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Director and Officer Liability Insurance Current Developments. Background. Events over the past two years have focused the attention of government authorities and the investing public on officers and directors of public corporations particularly in. Financial disclosure and reporting.

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Director and officer liability insurance current developments

Director and OfficerLiability InsuranceCurrent Developments


Events over the past two years have focused the attention of government authorities and the investing public on officers and directors of public corporations particularly in

  • Financial disclosure and reporting

  • Executive compensation

  • Corporate governance


Some of the situations are close to home --

  • Enron

  • Other energy trading companies

Others around the country and in the news --

  • Tyco

  • WorldCom

  • Adelphia


Financial Disclosure Problems

  • Revenue Recognition -- Software, etrade

  • Earnings management -- Hitting the numbers

  • Acquisition accounting

  • “Cooking the books”


Executive Compensation

  • Dick Grasso and the NYSE

  • The “acid test” of independence

  • Compensation consultants

  • Public opinion


Governmental agencies, the media and others describe these situations as, among other things, “failures of corporate governance” --

  • The White House

  • Congress -- Hearings and Sarbanes-Oxley

  • The SEC -- New rules, investigations and enforcement actions.

Invariably, and appropriately, the focus of corporate governance centers on the board. Why?


Because the directors, as a board, are charged with the responsibility for managing the business and affairs of public corporations.

  • The board has that ultimate responsibility —

  • not the officers--they are appointed by and report to the board; and

  • not the stockholders--they own the company, of course, but they have elected the directors to manage their company, ultimately for their benefit.

Legal framework
Legal Framework

Despite the risks, directors do have substantial defenses available to them

State law provides the basic concepts of corporate governance, the relationships among the constituents and director responsibilities

Federal law provides a pervasive backdrop, however, primarily through the federal securities laws (disclosure, proxy regulation, etc.), but now most importantly through Sarbanes-Oxley

Sarbanes oxley

  • Certification of financial statements by CEO and CFO

  • Increased disclosures and penalties

  • Prohibits loans to executives

  • Forfeiture of bonuses and profits

  • Increased responsibilities of audit committees, auditors and lawyers

State law
State Law

Directors are elected by the shareholders and specifically charged by state corporate law with the management of the “business and affairs” of the corporation, as fiduciaries

  • Delaware Section 141; TBCA Article 2.31

  • Fundamental -- The board is legally responsible for the management of the company


What are the legal responsibilities of directors?

Director responsibilities
Director Responsibilities

Director duties are fiduciary in nature, derived from trust law concepts.

  • Directors are the caretakers of other people’s property.

  • The corporate model places that primary fiduciary responsibility on them, not the management, although they too have fiduciary responsibilities.

  • What, precisely, is expected of directors?

Director responsibilities1
Director Responsibilities

Easy to state the general rule under state corporate law:

In discharging its responsibilities, the board and its individual members are expected to act in good faith, to be fully informed, and make decisions or take actions which they honestly believe are in the best interests of the company and its stockholders.

Fully informed
“Fully Informed”

A director

  • Should have a working knowledge of the company’s business and financial condition, its prospects, and its strategic business plan.

  • Should seek and carefully consider advice and opinions of management and outside advisors, and critically evaluate that information.

  • Should take as much time as is necessary to review and evaluate materials presented to the board, asking for additional materials or explanations needed.

Fully informed1
“Fully Informed”

An aspect of the Duty of Care

  • Importance of process

  • Reliance on reports and advice of officers

  • Reliance on professional advisors

  • Common sense/ prudence elements -- time and commitment are required

Good faith and loyalty
“Good Faith” and “Loyalty”

A director must put aside self-interest

  • Essential element of public trust

  • Independence is a key element of modern corporate governance

  • The duty of loyalty

  • The duty of good faith (a separate duty receiving current attention)

Independence of directors
Independence of Directors

  • Definitional challenges -- A variety

  • “Resume” independence

  • An overarching issue in most corporate governance discussions

  • Audit Committees

  • Compensation Committees

  • Nominating Committees

Responsibilities and liabilities
Responsibilities and Liabilities

  • With this focus on the board, directors have increasingly become target defendants in both civil and criminal proceedings

  • So why would anybody serve as a director or officer of a public company?

    • Independent directors now mandated

    • But where do you find them?

Director protections
Director Protections

  • Business Judgment Rule

  • Indemnification

  • Exculpation

  • Lawsuit advantages

    • Class Actions -- Reform Act (PSLRA)

    • Derivative Suits -- SLC’s (Special Litigation Committees)

  • Insurance

But each has vulnerabilities, especially now.

Business judgment rule
Business Judgment Rule

Provides a presumption of regularity when directors act in good faith, without self-interest, and on a fully informed basis.

  • Directors have to make an initial showing, and then

  • Burden of proof is on the party challenging a decision

Importance of process, reliance on inside and outside advisors, and avoidance of conflicts.


How strong is the current presumption?


Indemnification limited by

  • law and public policy (e.g., duty of loyalty, punitive damages, derivative claims)

State statutes are permissive; most companies convert to mandatory indemnification through charter, bylaw or contractual provisions

  • financial resources of the company itself (Enron and Adelphia examples)


  • The first line of defense

  • Authority to indemnify created by statute

  • Statutes are permissive in most respects, although indemnification is mandatory when

    • Wholly successful on the merits or otherwise

    • “Otherwise” includes procedural defenses

    • “Wholly” excludes in Texas partial successes

  • Statutes distinguish between claims made by third parties and those made by or in the right of third parties


  • Director must meet the statutory standard of conduct to be entitled to indemnification

    • Acted in good faith, and

    • In a manner reasonably believed to have been in the corporation’s best interests, or

    • Not opposed to such best interests in Delaware, and in Texas when director is not acting in an official capacity.

    • In the case of a criminal claim, the director must have had no reasonable cause to believe the conduct was unlawful.


  • Determination that standards have been met must be made by

    • a disinterested board or board committee, or

    • disinterested stockholders, or

    • special or independent legal counsel.

  • Determination need not be made, however, for advancement of expenses.

Advancement of expenses
Advancement of Expenses

  • Perhaps the most important aspect of indemnification, and it clearly is the most important at the outset of any claim or lawsuit.

  • Advancement is permissive unless made mandatory by charter, bylaw or agreement.

Advancement of expenses1
Advancement of Expenses

  • The advancement must be made in conjunction with an undertaking or promise to repay the amounts advanced if it is ultimately determined that the director is not entitled to indemnification.

  • The undertaking to repay the advancement need not be secured.


  • Several ways to make permissive indemnification mandatory

  • Bylaw or charter provisions

    • General or Specific

    • Separate Indemnification Agreements

Indemnification agreements
Indemnification Agreements

An indemnification agreement could provide, among other things, the following:

  • Prompt indemnification to the fullest extent permitted by law against any and all expenses (including attorneys' fees), judgments, fines and amounts paid in settlement of any claim (as defined).

Indemnification agreements1
Indemnification Agreements

  • Prompt advancement of expenses and reimbursement thereof if it is ultimately determined that indemnification is not permissible under applicable law.

  • A mechanism through which a director may enforce the terms of the agreement, and indemnification for the costs of enforcement, whether successful or not.

Indemnification agreements2
Indemnification Agreements

  • The agreement would impose upon the Company the burden of proving that a director is not entitled to indemnification in any particular case.

  • The agreement would also provide that the rights thereunder are not exclusive of any other rights to indemnification or insurance to which the director may be entitled, all of which are specifically reserved.


Corporate statutes generally permit companies to include in their charters (therefore, stockholder approval required) provisions that protect directors from liability to their corporations for monetary damages except in cases of

  • Breach of duty of loyalty or good faith

  • Other improper personal benefit

  • The limits of these statutes have not been fully defined.

Lawsuit advantages
Lawsuit Advantages

  • Securities Fraud Class Actions -- Reform Act

  • Motions to dismiss frequently granted.

  • Plaintiffs must be able to raise an inference that there was actual securities fraud.

  • But Enron and other corporate scandals may have reversed this trend, and we will have to watch the courts closely in the coming months.

Lawsuit advantages1
Lawsuit Advantages

  • Derivative Suits -- SLC’s

  • On behalf of the company

  • Special litigation committee procedure developed in Delaware, codified in Texas

  • SLC can secure the dismissal of the derivative suit if, after a thorough and independent investigation, the SLC concludes the claims are without merit.

  • Again, Enron could affect these procedures.


Fills the gaps left by indemnification limitations

  • Typically covers more than company can

  • Not dependent on financial health of the company

But there are challenges to deal with

  • Cost and coverage

  • Retentions and exclusions -- definitions

  • Application Process -- Rescission

D o insurance
D&O Insurance

Application Process

  • Sarbanes-Oxley Certifications

  • SEC Filings

Restatements -- Undermines application representations

Rescission -- Different legal standards

D o insurance1
D&O Insurance

  • Coverage for investigations

  • Definition of “Loss”

  • Definition of “Claims”

  • Definition of “Dishonesty”

D o insurance2
D&O Insurance

  • Typical coverage would involve both individual and company reimbursement

    • Coverage A or “Side A” -- directly insures individuals.

    • Coverage B or “Side B” -- would reimburse the company for amounts paid to indemnify directors and officers.

D o insurance3
D&O Insurance

  • Allocation issues arose when both the company and individuals were defendants

    • Insurers developed Coverage C, in part as a response to the allocation fights.

    • Coverage C or “Side C” -- insures the company directly for securities claims.

D o insurance4
D&O Insurance

  • Recently, problems have arisen in bankruptcy settings

    • Debtor claims the policy as an asset of the estate

    • Directors claim that they are entitled to the proceeds even if the policy is an asset of the estate.

    • With Coverage C, the outcome of that debate is less certain.

D o insurance5
D&O Insurance

  • Possible solutions

    • Side A only

    • Excess for Side A only

    • Priority of payments provisions

    • Each solution has its problems

  • Solution my depend on the purpose of insurance


Congress, the SEC, the NYSE, and Nasdaq are now requiring independent directors on boards --

But why would a person agree to serve on a public company board in this environment?

Liability protection is essential, and insurance can fill the gaps left by indemnification and other legal protections

Director and officer liability insurance current developments1

Director and OfficerLiability InsuranceCurrent Developments