D&O Liability: Executives Bear the Weight of Success or Failure

Directors and Officers liability, commonly known as D&O, is a complicated type of risk. While it covers corporate activities, a corporation is a legal person, as are the directors and officers (D’s&O’s) who direct it. All of them can be charged with liability for an ever-increasing panoply of actions and inactions.

Both the corporation and the D’s & O’s need insurance protection, but in cases where corporate interests may clash with those of the individuals responsible for managing its affairs, the coverage isn’t the same.

Gary Grasso, a partner who specializes in coverage issues and professional liability, in the Chicago-based law firm of Ungarretti & Harris, explained that, “An indemnity policy protects the corporation, while a D&O policy covers the individual acts of directors and officers. The coverage may be tied to the same events, but if the corporation is injured, it’s covered by the indemnity policy.”

He noted that, while often complementary, the two types of coverage are also frequently at odds. If, for example, an officer is charged with fraud, the defenses against coverage under a D&O policy increase while defenses against the corporation’s claim under an indemnity policy decrease. “If there’s no coverage under a D&O policy, the corporation’s a dead bang winner on indemnity,” Grasso said.

Size and status don’t matter; D’s&O’s of a two-man operation can be accused as easily as those of a large publicly held corporation. In addition, “company” can include non-profit organizations, charitable trusts, and civic associations. The one common thread tying them altogether is the concept of the “duty” owed by an officer or director to constituents such as shareholders, employees and the corporation itself.

D&O liability has its roots in the chancery (equity) courts, which considered such matters as breaches of fiduciary duty and good faith that were beyond the common law courts. This history helps explain why the legal structures governing D’s&O’s conduct are often vague and subject to differing interpretations. It also explains why the area is such a fertile field for litigators. Anyone suffering any sort of damages—a sharp drop in the share price or a wrongful termination, for example—can scrutinize corporate activity in the light of hindsight and accuse the manager(s) of having breached a corporate duty.

An integral part of liability coverage
Bill Bolton of Pasadena-based Bolton & Co. observed that D&O coverage has become an integral part of a very large field of liability. “It started out as a way to protect the officers and directors, as well as the corporate entity, and it used to be pretty much concerned with business litigation,” Bolton said. Now, however, there are all sorts of other issues involved, including public policy concerns, fraud, trade secrets, unfair competition, employment practices. “Now liability is open ended,” he observed.

D&O policies don’t, indeed can’t, cover criminal activities; they are concerned exclusively with civil remedies, mainly damages. Therefore, there’s a great deal of leeway in determining whether a director or an officer has breached one of his basic duties to the extent that the aggrieved party can recover.

“The fundamental responsibility of directors and officers is to represent prudently the interests of the shareholders as a group and other corporate constituencies in directing the business and affairs of the corporation within the law,” wrote Dan A. Bailey, a partner in the law firm of Arter & Hadden, in a paper he prepared for Chubb Corp.

Bailey grouped three basic responsibilities under the following headings:

“Duty of Diligence,” which requires that actions be carried out “in good faith.” D’s&O’s must perform acts “in a manner they reasonably believe to be in the best interests of the corporation,” and they have to keep themselves informed as to what’s going on. “They are required to implement reasonable programs to promote appropriate corporate conduct and to identify improper conduct.” That duty makes D’s & O’s more or less responsible for the acts or the failures of their employees, which in turn greatly extends their potential liabilities.

“Duty of Loyalty,” imposes a whole series of obligations upon D’s & O’s to refrain from taking unfair advantage of their position. They can’t enrich themselves, or cause harm to the corporation; they must avoid conflicts of interest, and cannot “usurp a corporate opportunity” for themselves. They can’t compete with the corporation, and they can’t personally profit from the use of inside information. These provisions essentially require an officer or director to judge what’s business and what’s private, and, if there’s any question, to act for the business first rather than themselves.

“Duty of Obedience,” means that, “Directors and officers are required to perform their duties in accordance with applicable statutes and the terms of the corporate charter.”

An alleged failure to observe any of the above exposes the director or officer to the possibility of a lawsuit, and not just because the stock went down. A study by Bolton & Co. reveals that according to the1997 Wyatt Survey 45 percent “of suits against Directors and Officers of privately held companies are, in fact, employment related.” Common claims involve breach of duty, mismanagement, conflict of interest, self-dealing, conspiracy and discrimination as well as about 30 others, which are by no means exhaustive.

The Bolton study asserts that private companies may be at even greater risk than publicly traded ones as “they simply do not have the same resources as large publicly held companies, so that their decisions are made without full or accurate information.” They’re also far less likely to be well informed of the risks and more likely to have insufficient coverage.

Applying the Business Judgment Rule
Grasso agreed that the apparent vagueness and open-ended liability that attaches to D&O coverage makes it a lawyer’s dream and an underwriter’s nightmare, as far as pricing coverage is concerned. Whoever may have done something, and whatever they may have done, can always be challenged if it turns out badly.

Bailey describes the attempt to make some sense out of the situation through the application of the “Business Judgment Rule (BJR).” He lists five key elements:

Business decision. The BJR Protects directors against claims for wrongful acts but not against claims for failure to act. Inaction by directors is protected by the BJR only if it is a result of a conscious decision to refrain from acting.

Disinterestedness. The BJR protects directors who are disinterested and independent with respect to the challenged action. For this purpose, disinterested directors are those who neither appear on both sides of the transaction nor expect to derive any personal financial benefit from it in the sense of self-dealing, as opposed to a benefit which inures to the corporation or all the stockholders generally.

Due care. The BJR protects directors if they reached an informed decision after making a reasonable effort to ascertain and consider all relevant information reasonably available to them and after reasonably deliberating the decision.

Good faith. The BJR protects directors if they acted with a good faith belief that their business decision was in the best interests of the corporation. The protection will not apply if the directors acted solely or primarily to preserve their positions or otherwise to benefit themselves.

No abuse of discretion. The BJR protects directors against honest errors of judgment, but does not provide protection for decisions that cannot be supported by some rational basis and are egregious on their face.

In effect the BJR sets out in a more precise manner what lawyers usually refer to as the “reasonable man” or the “prudent man” standard. It lays out some ground rules that an officer or director should observe, but arguments over whether he did or not have to be decided on the facts applicable to each individual case, and this frequently requires that any actions, taken or not taken, be defended in court if they’re challenged. A D&O Liability Policy provides the only real “protection” an officer or director has in that case.

Security litigation on the rise
Aon’s introduction to its D&O program says, “Directors’ and officers’ liability insurance (D&O) offers your individual directors and officers the protection they need from personal liability and financial loss arising out of wrongful acts committed or allegedly committed in their capacity as corporate (parent organization and subsidiaries) officers and/or directors. Most policies also cover the liability of the corporate entity itself if the liability arises out of a claim involving the purchase or sale of the company’s securities.”

Securities litigation is a field unto itself—one that is expanding following the meltdown in the prices of technology stocks over the past year. D’s&O’s of publicly traded companies are being increasingly targeted. “Public corporations are being sued simply because the [stock] price drops,” Bolton said. “There are law firms who watch for negative results in order to file lawsuits.” Although the Private Securities Litigation Reform Act of 1995 was designed to discourage excessive litigation, Aon notes that they’ve actually increased and that “Hi-tech companies are increasingly targeted.”

Any perceived violation of the Investment Company Act of 1940, the Securities Act of 1933, or the Securities Exchange Act of 1934 can lead to a civil lawsuit. More serious violations can lead to criminal charges against D’s&O’s, which their policies don’t cover, although, as Grasso noted, the corporation can be indemnified. These regulations have been in force for more than 60 years. The rules promulgated under them and the court decisions interpreting them fill several large libraries. Aon indicates, however, that the “vast majority of the federal securities class-action claims filed are based upon two allegations of wrongdoing: fraudulent or misleading financial statements, and/or claims of illegal insider trading.”

No lack of risk
Private company risks are less concerned with securities violations. Their main exposure is to employees, but “any company that employs one or more individuals or deals with customers, clients, competitors, the government, or other third parties has a D&O exposure,” says Aon. By that measure, unless you’re a one-man company that grows mushrooms in your own cave for your own consumption, you’re at risk.

Grasso and Bolton both agree that Employment Practices Liability (EPL) is now a field in itself. “It’s become an area of additional coverage,” Grasso indicated; “it can be like an excess policy in an employment situation, but it can also involve claims by [as well as against] management.” While formerly enhanced coverage on a standard D&O policy would cover EPL, and to some extent still does, any corporation, indeed any business, large or small can be accused. The actions can involve wrongful termination or demotion, failure or refusal to promote or hire someone; workplace harassment, retaliatory treatment; negligent evaluation of employee performance, breach of an implied contract or agreement; failing to follow strictures in a personnel manual; or a combination of any of them. “Companies definitely need to consider it [EPL] separately,” said Bolton.

While the lawyers’ dream/underwriter’s nightmare analogy may be true in some ways, the legal profession’s efforts to expand the boundaries of directors’ and officers’ liability has certainly provided agents, brokers and insurance companies with significant new sales opportunities. The pioneers and still the leaders in the field, AIG, Chubb and the Lloyd’s market, who together write over 50 percent of D&O coverage, haven’t curtailed their efforts to create new programs and products to cover it. As Grasso said, “You need one [indemnity or D&O] in case the other doesn’t work.”

Topics Lawsuits Claims Aon Directors Officers