Board Protection: Individual Liability Insurance for Independent Directors

Introduction

In the wake of recent corporate governance scandals, independent directors of public companies face increased levels of scrutiny and heightened prospects for the risk of personal liability. Recent court decisions have criticized directors of public and private companies for insufficient attention to their duties. The Sarbanes-Oxley Act of 2002 (S-O) and the proposed corporate governance reforms of the New York Stock Exchange (NYSE) and the Nasdaq Stock Market (Nasdaq) call for decisions about critical matters such as accounting policies and executive compensation to be made solely by directors who meet rigorous independence standards.

In response to the ongoing tide of corporate governance reforms as well as the rising numbers of shareholder lawsuits and escalating settlement costs, insurance companies have sharply increased premiums for traditional directors' and officers' liability insurance (D&O insurance), which typically insures officers and directors as well as the company itself. At the same time, insurers have narrowed the scope of coverage of D&O insurance policies in terms of both dollar limits and the types of insured events. Furthermore, carriers have considered policy rescission on the grounds of misstatements in applications. There is also concern as to the allocation of policy proceeds in bankruptcy.

In view of the foregoing, independent directors may wish to obtain additional personal insurance coverage in case the limitations of the company's indemnification policy and traditional D&O insurance coverage may leave them without adequate protection. Several insurance companies now offer “individual” director liability insurance policies, which insure individual directors even when exclusions or competing claims under the company's traditional D&O insurance policy curtail or make coverage unavailable.

Raising the Bar for Independent Directors

Recent Developments in Corporate Law. A fundamental principle of corporate law is that the courts will defer to the directors' business judgment if the directors have acted in good faith, in a manner loyal to the interests of the corporation and on an informed basis. Most states allow corporations to adopt charter provisions that eliminate or limit the personal liability of directors to the corporation or its stockholders for breaches of the fiduciary duty of care except in situations in which their business judgment may be challenged. For example, under Section 102(b)(7) of the Delaware General Corporation Law, director exculpation is subject to several limitations, including the proviso that the corporation cannot limit or eliminate director liability for breaches of the duty of loyalty or for acts or omissions not in good faith or which involve intentional misconduct or knowing violations of law. In several cases decided this year, courts have held that the business judgment rule and the exculpatory provisions of corporate charters may not shield directors from personal liability where directors were so derelict in performing their duties that their efforts could be construed as a lack of good faith or as intentional misconduct.

In In re The Walt Disney Company Derivative Litigation, a group of Disney shareholders filed a derivative action in the Delaware Court of Chancery alleging that the company's directors had breached their fiduciary duties in approving a lucrative employment agreement that would pay the president of the company more than $140 million upon termination. The board of directors moved to dismiss the case on the grounds that its actions were protected under the business judgment rule and that Disney's charter contained director exculpation provisions. The court denied the motion because the plaintiffs' allegations about the directors' lack of diligence suggested that they had “failed to exercise any business judgment and failed to make any good faith attempt to fulfill their fiduciary duties to Disney and its stockholders.” The Seventh Circuit Court of Appeals reached a similar decision in In re Abbott Laboratories Derivative Litigation, holding that the shareholder plaintiffs could proceed with their claims against Abbott Laboratories' directors notwithstanding the exculpatory provisions in the company's charter, where the directors of the company were allegedly aware of repeated notices of safety violations but neglected to take any action to avert huge government fines. Finally, in Pereira v. Hogan, a New York federal court held that the exculpatory provisions of a private corporation's charter would not insulate the directors from personal liability where there was a “complete lack of any exercise of due diligence” by the directors in the face of repeated self-dealing transactions by a controlling investor.

These cases underscore the need for directors to take a proactive and diligent approach to fulfilling their fiduciary duties. Directors should also ascertain that mechanisms are in place to fully apprise them about material corporate developments.

Public Company Board of Directors Reforms. The S-O and the corporate governance standards proposed by the NYSE and Nasdaq seek to place decisions about critical issues such as accounting policies and executive compensation in the hands of directors who meet independence standards.

The S-O generally prohibits national securities exchanges and associations such as the NYSE and Nasdaq from listing a company's securities unless all members of the company's audit committee are independent. To satisfy the S-O definition of independence, a director may not accept, directly or indirectly, any compensatory fees from the company (other than directors fees) and cannot be an affiliate of the company or any of its subsidiaries. The S-O also requires the audit committee to be responsible for appointment, compensation, retention and oversight of independent auditors, to establish procedures for handling complaints (including complaints from employees) about accounting, internal accounting controls or auditing matters, and to determine the compensation to be paid to independent auditors and other advisors employed by the committee.

The proposed corporate governance standards of the NYSE and Nasdaq require that independent directors comprise the majority of the members of a listed company's board of directors, and enhance the S-O's definition of independence by requiring the board of directors to affirmatively determine that an independent director has no material relationship with the company (in the case of the NYSE) or no relationship that would interfere with the exercise of independent judgment (in the case of Nasdaq). Both the NYSE and Nasdaq standards also would mandate that independent directors meet in regularly scheduled executive sessions not open to non-independent directors.

Finally, the corporate governance standards proposed by the NYSE and Nasdaq would give independent directors exclusive decision-making authority not only with respect to audit committee matters, but also over executive compensation and other key corporate governance issues. For example, the NYSE would require listed companies to have compensation and nominating committees composed entirely of independent directors, and Nasdaq would require executive compensation and director nomination decisions to be made by a majority of the independent directors serving on the board of directors or by compensation and nominating committees consisting solely of independent directors.

The Limitations of Traditional D&O Insurance

From the point of view of the independent director seeking to assure that liability claims will not reach his personal assets, traditional D&O insurance policies have several drawbacks. The policies often cover the company and all of the officers and directors under one umbrella. If the company's own liability claims and defense costs exhaust the aggregate liability limits of the policy, coverage may be unavailable to an individual director. Similarly, the insurance policy's per claim limits may be exhausted with respect to a particular incident such that an individual director does not receive adequate protection. Even if the D&O insurance policy creates separate sublimits for the corporation vis-a-vis the officers and directors or gives officers and directors priority over the corporation, the individual director must nonetheless share the coverage with several other insured persons.

An additional complication of shared coverage is the treatment of the D&O insurance policy if the company becomes involved in a bankruptcy proceeding. Even if the policy has separate sublimits for the company and the officers and directors, the trustee or creditors in the bankruptcy proceeding may assert that the policy or its proceeds are the property of the company's bankruptcy estate, thereby denying coverage to or delaying the receipt of insurance proceeds for the benefit of independent directors.

Traditional D&O insurance policies may also contain exclusions that disallow coverage to an independent director as a result of events beyond his control. For example, the D&O insurance carrier may rescind a policy or refuse payment on a claim if it determines that the insurance application contained misrepresentations. Similarly, the D&O insurance policy may contain an exclusion for fraud claims and impute the fraud of another insured person to an innocent independent director.

Individual Director Liability Insurance

In response to concerns about these limitations, some insurance carriers now are offering policies to individuals. The common denominator of “individual” director liability insurance policies is that their coverage is triggered when the company does not indemnify the director for a loss, coverage under the company's traditional D&O policy is either nonexistent or insufficient or “the company engaged in misrepresentation in preparing the insurance application”. These policies may also be non-rescindable except in the event of non-payment of premiums. Individual director liability insurance policies are available in several varieties. For example, some policies cover only a specified independent director for any, all or a combination of the boards of directors that served on, while other policies cover all of the independent directors of a particular company solely with respect to board activities for that company. Premiums for individual director liability insurance policies may be paid directly by the independent director or the company or may be reimbursed by the company.

Conclusion

The corporate scandals of the past few years have cast a spotlight on company directors. Recent legal developments and regulatory reforms serve as a reminder that directors must perform their duties diligently, and call for independent directors of public companies to shoulder more of the decision-making burden regarding crucial issues such as accounting policies and executive compensation. At the same time, price increases, coverage exclusions and competing claims under D&O insurance policies may leave independent directors exposed to greater personal liability risk without sufficient insurance coverage. Independent directors should review the terms of existing D&O insurance policies of the companies that they serve and consider whether they wish to avail themselves of the additional protection afforded by “individual” director liability insurance policies.

Introduction

In the wake of recent corporate governance scandals, independent directors of public companies face increased levels of scrutiny and heightened prospects for the risk of personal liability. Recent court decisions have criticized directors of public and private companies for insufficient attention to their duties. The Sarbanes-Oxley Act of 2002 (S-O) and the proposed corporate governance reforms of the New York Stock Exchange (NYSE) and the Nasdaq Stock Market (Nasdaq) call for decisions about critical matters such as accounting policies and executive compensation to be made solely by directors who meet rigorous independence standards.

In response to the ongoing tide of corporate governance reforms as well as the rising numbers of shareholder lawsuits and escalating settlement costs, insurance companies have sharply increased premiums for traditional directors' and officers' liability insurance (D&O insurance), which typically insures officers and directors as well as the company itself. At the same time, insurers have narrowed the scope of coverage of D&O insurance policies in terms of both dollar limits and the types of insured events. Furthermore, carriers have considered policy rescission on the grounds of misstatements in applications. There is also concern as to the allocation of policy proceeds in bankruptcy.

In view of the foregoing, independent directors may wish to obtain additional personal insurance coverage in case the limitations of the company's indemnification policy and traditional D&O insurance coverage may leave them without adequate protection. Several insurance companies now offer “individual” director liability insurance policies, which insure individual directors even when exclusions or competing claims under the company's traditional D&O insurance policy curtail or make coverage unavailable.

Raising the Bar for Independent Directors

Recent Developments in Corporate Law. A fundamental principle of corporate law is that the courts will defer to the directors' business judgment if the directors have acted in good faith, in a manner loyal to the interests of the corporation and on an informed basis. Most states allow corporations to adopt charter provisions that eliminate or limit the personal liability of directors to the corporation or its stockholders for breaches of the fiduciary duty of care except in situations in which their business judgment may be challenged. For example, under Section 102(b)(7) of the Delaware General Corporation Law, director exculpation is subject to several limitations, including the proviso that the corporation cannot limit or eliminate director liability for breaches of the duty of loyalty or for acts or omissions not in good faith or which involve intentional misconduct or knowing violations of law. In several cases decided this year, courts have held that the business judgment rule and the exculpatory provisions of corporate charters may not shield directors from personal liability where directors were so derelict in performing their duties that their efforts could be construed as a lack of good faith or as intentional misconduct.

In In re The Walt Disney Company Derivative Litigation, a group of Disney shareholders filed a derivative action in the Delaware Court of Chancery alleging that the company's directors had breached their fiduciary duties in approving a lucrative employment agreement that would pay the president of the company more than $140 million upon termination. The board of directors moved to dismiss the case on the grounds that its actions were protected under the business judgment rule and that Disney's charter contained director exculpation provisions. The court denied the motion because the plaintiffs' allegations about the directors' lack of diligence suggested that they had “failed to exercise any business judgment and failed to make any good faith attempt to fulfill their fiduciary duties to Disney and its stockholders.” The Seventh Circuit Court of Appeals reached a similar decision in In re Abbott Laboratories Derivative Litigation, holding that the shareholder plaintiffs could proceed with their claims against Abbott Laboratories' directors notwithstanding the exculpatory provisions in the company's charter, where the directors of the company were allegedly aware of repeated notices of safety violations but neglected to take any action to avert huge government fines. Finally, in Pereira v. Hogan, a New York federal court held that the exculpatory provisions of a private corporation's charter would not insulate the directors from personal liability where there was a “complete lack of any exercise of due diligence” by the directors in the face of repeated self-dealing transactions by a controlling investor.

These cases underscore the need for directors to take a proactive and diligent approach to fulfilling their fiduciary duties. Directors should also ascertain that mechanisms are in place to fully apprise them about material corporate developments.

Public Company Board of Directors Reforms. The S-O and the corporate governance standards proposed by the NYSE and Nasdaq seek to place decisions about critical issues such as accounting policies and executive compensation in the hands of directors who meet independence standards.

The S-O generally prohibits national securities exchanges and associations such as the NYSE and Nasdaq from listing a company's securities unless all members of the company's audit committee are independent. To satisfy the S-O definition of independence, a director may not accept, directly or indirectly, any compensatory fees from the company (other than directors fees) and cannot be an affiliate of the company or any of its subsidiaries. The S-O also requires the audit committee to be responsible for appointment, compensation, retention and oversight of independent auditors, to establish procedures for handling complaints (including complaints from employees) about accounting, internal accounting controls or auditing matters, and to determine the compensation to be paid to independent auditors and other advisors employed by the committee.

The proposed corporate governance standards of the NYSE and Nasdaq require that independent directors comprise the majority of the members of a listed company's board of directors, and enhance the S-O's definition of independence by requiring the board of directors to affirmatively determine that an independent director has no material relationship with the company (in the case of the NYSE) or no relationship that would interfere with the exercise of independent judgment (in the case of Nasdaq). Both the NYSE and Nasdaq standards also would mandate that independent directors meet in regularly scheduled executive sessions not open to non-independent directors.

Finally, the corporate governance standards proposed by the NYSE and Nasdaq would give independent directors exclusive decision-making authority not only with respect to audit committee matters, but also over executive compensation and other key corporate governance issues. For example, the NYSE would require listed companies to have compensation and nominating committees composed entirely of independent directors, and Nasdaq would require executive compensation and director nomination decisions to be made by a majority of the independent directors serving on the board of directors or by compensation and nominating committees consisting solely of independent directors.

The Limitations of Traditional D&O Insurance

From the point of view of the independent director seeking to assure that liability claims will not reach his personal assets, traditional D&O insurance policies have several drawbacks. The policies often cover the company and all of the officers and directors under one umbrella. If the company's own liability claims and defense costs exhaust the aggregate liability limits of the policy, coverage may be unavailable to an individual director. Similarly, the insurance policy's per claim limits may be exhausted with respect to a particular incident such that an individual director does not receive adequate protection. Even if the D&O insurance policy creates separate sublimits for the corporation vis-a-vis the officers and directors or gives officers and directors priority over the corporation, the individual director must nonetheless share the coverage with several other insured persons.

An additional complication of shared coverage is the treatment of the D&O insurance policy if the company becomes involved in a bankruptcy proceeding. Even if the policy has separate sublimits for the company and the officers and directors, the trustee or creditors in the bankruptcy proceeding may assert that the policy or its proceeds are the property of the company's bankruptcy estate, thereby denying coverage to or delaying the receipt of insurance proceeds for the benefit of independent directors.

Traditional D&O insurance policies may also contain exclusions that disallow coverage to an independent director as a result of events beyond his control. For example, the D&O insurance carrier may rescind a policy or refuse payment on a claim if it determines that the insurance application contained misrepresentations. Similarly, the D&O insurance policy may contain an exclusion for fraud claims and impute the fraud of another insured person to an innocent independent director.

Individual Director Liability Insurance

In response to concerns about these limitations, some insurance carriers now are offering policies to individuals. The common denominator of “individual” director liability insurance policies is that their coverage is triggered when the company does not indemnify the director for a loss, coverage under the company's traditional D&O policy is either nonexistent or insufficient or “the company engaged in misrepresentation in preparing the insurance application”. These policies may also be non-rescindable except in the event of non-payment of premiums. Individual director liability insurance policies are available in several varieties. For example, some policies cover only a specified independent director for any, all or a combination of the boards of directors that served on, while other policies cover all of the independent directors of a particular company solely with respect to board activities for that company. Premiums for individual director liability insurance policies may be paid directly by the independent director or the company or may be reimbursed by the company.

Conclusion

The corporate scandals of the past few years have cast a spotlight on company directors. Recent legal developments and regulatory reforms serve as a reminder that directors must perform their duties diligently, and call for independent directors of public companies to shoulder more of the decision-making burden regarding crucial issues such as accounting policies and executive compensation. At the same time, price increases, coverage exclusions and competing claims under D&O insurance policies may leave independent directors exposed to greater personal liability risk without sufficient insurance coverage. Independent directors should review the terms of existing D&O insurance policies of the companies that they serve and consider whether they wish to avail themselves of the additional protection afforded by “individual” director liability insurance policies.