Some Companies Purchase Directors and Officers Liability Insurance - Coursework Example

Running Head: Directors’ and Officers’ liability insurance Why do some companies purchase Directors’ and Officers’ liability insurance while others do not? [Name of writer appears here] [Name of institution appears here] Why do some companies purchase Directors’ and Officers’ liability insurance while others do not? Introduction Directors and officers of business corporations and other entities, including universities, churches, and foundations, can be liable for financial injuries they cause while working as directors or officers. They may be sued by: (1) the corporation itself or the corporations trustee in bankruptcy; (2) other successors to the corporation, including government entities like the Resolution Trust Corporation, the Federal Savings and Loan Insurance Corporation, the Federal Home Loan Bank Board, or the Federal Deposit Insurance Corporation; (3) shareholders in shareholder derivative actions; (4) creditors of the corporation; or (5) other corporations suing in the context of contested takeovers or other--sometimes unusual-situations. Governments occasionally use criminal laws to attack the conduct of directors and officers. Liability insurance is available to cover some of these judgments. Often it is known as "directors and officers insurance," or "D&O insurance." This Article discusses some significant parameters of D&O liability, expounds on some of the ways typical D&O insurance contracts work, and explores the law governing this type of insurance. This Article does not discuss general principles of D&O underwriting, principles of D&O risk control, or the process of dealing with D&O claims. It is becoming fashionable to refer to D&O insurance as a form of "executive liability insurance." One leading D&O carrier has titled one of its package policies the "Executive Protection Policy," and that policy includes D&O insurance. Executive liability insurance is a broader concept than D&O insurance and includes employment practices liability insurance, fiduciary liability insurance (which is basically designed to take care of liability exposures under the Employee Retirement Income Security Act (ERISA), kidnap/ransom insurance, and specialized executive insurance. Executive liability insurance, and D&O insurance in particular, must be distinguished from financial institution bonds and fidelity coverage. Fidelity bonds and insurance are designed to cover losses caused by dishonesty and fraud, usually committed by employees, near-employees, and trusted independent contractors. In contrast, director s and officers insurance is not designed to cover risks arising from moral turpitude or a want of integrity. Indeed, as this Article explains, there is a dishonesty exclusion included in standard D&O policies. To a considerable degree, D&O insurance generally purports to cover good faith errors and omissions, as well as negligence in business contexts. There are far fewer reported cases about the subject throughout the country than about most other types of insurance contracts. As this Article will discuss, several reasons explain this state of the law. First, there are fewer D&O policies than comprehensive general liability, homeowner, or vehicle policies. Second, many D&O policies contain arbitration clauses, thereby avoiding trials and published opinions. Third, D&O policies are structured in such a way that few "long-tail" claims are asserted under them, i.e., there are hardly any claims in which the plaintiff asserts he was injured many years earlier, as is common, for example, in asbestos cases. Legal Duties of Directors and Officers In general, directors and officers have duties to act in good faith with loyalty to the corporation and with due care. In most states, liability cannot be based on a directors negligence in breach of these duties. This is often true because of the application of the business judgment rule (BJR) or as a result of director shield statutes. The business judgment rule is a commonly used defence that raises the required standard for liability to something greater than negligence. Director shield statutes, enacted after a landmark Delaware case, hold both directors and officers liable for breaching a specified duty of care. D&O liability for fraudulent behaviour or intentional conduct is not discussed here, primarily because most, if not all, D&O insurance policies do not cover intentional conduct. Thus, this Article discusses the following foundation issues: (1) the duties of directors and officers, (2) their primary legal defences (other than attacking the merits of the claim or genetic defences such as statute of limitations bars), (3) the standard of conduct (between negligence and intentional conduct) required to impose liability, and (4) the different liability standards applied to directors and officers. A companys articles of incorporation may address its director liability, but essentially cannot touch the core duties that directors owe to the corporation (and its creditors if the corporation has entered the vicinity of insolvency). Specifically, the articles of incorporation may not limit the liability of a director for: (1) A breach of the directors duty of loyalty to the corporation or its stockholders or members; (2) An act of omission not in good faith that constitutes a breach of duty of the director to the corporation or an act, omission that involves intentional misconduct, or a knowing violation of law; (3) A transaction from which the director receives an improper benefit, whether or not the benefit results from an action taken within the scope of the directors office; or (4) An act or omission for which the liability of a director is expressly provided under an applicable statute. This formulation--in short, the duties of good faith, care, and loyalty -- reflects the standard in most states since the mid-1980s. Most states routinely applied roughly the same standard for officers and directors until about 1985. After 1985, as the result of states reaction to Smith v. Van Gorkom, an important Delaware case holding directors liable for breach of their duty of care (which was rare before 1985), most states adopted director shield statutes to supplant these standards. In some states, including Delaware, the director shield statutes simply provided corporations with the option of including liability-limiting language in their articles of incorporation. Duties after Smith v. Van Gorkom (Post-1985) Although the duties of good faith and loyalty were untouched by Smith v. Van Gorkom, the Van Gorkom court gave directors and officers duty of care real teeth. The decision made clear that directors have the specific duty to stay informed and to provide information, both of which fall under the umbrella of "duty of care." The Van Gorkom opinion also demonstrated that the business judgment rule would not necessarily protect directors and officers from liability for failing to use care in exercising their business judgment. In voting to approve a proposed merger, the directors of TransUnion had not adequately informed themselves of the role that Van Gorkom, the chairman and CEO, played in the negotiations. The directors were uninformed about the intrinsic value of the company and under the circumstances were, at a minimum, grossly negligent in approving the sale after only two hours consideration. They had not reviewed or relied on even a fraction of the information available to them. Van Gorkom failed to provide the board with adequate information. He did not invite the companys investment banker to the meetings at which the merger was discussed, did not provide copies of the proposed merger agreement to the board, and ignored and did not make available to the board a study showing that the proposed stock price was at the low end of a reasonable range. He went forward with the board meeting, at which the proposal was presented in the face of strenuous objections from senior management. Business Judgment Rule Generally, under present application of the business judgment rule, if decisions are made as part of a process that is "either rational or employed in a good faith effort to advance corporate interests," directors are protected from liability for the losses resulting from those decisions. Although heavily discussed in legal literature, the Delaware courts generally accepted pre-1985 statement of the business judgment role described it as "a presumption that in making a business decision the directors ... acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company." The business judgment role was established pursuant to the policy concern that courts might interfere with routine and necessary business decisions such as choosing advertising campaigns or selecting materials suppliers. Courts are "ill-equipped and infrequently called on to evaluate what are and must be essentially business judgments." The rule remains in place to keep courts from second-guessing corporate decision-makers in the exercise of their "business judgments," even if those judgments are in hindsight ridiculous or harmful to the company. The most important application of the business judgment rule is as a defence to a claim for breaching the duty of care. The business judgment rule narrowly applies only when the subject of the allegations is an actual business decision: Technically speaking, it has no role where directors have either abdicated their functions, or absent a conscious decision, failed to act. But it also follows that under applicable principles, a conscious decision to refrain from acting may nonetheless be a valid exercise of business judgment and enjoy the protections of the rule. The rule incorporates not only the presumption of due care, but also the presumptions of good faith and loyalty. If the liability claim is based on an act of bad faith or disloyalty (self interest), the business judgment role provides only a presumption- or burden-shifting device. The loyalty requirement is largely a question of disinterestedness, and good faith involves a duty to act "in the honest belief that the action taken was in the best interests of the company." However, a plaintiff would still have to be able to prove disloyalty and bad faith as part of his case-in-chief. The true usefulness or importance of the business judgment rule before 1985 was its application to almost completely prevent claims for breach of the duty of due care. Under the role, courts would refuse to review the substance of the transaction (the outward manifestation of the business judgment), and thus never find liability for a directors failure to use due care in executing a transaction or decision. The business judgment role was a more interesting and certainly more substantive hurdle when applied to claims for breach of the duty of care, as was the case in the 1985 Van Gorkom decision. Director Shield Statutes The Van Gorkom case raised concerns that good candidates would avoid serving as directors, that corporations would become overly conservative in their business decisions, and that D&O liability insurance would become unaffordable. In response, a number of states enacted director shield statutes. As a result both of Van Gorkom and its progeny and a reduced numbers of carriers, premiums on D&O insurance rose to record levels. According to the Wall Street Journal, premiums for D&O insurance increased more than 360 percent in the year following these decisions. The most common type of director shield statute is often referred to as a charter option statute. Delawares statute is a model for many states. It allows a corporation to include provisions in its charter that effectively eliminate liability for a breach of the duty of care, essentially reinstating the pre-Van Gorkom law. By 1988, at least forty states had adopted statutes reducing the personal liability of directors for money damages. Therefore, one must carefully examine the shield statute of the companys state of incorporation as well as the corporations charter or articles of incorporation to determine the risk of liability for a director. The statutes rarely allow a director to avoid liability for breaches of loyalty or good faith, but this review is critical with claims for breach of the duty of due care. Reliance on Other Corporate Officials or Professionals Directors and officers may rely, however, only on individuals they reasonably believe are "reliable and competent," and they may not rely on others information if they have better knowledge in the matter. Moreover, if a director has a particular area of expertise, this may limit his ability to rely on advice from third parties within his area of expertise. For example, extremely interesting problems arise for lawyers who serve on boards of directors. For example, the lawyer/director would face the question of which insurance policy will apply, the lawyers malpractice policy or the D&O policy. If a director defends a lawsuit against him on the basis that he relied on the opinion of another--someone who was an expert and who should have knowledge--it will not automatically be true that his insurance carder will not have to pay. First, reliance is factual in nature. Therefore, it is unlikely to be dispositive or resolved early in the case. The director must actually have relied, and the reliance must have been reasonable under the circumstances. Second, the policy may also cover the officer, director, or committee upon which the director relied. Thus, even if the director who relies is exonerated, the person or entity upon which he relied may require indemnity. Finally, there may be issues of joint liability, for example, when accountants or attorneys were consulted or when both management and the professional were negligent. When two or more people are negligent together, they both have to pay and then divide between themselves who has to pay what amount. Bibliography Bhagat, S., J Brickley & J Coles (1987) Managerial indemnification and Liability Insurance: The Effect on Shareholder Wealth, Journal of Risk and Insurance, 54, 4, 721-736 Chalmers, J., L Dann & J Hartford (2002) Managerial Opportunism: Evidence from Directors’ and Officers’ Insurance Purchases, Journal of Finance, 57, 2, 609-636 Core, J., (1997) On the Corporate Demand for Directors’ and Officers’ Insurance, Journal of Risk and Insurance, 64, 1, 63-87 Core, J., (2000) The Directors’ and Officers’ Insurance Premium: An Outside Assessment of the Quality of Corporate Governance, Journal of Law, Economics & Organization, 16, 2, 449-477 O’Sullivan, N., (1997) Insuring the Agents: The Role of Directors’ and Officers’ Insurance in Corporate Governance, Journal of Risk and Insurance, 64, 3, 545-556 Read More