RISKVUE ARCHIVE | INDUSTRY WATCH >DIRECTORS & OFFICERS LIABILITY (D&O)

Addressing The Board Member’s Personal Risk Exposure

By William R. Henry, Jr.

More than ever before, individual members of a board of directors place their personal assets at risk when they agree to serve. Although most media coverage of board activities and corporate governance in general has focused on the travails of large, publicly held companies, privately held organizations and their directors also need to be concerned. In a recent survey of private companies by The Chubb Group of Insurance Companies, 18 percent reported that they had been sued within the past few years. Nearly two in five believed it is “likely” they will be sued in the future — by customers (37%), vendors (30%) or shareholders (21%).

A corporate (or nonprofit) directors and officers liability policy is crucial protection, and we recommend that every organization seriously consider having such a policy. However, D&O coverage for the organization might fail to protect the individual director completely, for any of several reasons. Limits can be inadequate for claims. In bankruptcy proceedings, the limits of the policy can be seized as assets available to creditors. The D&O insurer can rescind the policy if the application was fraudulent. Depending on the D&O policy’s exclusions, an individual director can be exposed to risk because of wrongful acts of other directors. The director’s specific actions in question might be excluded by the policy.

Independent directors, and would-be directors, have taken notice. In a Korn-Ferry survey, 48% of independent directors indicated they had turned down directorships because of a fear of being sued. Half of the respondents said that adequate D&O insurance was critical in their decision whether or not to serve. In order to attract qualified, motivated independent directors, the organization needs to satisfy the individual directors’ concerns that they might lose their homes and their retirement assets as a perverse result of well-intentioned service.

Fortunately, there are steps the organization can take to minimize this risk. The following discussion provides guidance both for the organization that seeks to protect its directors, and for the individual who is serving or would like to serve on a board but has concerns about personal risk exposure.

Personal Director Liability Policy

In recent months, some insurers have begun offering policies for the individual directors of for-profit (publicly and privately held) and nonprofit organizations. These policies can be purchased either by the organization or by the individual. (Where the individual is the purchaser, coverage can apply to service either to a single board, or any combination of boards.) Some policies are available only to independent directors; others are available to “insider” directors and officers.

These new policies pay legal defense, judgments, and settlements on behalf of the individual director (or more than one director, if that is the chosen coverage) where the organization is unable or unwilling to pay, or is legally prohibited from paying. Their limits are not diminished by any amounts paid by the primary D&O policy, nor are they vulnerable in a bankruptcy proceeding against the organization. The personal D&O policy can be written either on a primary or excess basis; most excess policies include a “drop-down” feature that makes them primary in the event the primary policy does not respond to a claim.

When the personal D&O policy is excess, it is typically priced lower than a traditional D&O policy that covers the organization and its directors on a primary basis.

Loss Prevention For The Board

In addition to insurance protection, there are steps the organization and its board can take to minimize the risk of litigation — by vendors, customers, employees or other stakeholders — that jeopardize the assets of the organization and its board members. In the wake of Enron, WorldCom and other high-profile scandals, Congress in 2002 enacted the Public Company Accounting and Investor Protection Act (Sarbanes-Oxley Act), aimed at improving corporate governance and accountability in a variety of ways. The New York Stock Exchange, last November, also adopted similar new rules for its members. Although these new rules apply to publicly held companies (plus those that have filed Initial Public Offering registration statements), it is likely that many of the same requirements will become the expected standard for privately held organizations — and might become underwriting requirements for insurance coverage.

Lisa McGee, manager of Chubb Specialty Insurance’s private company customer group, commented that adhering to Sarbanes-Oxley standards is a “checkmark in the‘plus’ column” right now for privately held firms, as far as D&O underwriters are concerned, and might become a requirement over time, as more and more private companies adopt those standards.

In any event, effective risk management requires that every company or nonprofit, regardless of its size, review its board activities to identify and correct any practices that do not serve the organization’s proper mission.

The following suggestions are taken from a new publication by Chubb, “Loss Prevention Guidelines For Independent Directors”:

• Define “independent” directors so they truly are independent. A definition such as “receives no direct compensation” is not sufficient, in cases where a director stands to benefit indirectly from a board action.
• Consider requiring that certain committees of the board be composed entirely of independent directors. Sarbanes-Oxley, for example, requires that the audit committee be constituted that way. Consider such a requirement for the compensation and nomination committees.
• Establish a detailed orientation program and continuing education program for directors, covering not only the organization and its class of business, but also how to spot and resolve potential conflicts of interest.
• Establish a periodic review/evaluation of all board members, and a CEO succession/senior management development plan.
• Establish effective procedures for meetings — everything from frequency to preparation to keeping of minutes and directors’ notes.
• Establish and follow a document-retention policy, but never destroy documents that might pertain to litigation.
• Require that independent directors meet occasionally without management present.
• Investigate any warning signs such as troubling reports from management, inconsistent information, increases in transactions involving related parties, or complex transactions that are not easily explained to the board.
• Establish a zero-tolerance policy for questionable behavior by management or board members.
• Involve the board in establishing and reviewing internal controls designed to prevent self-dealing or other questionable activity within the organization.

ABOUT THE AUTHOR

William Henry is director of communication for The CIMA Companies, Inc., an independently owned insurance broker and risk management firm with offices in Alexandria, VA, Baltimore, MD, and Atlanta, GA. More information is available at www.cimaworld.com.

riskVue | The webzine for risk management profesionals
June 2004