis.
These indemnification provisions must be drafted with attention to the language of the enabling statute; otherwise a corporation may inadvertently obligate itself to indemnify under unintended conditions.
For example, charter or bylaw provisions should specify whether coverage is limited to directors and officers, or if it includes other individuals that statutes permit the corporation to indemnify, such as employees or agents. In a 1983 Delaware Supreme Court case (Hibbert v. Hollywood Park, Inc.), a corporation was surprised that a broadly worded bylaw required indemnification of litigation expenses incurred by a group of directors—as plaintiffs—in an unsuccessful action against the corporation and other directors.
In Marshall Manley v. AmBase Corporation (2001), AmBase learned just how far the limits of indemnity can extend. In the case, Marshall Manley, an attorney, was hired by AmBase to work as the president and chairman of one of the company’s subsidiaries. While working for AmBase, at the request of its chairman and with the knowledge of its board of directors, Manley maintained his status as a partner at a law firm. AmBase agreed in writing to provide Manley with indemnification for all claims, suits and proceedings arising during the time of his employment to the fullest extent allowable by law.
During Manley’s tenure at AmBase, his law firm went bankrupt and, as a result, he was sued in more than twenty legal actions. AmBase eventually terminated Manley’s employment.
Manley sued AmBase to recover his legal fees and settlement monies paid in the resolution of claims against the bankrupt law firm. The court upheld Manley’s right to seek reimbursement for incurred legal fees, as well as the $3.45 million he had committed to pay to settle the claims against the defunct law firm.
D&O Insurance
The Delaware, California and New York corporate statutes and the MBCA permit corporations to buy insurance to cover the liabilities of directors and officers, including liabilities that the corporation would be otherwise unauthorized to indemnify. This wider potential coverage is a major advantage of D&O insurance, beyond the financial protection that insurance ordinarily provides. D&O insurance also gives coverage to directors and officers when the corporation itself is financially unable to indemnify.
D&O policies are claims-made policies that typically insure directors and officers for judgments, settlements and defense costs directly incurred. (See “Mergers and the Claims-Made Policy,” p. 32.) The policies also cover the amounts for which the company indemnifies its directors and officers for losses arising from alleged or actual errors, omissions, statements, misleading statements or breaches of duty. Although insurers expressly decline any duty to defend, modern policies usually obligate the carrier to advance defense costs to the insured.
D&O policies exclude claims for physical injury, property damage, defamation, pollution and other liabilities typically covered by a company’s general liability policy. Coverage is limited to those potential liabilities particular to the status of the director or officer. Coverage is excluded, however, if the director or officer deliberately engages in criminal activity (e.g., fraud), or gains a profit or other advantage to which he or she is not entitled.
The language of the D&O policy is vital. A recent Seventh Circuit case (Level 3 Communications, Inc. v. Federal Insurance Company, 2001) illustrates how the precise choice of words used in a policy can significantly affect the rights of those seeking its benefits. Interlocken, Colorado-based Level 3 sought recovery of an amount it paid to settle a securities fraud action. It claimed that the payment constituted a “loss,” which the policy defined as “the total amount which any Insured Person becomes legally obligated to pay . . . including, but not limited to . . . settlements.”
Noting that Level 3 had made no attempt to demonstrate that the securities fraud action was groundless, the court ruled that the settlement payment could not constitute a loss. It determined that the fraud case, in essence, sought repossession of property to which Level 3 was not entitled. The court compared the case to one in which an insured prevailed on similar facts, because “the operative term in the insurance policy was ‘damages’ [which is broader] than ‘loss.’”
Securities Claims—What Is Covered, What Is Not?
Difficulties can arise if both a corporation and its directors and officers are sued for the same claim, particularly in securities litigation. Publication of misleading financial data, for example, can result from errors by company personnel not covered by the D&O policy.
Because the D&O policy covers only losses incurred by directors and officers, it may be necessary to allocate defense costs and settlement or judgment payments between the directors and officers and the company. To avoid these situations, D&O insurers now offer entity coverage, which includes the corporation and its employees for securities claims.
Trends in D&O Coverage for Employment Claims
It has also become common to offer D&O coverage for employment claims, such as employment discrimination, sexual harassment and wrongful discharge. Some policies handle the coverage on the same basis as other D&O claims. Others treat both the individual defendant and the corporation as insured parties and assume the duty to defend. Such endorsements can circumvent difficult issues relating to the scope of a corporation’s indemnification obligations and scope of insurance coverage.
In one instance, a California appellate court granted broad indemnity in a decision that examined whether an officer sued for sexual harassment by a coworker could seek indemnity for legal costs incurred in successfully defending the lawsuit. In the case, Russell Jacobus v. Krambo Corporation (2000), both the company and Jacobus, an officer, were sued. Because Jacobus admitted to engaging in the alleged conduct, the company, and thus the carrier, denied Jacobus a defense and any indemnity under the policy.
Previous cases in California have held that since sexual misconduct is outside the course and scope of employment, an employee found to have engaged in it is not entitled to indemnity or a defense under the California Labor Code. In Jacobus, however, the the plaintiff welcomed Jacobus’ sexual misconduct and was a voluntary participant in it. Thus, the jury found in Jacobus’ favor.
Jacobus sued Krambo for the $82,083 in legal fees he incurred defending the lawsuit. The court found that he was entitled to the fees he incurred in the underlying action, as well as those incurred in pursuing the company for indemnity. The court also found that the carrier had wrongfully denied Jacobus a defense in the action, even though he would not be entitled to indemnity since his intentional acts were excluded under the policy.
Conclusion
Directors’ and officers’ liability is a dynamic area, especially as case law expands its scope and insurance products evolve to meet the changing legal landscape. Risk managers must continually assess the exposure to the corporation and its directors and officers to D&O claims, and be alert to new forms of liability. They must regularly survey the market for D&O insurance to take advantage of product innovations.
A total assessment of D&O protection should take into account the following items:
1. A review of the corporate and labor laws of the state of incorporation and any state where the company has substantial business operations, including pending court cases;
2. A review of corporate charter, by-laws, board minutes or other documents that reflect the intended scope of indemnity to be afforded to the company’s directors and officers;
3. An inventory and review of employment agreements with directors, officers, and other employees containing indemnification provisions; and
4. A careful analysis of coverage provided by D&O policies.
Risk managers may wish to recommend to senior management that their companies conduct formal assessments of the exposure to personal liability for corporate personnel. (A copy of this article might be attached to such a recommendation, as well as updates on the constricting D&O market—see “Details,” p. 11.) Officers responsible for a company’s discrete business operations and geographic units, as well as company counsel, should be assigned responsibility for alerting the risk manager to changes in the business or the law; and the risk manager should regularly inquire about these matters. This information can then be taken to the broker or carrier, from which the company should expect support in developing the scope of its D&O coverage.
(Sidebar) Fiduciary Duties Defined
Under common law, directors and officers owe to the corporation duties of care and loyalty. Care refers to making corporate decisions prudently and on an informed basis. Loyalty requires subordinating personal interests to those of the corporation. This means the director or officer must refrain from self-dealing, disclose potential conflicts of interest and offer to the corporation any business opportunity that he or she receives in a corporate capacity.
(Sidebar 2) Securities Laws
The most common form of stockholder action under the federal securities laws is based on Rule 10b-5 under the Securities Exchange Act of 1934. This rule prohibits, in connection with any purchase or sale of a security, the use of “any device, scheme, or artifice to defraud”; the making of “any untrue statement of a material fact”; or information omissions that make any statements misleading. Corporations and their officers and directors can be held liable for false information contained in documents filed with the Securities and Exchange Commission, as well as in news releases or through public platforms, such as a Web site. Directors, officers and other insiders also can be liable for trading in a corporation’s securities while possessing material information that has not been publicly disclosed.
Shareholder suits can also arise from the Securities Act of 1933, which imposes strict liability on directors and certain corporate officers for misleading information contained in a prospectus used in a registered public offering.
