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Reader
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Editor's note: Each month, we ask a Directors & Boards reader to comment on critical issues facing directors today. If you'd like to participate in this section in the future, please email Scott Chase. At recent industry conferences and other events we have heard the remark that Sarbanes-Oxley and other regulatory initiatives have created “a direct line to the federal penitentiary.” Does D&O insurance make that an overstatement? Here’s a scenario: It had been a long week at the corporate headquarters of XYZ Corporation (‘XYZ’). The firm’s quarterly earnings were to be reported the next morning. A revenue recognition issue had been resolved. In the words of the CFO, “Everyone needs to get on board with the decision made to recognize that the current quarter’s revenue is in accordance with FASB.” A new employee in the accounting group had taken issue with the approach and was not alone in her position. The debate had become heated, but the CFO said he had to make the call. The new employee (now whistle-blower) left XYZ three months later and went to the SEC with her view of the company’s accounting practices. The SEC began an investigation. XYZ hired independent outside auditors to conduct an investigation. XYZ’s stock price went down. The outside auditors concluded that revenue had been improperly recognized and a multi-year restatement was necessary. XYZ’s lenders and debt rating agencies became aware of the situation. The lenders were concerned because the company was in violation of several of its debt covenants including its net worth ratio. The debt rating agencies downgraded XYZ’s credit. Institutional investors had to get out. Securities and shareholder derivative lawsuits were filed against XYZ Corporation and the company’s directors and officers. The price of the stock continued to go down. XYZ filed for Chapter 11 protection. A ‘follow-on’ lawsuit was also filed under the Employment Retirement Income Security Act of 1974 naming all directors and officers alleging breach of fiduciary duty because XYZ had invested some of its own stock in its 401K Plan. XYZ’s shareholders lost lots of money…many employees lost jobs, and all directors and officers were involved in litigation. But since the company had D&O insurance, the directors and officers presumed they were protected from any personal liability. This scenario is precisely the type of situation when D&O insurance is needed—right? The D&O insurance carrier reserved all rights via a “bad news” letter, and eventually exercised its right to rescind the policy (restatement of earnings can trigger rescission under many policies), leaving the directors and officers with no coverage. To make matters worse, most ERISA claims are excluded under D&O policies. XYZ’s indemnification of the directors and officers could not be utilized because the company was insolvent. The directors were left with having to pay expensive legal bills and possible judgments. Could this happen to you as a director? The unfortunate, but realistic answer is yes! Directors are named defendants in numerous lawsuits pending in our court system across the country right now. These lawsuits include not only the well-publicized corporate fraud and financial malfeasance cases, but also many cases where there has really been no wrongdoing. The cases are being driven by aggressive plaintiffs’ attorneys. In these cases, innocent directors could be subject to personal liability. There was a record 323 restatements of financial reports in 2003 according to the Huron Consulting Group. In a Duke University survey of 401 corporate financial executives in November 2003, two out of five said they would use legal ways to book revenues early if that would help them meet earnings targets. Restatements of financial reports are a nightmare to directors and, not surprisingly, attract plaintiff attorneys like bees to honey. Many observers believe the number of securities and shareholder derivative lawsuits being filed will increase. The current environment has been described as the ‘Perfect Storm’ for directors with the combination of increased laws and regulations, such as Sarbanes-Oxley, a series of adverse decisions for corporations (and directors and officers), and an aggressive plaintiff’s bar. Consider the following facts:
In view of this ‘Perfect Storm’ facing directors, how do directors protect themselves from personal liability? It is a totally new world for directors. They are not only expected to set the strategy for a company, but also in the words of Andy Groves, Chairman of the Board of Intel Corporation, be a ‘fierce watchdog’ (Fortune Magazine, August 23, 2004). Directors must spend much more time monitoring the management of companies. For example, in the past, no matter how outrageous a CEO’s compensation might have been, it was almost impossible for shareholders to sue because of the ‘business judgment rule.’ However, the Delaware Court of Chancery changed the game recently in the suit against Disney over the pay of Michael Ovitz who served a little over a year as Disney’s President and left with $140 million in compensation. The court refused to dismiss the suit and said that if the charges against the directors were true, the directors did not act in ‘good faith.’ The directors were allegedly unaware of the ‘deal.’ In Delaware and most states, if directors are found to have not acted in good faith, the company cannot indemnify them. This same reasoning could easily apply to other significant issues facing a company and its directors. This case could have significant implications for directors and the potential for personal liability. In today’s new world, many directors are unknowingly not protected from personal liability. How did this happen? It all began with the well-publicized corporate scandals and subsequent litigation which involved directors and officers being named defendants in the lawsuits. D&O coverage became a hot issue. The amount of payouts by the insurance industry in response to the corporate scandals is still unknown as the lawsuits are working their way through the legal system. This has obviously put financial pressure on the D&O insurance carriers. Many observers expect the number of securities and shareholder derivative lawsuits being filed by plaintiffs’ firms naming directors and officers to increase. The financial impact of all of this is yet to be realized. So where does it leave directors? Today, they have more responsibility, more potential liability, and a greater need than ever for protection. Directors must take steps to educate themselves about their exposure, the various pitfalls, and take action to reduce the likelihood of a problem creating personal liability. There are three areas where directors must look for protection—Corporate Indemnification, D&O insurance, and the Business Judgment Rule. Let’s briefly look at each area. Indemnification: Indemnification is the first line of defense for a director. Often, the indemnification language may be inadequate and could be improved from the director’s standpoint. There are also limitations on the availability of corporate indemnification. For example, in Delaware and a majority of other states, corporate indemnification is not available for settlements of derivative litigation when the directors are found not to have acted in good faith. D&O Insurance: This insurance is critically important to a director if he/she gets sued. D&O premiums have gone up due to record settlement costs affecting the carriers. The following dangers lurk: Rescission: The biggest concern for a director is can the policy be rescinded and if so, on what basis? An application for D&O insurance incorporates financial statements and represents that they are true and accurate. Any false or misleading information relied upon by the carrier can result in a rescission of the policy leaving innocent directors without D&O insurance. Restatement of Earnings: Restatements of financial reports can trigger a rescission on the traditional D&O policies leaving directors without D&O coverage in any legal action that follows. Full Severability of the Application: In theory, this means that if the insured company’s financial condition has been misrepresented to the insurer, only those who were aware of the misrepresentation would lose their D&O coverage. However, the allegation of misrepresentation, such as the one related to financial statements, may be broad based and it may be difficult to show that specific directors had no knowledge of the relevant facts. Bankruptcy: In certain cases, creditors have argued and courts have declared the traditional D&O policy part of the corporate bankruptcy estate leaving the directors without access to D&O coverage. Credit Quality and Commitment of D&O Carrier: In 1998, Reliance National Insurance Co. was the second largest underwriter of excess D&O coverage. In 18 months, it went from an A-credit to insolvency. Business Judgment Rule: The Business Judgment Rule is very important to the protection of directors from personal liability and may represent the area where the greatest change impacting the issue of personal liability has occurred. Congress and the various regulatory agencies have increased the role of the director—directors must do more than set strategy—they must monitor management. In order to be able to use the Business Judgment Rule to defend their actions and conduct business as directors, they need to know more about the significant issues of the company such as executive compensation. The dilemma should be apparent. We need very talented people to serve on corporate boards and, at the same time, because of recent corporate scandals and frauds, we are asking more of directors to satisfy what is legally required of them. The bottom line is directors should not have to be exposed to personal liability in their role as a director, absent fraud, deliberate misconduct or some similar activity for personal gain. Today, the director’s role has changed and there is a new and increased risk of director’s incurring personal liability. Directors must take action to protect themselves from personal liability, or our country will experience a serious brain drain from corporate board service. |
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| Bill Pollock
founded LCM Resource Group in 2002 and is the Chief Executive
Officer. He has over 25 years of business and legal experience. Pollock practiced law in Dallas, Texas from 1976 to 1981. From 1981 to 1984, he was General Counsel of a wholly owned subsidiary of Centex Corporation. In 1984, he formed Hanover Energy, an oil and gas investment company headquartered in Dallas, Texas. As Chairman and CEO of Hanover until 1992, he orchestrated a series of acquisitions, joint ventures and divestitures primarily in the natural gas gathering, processing, transmission and compression business. One of these transactions included the acquisition of United Gas Pipeline, which had 1,700 employees and $1.5 billion of assets. As Chairman and CEO of United from 1989 to 1992, he led the successful restructuring of the company which included non-judicial settlements of over $1 billion of claims against the company. He also formed Hanover Compression which is a NYSE traded company and is the largest of its kind. From 1993 to 2002, Pollock was active in the formation of several ventures including two natural gas service companies for which he served as CEO and Chairman. Pollock earned a Bachelor’s Degree in Economics from Dartmouth College in 1972 and was Magna Cum Laude and Phi Beta Kappa. He also played quarterback on three consecutive Ivy League Championship football teams. He earned a Juris Doctorate in 1975 from the University of Virginia. Copyright © 2004 Directors & Boards, P.O. Box 41966 Philadelphia, PA 19101-1966. All rights reserved. Contact the webmaster. < Privacy Notice > |
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