Director Exposure & Coverage

OVERVIEW OF EXPOSURE1

After a company begins to experience economic distress or other legal and financial challenges, opportunities to minimize risk to the company and its individual directors are limited. When directors are most focused on the company and its difficulties, they face increased exposure, potential limitations on indemnification and insurance coverage, and greater challenges from government agencies, private plaintiffs and even a trustee in bankruptcy. Planning ahead to manage exposure involves understanding the risks and the available protection for directors, including a director of a wholly-owned nonpublic subsidiary.

DUE DILIGENCE—UNDERSTANDING THE RISKS

Before joining a board of directors, and periodically while serving as a director, seasoned directors conduct due diligence on the company not dissimilar to that which would be conducted for a corporate merger. Risks can arise from tax status, pending and threatened litigation, experience and tenure of management, and capital structure, including debt terms, working capital and liquidity.

Serving as the director of an independent company with no corporate parent or affiliates simplifies the fiduciary duties that apply and reduces potential conflicts of interest. A director owes a duty of loyalty and care to each corporation served. Thus, a director who serves multiple corporations owes duties to each. Conflicts of interest may arise unless a complete identity of interest (i.e., same shareholders and creditors) exists among all entities within the affiliated group.

Regulated industries often encounter further risks. Although regulatory agencies provide some oversight, directors can take little comfort from a litigation perspective—as a company cannot bring a cause of action against an agency for negligent regulatory supervision. In fact, regulatory oversight often imposes political agendas that may lead to litigation brought by the regulators or third parties against directors.

HIDDEN SOURCES OF PERSONAL LIABILITY

Relatively few lawsuits against directors arise from a clear-cut intentional tort such as fraud or embezzlement. Rather, lawsuits that name directors generally arise from an unintentional failure to act or prevent the acts of others. Personal liability results primarily from breach of a director's duty of care or loyalty (including, in Delaware, the duty of good faith), improper declaration of dividends, violation of statutory requirements or government enforcement actions initiated against the company and its insiders.

Government Enforcement Actions

Actions by government agencies such as the Securities and Exchange Commission (SEC) can generally be grouped into formal and informal actions. Almost all SEC actions start as informal investigations, which can lead to a Wells notice indicating that the SEC staff is considering recommending a civil enforcement action. Formal actions against an organization include cease and desist orders, written agreements, the imposition of corporate monitors and civil monetary penalties.2 Formal action against individuals include bars against the individual serving as an officer or director of a public company, civil monetary penalties and cease and desist orders. The SEC may also enter into cooperation agreements, deferred prosecution agreements and non-prosecution agreements.3

Government inquiries by and settlements with the SEC, Department of Justice (DOJ) and other agencies increase the scrutiny of company records, require directors to provide added oversight, multiply risks of private litigation and may limit the company's business operations and restrict the conduct of officers and directors. For individual directors of public companies, certain kinds of governmental proceedings may require adverse disclosures in the annual proxy statement and effectively foreclose a director from continuing to serve as a director or officer of a public company.

Because of highly publicized insider misconduct, regulators more and more frequently focus attention on directors, including outside directors. Each director, before entering into any settlement agreement with a government agency binding on the company and/or its insiders, needs to fully understand the provisions, the procedures required to ensure compliance, the potential for any criminal charges and the consequences to the company and individual directors of any future violations of the agreement. Settlements of enforcement actions, as originally drafted and presented by the regulators, are broadly worded, leaving maximum discretion and interpretation with the regulator. Some SEC settlements may prevent individuals from receiving reimbursement, indemnification or insurance payments for penalties imposed.

Breach of Duty

The duty of loyalty owed by directors prohibits a director from advancing personal or business interests, or interests of others, at the expense of the corporation. The duty of care requires a director to act as a prudent and diligent businessperson in conducting the affairs of the company. This standard makes a director responsible for selecting, monitoring and evaluating competent management; establishing business strategies and policies; monitoring and assessing business operations; considering business alternatives establishing and monitoring adherence to policies and procedures required by statute and regulation; and making business decisions on the basis of fully informed and meaningful deliberation.

Breach of duty cases are by their nature fact specific. Factors leading to liability in litigation against directors include:

Excessive absence from meetings; Failure to give even a cursory reading of financial records; Failure to respond promptly and appropriately to negative information received from auditors, and other reliable sources; and Failure to require adherence to corporate policy. Directors are advised to avoid the appearance of these factors, which may lead to liability, especially in conjunction with other "bad facts" and troubled circumstances for the company. Under Delaware law, directors who act with a conscious disregard for their responsibilities do not act in good faith, and cannot be exculpated under a limitation on liability provision in the company's charter.

Improper Dividends

Most states have statutes which provide that a board of directors of a corporation cannot declare a distribution if the distribution would cause the corporation to become insolvent or unable to pay its debt. These statutes follow the Model Business Corporation Act (MBCA).4 The determination of solvency rests on an equity test which requires "that decisions be based on cash flow analysis that is itself based on a business forecast and budget for a sufficient period of time to permit a conclusion that known obligations of the corporation can reasonably be expected to be satisfied over the period of time that they will mature."5 The statutes also require a company to have a positive net worth reflected on the balance sheet. Accounting errors or irregularities, or insufficient analysis of a company's debt and other financial obligations, can put directors at risk when the Board declares dividends.

The MBCA suggests that the validity of the determining factors depends on the circumstances, and must also be reasonable within those circumstances.6 Specifically, the statute provides that directors who approve "the declaration of any dividend or other distribution of assets to the shareholders contrary to the provisions of this act or contrary to any restrictions in this certificate incorporation" will be liable to the corporation, which acts on behalf of its creditors or shareholders.7 To the extent recovery is sought against the directors, the directors are allowed to be subrogated to the rights of the corporation—but only "against shareholders who received such dividend or distribution with knowledge of facts indicating that it was not authorized by this act," and only "in proportion to the amounts received by them respectively." In effect, directors are charged with reviewing relevant circumstances at the time of declaring dividends and may face personal liability for improperly declared dividends.

Business Judgment Rule

The business judgment rule offers a potential defense to personal liability if directors meet the duty of loyalty. Generally, the business judgment rule protects actions by members of a board of directors if the actions were made in good faith, and comport to the standard of the prudent person in the same or similar position as the director. Directors may also seek the advice of experts and officers of the company to support the applicability of the...