Risk Management For Dummies

Independent directors take steps to shield themselves frompersonal liability

Changes over the past decade in the ways independent directorsare judged have made them more vulnerable than ever to personalexposure to claims stemming from their service on boards. Recentcases, in which honest directors have been vilified, could beleading to a major crisis--empty seats in the boardroom.

Companies hoping to attract independent directors to sit ontheir company board--and agents and brokers assisting in theseefforts--need to be aware of these recent cases, and to understandwhen and how insurance policies can respond in these types ofsituations.

Directors' personal exposure, combined with the perceivederosion of the protections of the business judgment rule, areleading many qualified people to question whether serving on aboard is worth risking their personal financial situation.

Yet at no time in this country's financial history has thesignificance of independent directors been more clearly apparent.With the financial meltdowns of Enron, Worldcom, Adelphia andothers, we have seen that a lack of financial integrity andtransparency can have devastating consequences for corporations,their employees, shareholders and institutional investors,highlighting the need for independent oversight.

Not everyone in the general public realizes that the typicalboard of directors for a publicly traded company tends to be agroup of people with very diverse backgrounds--arguably the morediverse the better.

Yes, "insiders" are involved in the company's operations on theboard. Typically, the chief executive officer or equivalent leadersof the organization have board involvement.

But a majority of board members needs to be independent frommanagement to fulfill its fiduciary duty--to oversee the operationsof the company; to question, probe and examine management's conductin executing the organization's strategic plan. It is here--in thisdynamic of checks and balances--that the importance of theindependent director is realized.

Independent directors need to be "independent" of management,not beholden to the CEO for their jobs, or to have any other suchconflicts that might inhibit their judgment. They must also,unquestionably, be qualified to do the job. Qualified, however,does not mean they must have an MBA or need to have been CEO of apublicly traded company.

"Qualified" can mean they have experience relevant to the taskand the analytical capabilities to question and thinkstrategically. It is for this reason that many corporate boardscontain members with backgrounds in academia, public service andindustries other than that on which the company focuses.

Business Judgment

The business judgment rule has long been a part of corporatecommon law, dating back as far as the case United Copper SecuritiesCo. v. Amalgamated Copper Co. in 1917. The rule exists to encouragequalified people to sit on boards.

The modern version of the business judgment rule was bestarticulated by the Delaware Supreme Court's 1985 ruling in Smith v.VanGorkon: "In carrying out their managerial roles, directors arecharged with an unyielding fiduciary duty to the corporation andits shareholders. The business judgment rule exists to protect andpromote the full and free exercise of the managerial power grantedto...directors."

The fundamental principle has been that the public investmentcommunity is best served by having qualified people serve onboards. And so, if they act prudently, and make the best decisionsthey can, they will be protected.

However, in the recent Worldcom litigation, the settlementrequired more than $20 million in personal contributions bydirectors. The message to board members across the country isclear: If you are a director on a board such as this and there is ameltdown, be prepared to personally contribute to the settlementfund.

When evaluating whether to sit on a publicly traded board, thisnightmare scenario must be considered. (See the sidebar on"shields" for some risk management tips on how board members canprotect themselves.)

Industry experts are still debating what the fallout will be,and whether personal contribution by directors will be a trend.While it is too early to tell for sure, here are a fewobservations:

o Institutional investors--and investors, in general--are notserved in the long run by settlements requiring personalcontributions from independent directors. All investors want themost qualified boards they can get, and personal contributionscould scare away from the boardroom those most qualified toserve.

o The circumstances surrounding Worldcom, Enron and otherhigh-profile cases have caused an outcry that is reminiscent of thesavings and loan crisis that hit the United States in the 1980s.Reforms and legal trends that sprang from that crisis wereshort-lived products of the fury surrounding the crisis.

o Personal liability--a significant departure from long-held lawsurrounding the business judgment rule--could also be anoverreaction to the public outcry resulting from corporatesuper-scandals.

For these reasons, it appears likely that personal contributionby independent directors will not be long-lived. If it is,boardrooms around the country may see an epidemic of emptyseats.

Jeffrey P. Klenk is seniorvice president of the Executive Liability Business Group of St.Paul Travelers Bond in Hartford, Conn.

Flag: Liability Shields

What Risk Management Steps

Can Independent Directors Take?

Here are some of the preventative steps corporate board memberscan take to protect themselves:

o Know your organization. Before joining theboard, become familiar with the organization's operations and makecertain you are confident in your ability to assess, monitor andcritique them.

o Know your duties. Work with legal experts tounderstand your duties as a fiduciary, to whom those duties areowed, and how to avoid conflicts that can lead to legalliability.

o Know your fellow board members andmanagement. You are getting into close quarters with thesefolks, and taking on potential liability. Be certain you know whothey are, and make certain you are confident in their capabilitiesand business ethics.

o Do your homework and attend all meetings.Being prepared for these meetings is part of your duty as a boardmember. Another aspect is continuing education and staying currenton contemporary corporate governance.

o Push, probe and question. You are there tokeep a check on management and to represent the shareholders. Don'tget comfortable or complacent. Don't be subservient.

o Utilize insurance. In addition to traditionaldirectors and officers liability insurance, there are otherprotections that directors can gain through policies such asA-side-only policies and differences-in-conditions policies. (Seerelated article on page 24.) Work with a knowledgeable insurancebroker to assess and manage your personal risk. Be actively anddirectly involved in the corporation's purchase of yourinsurance.

"Worldcom, Enron and other high-profile cases have caused anoutcry... reminiscent of the savings and loan crisis of the 1980s.Reforms and legal trends that sprang from that crisis wereshort-lived products of the fury surrounding the crisis."

Jeffrey P. Klenk

Best art would have empty seats--or someone exiting theboardroom

Alternate: one director in the boardroom dressed in armor

The looming threat of having to pay legal judgments out of theirown pockets has put outside directors on the hot seat, promptingthem to consider precautions or perhaps not serving at all.