Risk Management For Dummies

Independent directors take steps to shield themselves from personal liability

Changes over the past decade in the ways independent directors are judged have made them more vulnerable than ever to personal exposure to claims stemming from their service on boards. Recent cases, in which honest directors have been vilified, could be leading to a major crisis--empty seats in the boardroom.

Companies hoping to attract independent directors to sit on their company board--and agents and brokers assisting in these efforts--need to be aware of these recent cases, and to understand when and how insurance policies can respond in these types of situations.

Directors' personal exposure, combined with the perceived erosion of the protections of the business judgment rule, are leading many qualified people to question whether serving on a board is worth risking their personal financial situation.

Yet at no time in this country's financial history has the significance of independent directors been more clearly apparent. With the financial meltdowns of Enron, Worldcom, Adelphia and others, we have seen that a lack of financial integrity and transparency 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 typical board of directors for a publicly traded company tends to be a group of people with very diverse backgrounds--arguably the more diverse the better.

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

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

Independent directors need to be "independent" of management, not beholden to the CEO for their jobs, or to have any other such conflicts 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 a publicly traded company.

"Qualified" can mean they have experience relevant to the task and the analytical capabilities to question and think strategically. It is for this reason that many corporate boards contain members with backgrounds in academia, public service and industries other than that on which the company focuses.

Business Judgment

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

The modern version of the business judgment rule was best articulated by the Delaware Supreme Court's 1985 ruling in Smith v. VanGorkon: "In carrying out their managerial roles, directors are charged with an unyielding fiduciary duty to the corporation and its shareholders. The business judgment rule exists to protect and promote the full and free exercise of the managerial power granted to...directors."

The fundamental principle has been that the public investment community is best served by having qualified people serve on boards. And so, if they act prudently, and make the best decisions they can, they will be protected.

However, in the recent Worldcom litigation, the settlement required more than $20 million in personal contributions by directors. The message to board members across the country is clear: If you are a director on a board such as this and there is a meltdown, be prepared to personally contribute to the settlement fund.

When evaluating whether to sit on a publicly traded board, this nightmare scenario must be considered. (See the sidebar on "shields" for some risk management tips on how board members can protect 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 few observations:

o Institutional investors--and investors, in general--are not served in the long run by settlements requiring personal contributions from independent directors. All investors want the most qualified boards they can get, and personal contributions could scare away from the boardroom those most qualified to serve.

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

o Personal liability--a significant departure from long-held law surrounding the business judgment rule--could also be an overreaction to the public outcry resulting from corporate super-scandals.

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

Jeffrey P. Klenk is senior vice 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 members can take to protect themselves:

o Know your organization. Before joining the board, become familiar with the organization's operations and make certain you are confident in your ability to assess, monitor and critique them.

o Know your duties. Work with legal experts to understand your duties as a fiduciary, to whom those duties are owed, and how to avoid conflicts that can lead to legal liability.

o Know your fellow board members and management. You are getting into close quarters with these folks, and taking on potential liability. Be certain you know who they are, and make certain you are confident in their capabilities and business ethics.

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

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

o Utilize insurance. In addition to traditional directors and officers liability insurance, there are other protections that directors can gain through policies such as A-side-only policies and differences-in-conditions policies. (See related article on page 24.) Work with a knowledgeable insurance broker to assess and manage your personal risk. Be actively and directly involved in the corporation's purchase of your insurance.

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

Jeffrey P. Klenk

Best art would have empty seats--or someone exiting the boardroom

Alternate: one director in the boardroom dressed in armor

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

Special Reports /

Personal Liability Puts Outside Directors On The Hot Seat

Related Stories

Recommended For You