This Delaware statute proved a popular vehicle for limiting liability. Most other states have now adopted similar optional provisions.

 

While liability-limiting statutes like the one adopted by Delaware and other states may provide a welcome relief from some types of liability, there are important exceptions to the extent to which liability can be limited for other types of misconduct. Although the law varies by jurisdiction, the following are not normally subject to the liability-limiting provisions of the law:

 

•Liability based on the duty of loyalty

•Wrongful acts or omissions where the director or officer has not acted in good faith, violations of law, or other intentional misconduct

•Liability based on transactions in which the director or officer derived an improper personal profit, benefit, or advantage

 

It should be noted that not all states extend the benefit of charter-amendment protection to officers of the corporation. Most states follow the Delaware model and allow the immunity to apply only to directors of the corporation. Such provisions also only apply to liability a director, or in some instances an officer, has to the corporation or shareholder, and do not apply as respects liability to third parties. The Delaware law is also enabling, meaning that in order for the grant of protection to apply, the corporation must have amended its certificate of incorporation or bylaws to include the liability-limiting provision. In these instances, protection only applies to wrongful acts or omissions occurring after the time such a provision becomes effective.

 

Business Judgment Rule Expanded to Include Considerations of Outsider Interests

 

Directors and officers are charged with making business decisions in an informed fashion, mindful of the best interests of the corporation. (The “business judgment rule” immunizes management [including corporate directors and officers] from liability in corporate transactions undertaken within both the powers of the corporation and the authority of management where there is reasonable basis to indicate that the transaction was made with due care and in good faith. For further discussion of the business judgment rule, see Duty of Diligence and Care.) Questions regarding such decisions often arise out of the board's response to hostile-takeover bids and to shareholder-derivative actions, which often allege that the chosen course of action was not in the corporation's best interests.

 

Many state statutes now have expanded the criteria of what constitutes the corporation's best interests to also include consideration of non-shareholder interests, including those of employees, creditors, customers, and other outside entities. Some statutes even extend consideration to community, state, and nation. There is considerable variety in how and to what extent the individual jurisdictions apply such statutes. Some states allow consideration to extend to outside interests, while other states mandate such consideration. Debate continues on whether these types of statutes add any protection from liability. Some have suggested that requiring directors to consider outside constituencies may invite criticism from, or imply some obligation to, these parties, an obligation that may not have existed prior to enactment of the legislation.

 

Insurance and Other Risk-Financing Techniques

Risk-control techniques, indemnification, and legislative reforms cannot completely protect an organization or its directors and officers from the risk of serious financial loss. Any claim or incident can lead to litigation, and even nuisance suits can cost tens of thousands of dollars to resolve. Defense of more serious claims can cost many times this amount. Small or thinly capitalized firms may be severely impacted by even a single claim, but even larger firms might find it difficult to absorb the cost of multiple suits or a large class-action suit.

 

The adoption of indemnification provisions does not always guarantee financial protection for directors or officers. D&O insurance may be available only at extremely high cost, may be limited in amount, and is often subject to numerous exclusions and exceptions from coverage. Since insurance, even if available, does not always offer comprehensive and secure protection for corporate directors and officers, many companies now are using or considering alternative ways to fund indemnification agreements outside of traditional insurance coverage.

 

Alternate Indemnification-Funding Methods

 

Many states have adopted statutes in recent years addressing alternative indemnification-funding methods. Although indemnification provisions may be quite broad, they are no guarantee of the corporation's financial ability to pay. D&O insurance, even when available and affordably priced, contains many exclusions and limitations of coverage and is often neither comprehensive nor an absolute form of protection. Alternative indemnification-funding methods may include any of the devices listed subsequently. For a thorough discussion of alternative indemnification funding methods, see “Corporate Director and Officer Indemnification: Alternative Methods for Funding” by J. Phil Carlton and M. Guy Brooks, III found in the Wake Forest Law Review, Volume 24 (1989).

 

Letters of Credit

 

An irrevocable letter of credit issued by an independent third party, such as a bank, may be used solely to pay indemnity claims whether these claims arise under an indemnification contract or the corporate charter or bylaws. A letter of credit is sometimes desired because it commits the credit and assets of an independent third party—the provider of the instrument—to cover the indemnity claims under specified conditions. Such conditions may include the refusal or inability of the corporation to pay the claims. However, a corporation in need of significant indemnification protection may not have the credit rating required for a letter of credit.

 

Indemnity Trust Funds

 

Some corporations separate the director and officer indemnification reserves from other corporation reserves through the use of indemnity trust funds. An indemnity trust involves an irrevocable disposition of assets to an independent trustee pursuant to the trust agreement and the sole purpose of the trust is to pay indemnity claims.

 

Under an indemnity trust, the trustee (usually a bank) holds funds deposited by the corporation in trust for the benefit of directors and officers protected by indemnification obligations. Funding of the trust may be effected in several ways, including an initial one-time contribution upon establishment of the trust, annual specified contributions, periodic funding designed to maintain a specified balance of funds in the trust, or a combination of methods. The trustee then pays indemnity claims as they arise according to procedures set forth in the trust agreement.

 

Some indemnity trusts provide for the trustee or other third party to administer claims, with the protected persons dealing directly with the trust's administrator. Other trusts may provide for the corporation itself to administer indemnity claims. When the corporation is the administrator, directors or officers who have been denied indemnification may be allowed to seek indemnification from the trust after some specified period of time. Also, trust agreements often require the repayment of any indemnification in the event such indemnification is later denied.

 

How indemnity trusts are set up is dictated by the restraints on indemnification imposed under state law and by the extent to which the corporation desires to grant and fund indemnification under the law. Consequently, they may be subject to scrutiny by federal and state tax agencies as well as the corporation's shareholders. However, such trusts can reassure company officials that if the need for indemnification arises, funds will be available to satisfy the company's indemnification obligations.

 

Self-insurance

 

Some corporations assume—or self-insure—all or a portion of their insurance risks, including the potential obligation to indemnify directors and officers. Self-insurance involves the corporation providing needed indemnification out of current operating funds or establishing a liability reserve fund to cover its indemnification obligations.

 

By establishing a self-insurance reserve, the corporation can avoid the payment of insurance premiums and earn interest on the reserved funds. The corporation avoids the periodic “crises” associated with the cost of director's and officer's liability insurance.

 

Self-insured obligations may not be considered insurance under some state laws. Rather, these states may consider self-insurance the same as indemnification, which is subject to the same statutory and public policy limitations associated with indemnification. Thus, unlike commercial insurance, self-insured reserves may be available to pay indemnification claims that the corporation would not be allowed to pay under state law.

 

Captive Insurance Company Arrangements

 

Some corporations establish an insurance company which is formed usually as a wholly-owned subsidiary to provide directors' and officers' liability insurance for the parent company and perhaps a subsidiary or other affiliated company. Many of these captive insurance companies are domiciled in foreign or state jurisdictions that permit organization of such limited purpose entities as well as provide certain tax advantages. Captives typically are capitalized by the parent entity, are managed professionally, and provide insurance through policies similar to traditional insurance policies but without some of the limitations and exclusions that are present in commercial insurance policies.

 

Captive insurance companies have both advantages and disadvantages. As compared to regular insurance companies, captives generally (1) can be more efficient and productive, (2) may provide insurance at a lower cost, (3) may provide greater access to affordable reinsurance, (4) may be more profitable, and (5) may provide tax benefits. However, captives also may be subject to statutory and public policy limitations on indemnification and are often expensive to organize, capitalize, and operate in accordance with applicable corporate and insurance laws.

 

Risk Retention Groups (Group Captives)

 

Some corporations, usually members of trade and industry groups, band together to form an insurance company to provide directors' and officers' liability insurance to the members of the group. Group captives are typically formed to provide insurance that is otherwise unavailable to the individual members at an affordable price. The theory behind the creation of group captives is that since they are not controlled by one entity and the risk is spread among the members, the group captive should be able to avoid the tax and indemnification problems of single-parent captive insurers.

 

Like single-parent captives, group captives offer the potential advantages of (1) reduced insurance costs, (2) ability to retain investment income, (3) greater access to affordable reinsurance, (4) favorable tax consequences and (5) the ability to tailor coverage to the specific needs of the group members. However, membership in group captives tends to be expensive and involves a long-term commitment of capital. In addition, group captives must satisfy stringent insurance, underwriting, and other regulatory requirements relating to capitalization.

 

Fronting Arrangements

 

Another indemnification funding alternative is the establishment of a fronting arrangement by a corporation—and perhaps its captive insurer—with a traditional commercial insurer. Under such an arrangement, the commercial insurer becomes a “fronting company” and issues a regular directors' and officers' liability insurance policy to the corporation. The corporation then reimburses the fronting insurer for all or part of the losses the insurer pays in excess of the premiums. The commercial insurer receives a fee or a minimum nonrefundable premium for fronting the corporation and typically reimburses the corporation if premiums exceed losses. In some fronting arrangements, the corporation's captive reinsures all or part of the risk.

 

Insurance

 

State statutes may prevent the corporation from indemnifying its directors and officers in some instances. However, nearly all states permit the purchase of insurance to protect these individuals in situations where the corporation is not allowed to indemnify. An example would be in derivative actions, where the indemnification of judgments and settlements might be precluded by law in some states. The emphasis of insurance normally has focused on protecting the directors and officers from personal liability. As a practical matter, D&O insurance probably is equally desirable as a means of financing the corporation's indemnity obligations. In some instances D&O insurance may also provide protection for loss associated with direct suits filed against the corporation.

 

D&O liability insurance can cover much of the risk that cannot be otherwise reduced or eliminated. Numerous insurers provide insurance specifically designed to protect against claims or suits alleging wrongful acts by the company and/or its directors and officers. Very high coverage limits are usually available, making it possible to buy excess D&O insurance above primary coverage or a relatively large self-insured retention.

 

It should be noted, however, that D&O policies may not and often do not provide coverage for the corporate entity, wrongful employment practices, or offenses under environmental legislation or securities laws. Coverage for these exposures is sometimes available by endorsement or under a separate policy form.

 

Stand Alone Side-A Insurance Policies

 

Some company directors and officers may be concerned that standard D&O policies do not afford enough protection for their individual liability. Often this is because of the potential erosion of policy limits in payment of losses to the company under entity coverage provisions or class action lawsuits. As a result, some companies consider the purchase of a Stand Alone Side-A D&O policy that applies excess of the company's standard D&O insurance program.

 

Policies providing only Side-A coverage have been available for many years but only recently have been receiving considerable attention. Such policies can not only provide coverage limits in excess of the company's standard D&O policy, but can also serve as a Difference-in-Conditions (DIC) policy to fill coverage gaps that may result from the depletion of D&O policy limits or when the corporation is unable or unwilling to indemnify the directors and officers for expenses incurred in defending lawsuits.

 

The two most frequent circumstances under which a corporation does not indemnify its directors and officers (and thus Side-A coverage applies) are as follows:

 

1. The company is financially insolvent, bankrupt, or otherwise financially unable to fund the indemnification.2. The defendant directors and officers are obligated to pay a settlement or judgment amount in a shareholder derivative lawsuit. In most states, companies are prohibited from indemnifying the directors and officers for settlements and judgments in shareholder derivative lawsuits. This prohibition is intended to prevent the meaningless and circular result that would occur if the directors and officers paid money to the company in settlement of the derivative claim and then received indemnification of the settlement amount from the company.

 

Most traditional D&O insurance policies afford both Side-A coverage for nonindemnified loss and Side-B coverage for indemnified loss and are perceived by many to adequately respond to these two nonindemnifiable exposures. However, under certain circumstances traditional policies may not afford the full amount of desired protection for the directors and officers . Stand Alone Side-A policies can also play important roles in covering foreign country executives in jurisdictions that may preclude D&O coverage or where Side-B coverage is not allowed.

 

There are several areas where a Side-A only D&O policy can provide greater protection to directors and officers than a typical D&O insurance policy.

 

Risk Retention

 

Most organizations retain some portion of risk as a cost of doing business unless there is some specific reason or requirement to do otherwise. In the past, little consideration may have been given to retaining losses that might arise out of the D&O exposure because the risk was often considered to be so small that it was of little consequence. Today, however, the D&O liability exposure is better recognized and understood. Now with the option to insure against loss arising out of wrongful acts by the corporation's directors, officers, and employees, a more thorough analysis of how much of the D&O risk should be retained is warranted.

 

One reason for retaining risk is that there is a charge for insurance. Insurance companies must charge an amount of premium in excess of what it expects to pay in losses to cover general overhead, producer commissions, and state and federal taxes. Because of this, insurance will usually cost much more than retention. Risk retention for D&O claims also focuses attention on and promotes the prevention and control of loss.

 

An arguable disadvantage of risk retention is that costs may vary significantly from year to year. However, past insurance market conditions have demonstrated that even insured programs are subject to unplanned, substantial fluctuations in cost.

 

Amount of Risk Retention

 

A general rule of thumb is that all predictable losses should be retained. However, D&O losses usually are infrequent and thus may not be predictable. In order to establish what amount of retention is acceptable, it usually is necessary to examine annual revenues, which are a measure of an entity's loss-absorbing capacity. When a sudden expense occurs, it may be possible to shift expenditures, defer projects, or somehow readjust finances to accommodate the need. The degree of flexibility within an organization's budget to make such accommodations is one measure of a tolerable loss level.

 

Perhaps the most common method of selecting a retention amount is to have premium quotations provided at different retention levels. A decision usually can be made on an intuitive weighing of dollars saved versus expected losses assumed. But such an approach also can be misleading. The premium reduction gained by increasing the retention may at the time appear small in relation to the possible assumed loss. However, because the insured may have no way to calculate the actual frequency of claims, this may result in the insured rejecting a premium reduction that would be beneficial in the long run.

 

Whatever risk-retention level is chosen, it should be selected by the board of directors after consultation with the corporation's chief financial officer to determine how unbudgeted losses will impact the organization's present and future financial condition.

 

Not-For-Profit Organizations

 

Courts usually divide not-for-profit organizations into one of three categories: (1) religious organizations, (2) universities or private colleges, and (3) other private not-for-profit organizations. Once thought to be immune from D&O liability, not-for-profit organizations have seen increased claims and lawsuits involving a wide variety of legal issues. These include but are not limited to claims alleging tort liability, discrimination, wrongful employment practices, personal injury, breach of fiduciary duty, and other types of wrongdoing. 

 

Although many directors of not-for-profit organizations may be aware of their personal and organizational risk through their service to the not-for-profit organization, others may not fully understand the extent of such potential liability and how, if at all, insurance might apply.

 

The reality today is that there is an extremely wide range of potential personal and organizational risks to which a not-for-profit organization and its management, staff, volunteers, and others are exposed. The following is a brief review of such exposures and considerations when arranging D&O insurance coverage.

 

Charitable Immunity

 

Charitable immunity generally refers to the legal doctrine that establishes immunity from civil liability (tort) under certain circumstances for charitable organizations. Such doctrines are sometimes referred to as Good Samaritan Laws, Volunteer Protection, Volunteer Immunity, Liability Limitation Shield Laws, and Charitable Immunity or other names. Such terms actually have subtle and not so subtle distinctions but collectively can be described as laws that protect people and organizations in the nonprofit sector from claims, lawsuits, and allegations of wrongdoing.

 

The concept of so-called charitable immunity originated under nineteenth century English common law. The intent of the law was to preclude organizations that did not profit from the actions of their agents from being held liable for such actions. These early laws, including those that later developed in the United States, shielded charitable organizations from liability as a matter of law. By the late 1930s and early 1940s, a majority of states had broad charitable immunity laws on the books. Over time, however, it became evident that the so-called charitable immunity laws were inequitable in many situations. As a result the laws began to be rewritten to reduce the degree of immunity or even to eliminate charitable immunity all together. Today, while all states have laws addressing how such doctrine applies, the majority do not grant such immunities. Those states that do grant immunities generally do so subject to varying degrees and under specific circumstances.

 

Although there has been significant analysis and writings on the subject of charitable immunity by practitioners and scholars alike over the past twenty years, there is still widespread confusion as to whether volunteers and nonprofits can be sued and held liable for their negligent acts. Common questions include the following: Can we be sued? Can we be held responsible? Are there laws that protect us because we are a not-for-profit or volunteer?

 

The reality is that any organization or person can be sued for anything by anyone or any entity at any time and just defending lawsuits can be costly, resulting in possible financial dislocations.

 

Determining whether a not-for-profit organization, director, officer, employee, or volunteer will be legally responsible for an alleged wrongful act depends on numerous factors. These include but are not limited to whether there was a duty of care with respect to those who were harmed, such duty of care was breached, actual harm occurred, such harm was foreseeable, the breach was a direct cause of the harm that occurred, and/or reasonable measures would have prevented the harm from occurring.

 

Because charitable immunity laws differ by jurisdiction, it is imperative that all not-for-profit organizations understand how such laws, if any, apply in their respective state(s) of operation.

 

Entity Liability

 

Because many not-for-profit organizations are involved in a wide range of activities and operations, the organization and its directors, officers, volunteers, employees, and others can have significant exposure to loss from lawsuits. Such liability can result not only from of actual wrongful acts but also may arise from omissions or the failure to act. Where such activities or omissions cause harm, the organization can be subject to any number of typical tort claims and other types of claims such as wrongful employment practices, membership discrimination, and others. The following are the most common types of claims:

 

Tort Liability. Tort claims are civil wrongs that cause another person or entity to suffer loss, and are perhaps the most common types of claims made against not-for-profit organizations. These include claims such as automobile accidents, false imprisonment, defamation, product liability, pollution, and many other types. Keep in mind that not-for-profit organizations are generally liable for the torts of their volunteers to the same extent that companies are liable for the torts of their employees. Tort claims are most often associated with commercial general liability coverage.

 

Wrongful Employment Practices/Sexual harassment. Such suits are usually brought by employees and volunteers for acts such as discrimination, sexual harassment, wrongful discharge, molestation, and a whole host of other wrongful acts. The complaints pose potential liability risks for all not-for-profit organizations. In recent years the most notable have been brought against churches, parishes, and athletic associations/programs.

 

Patent or Copyright Infringement. Not-for-profit organizations can have significant liability for damages caused by patent or trademark infringement. Such claims are common for entities like schools, athletic associations, and publishing companies. The cost of defending such cases is very high, and it is not uncommon for defense-only costs to approach or even exceed $1 million. Although patent and trademark infringement liability claims are most often covered by general liability policies, D&O policies may also provide coverage depending on the particular circumstances.

 

Discrimination by Not-For-Profit Organizations. Discrimination suits are not uncommon for associations and private clubs where employment or membership has been denied. These claims usually are brought under state civil rights statutes that prohibit discrimination in places of public accommodation and are likely to be covered under general liability and D&O policies.

 

Parent Organization Liability. Not-for-profit parent organizations can be held liable for the wrongdoing of their chapters, parishes, or affiliates. The extent of liability usually depends upon the degree of control that is exercised by the parent over its affiliate or chapter. Although it may seem unlikely for a person to be able to exercise ownership control over a not-for-profit corporation, a person or organization still be can held liable under an alter ego theory An alter ego theory is A doctrine by which a court can hold individual shareholders liable for a corporation's debts if the corporation is deemed to be nothing more than an “alter ego” of the corporation's owners. Such doctrine could be the basis to ignore the corporate status of a group of stockholders, directors and officers so that they can be held personally responsible for wrongdoing. In this way if the parent is found to control and direct the affiliate to carry out its own business purposes then the controlling party might be found liable.

 

Director Liability- Breach of Fiduciary Duty. Like their for profit counterparts, the directors or officers of not-for-profit organizations have certain fiduciary duties to the not-for-profit organization, which are the duty of care and loyalty. Not-for-profit statutes may limit or eliminate director or officer personal liability for breach of fiduciary duty, but directors and officers may still face the threat of potential liability for breach of the duty of loyalty. The major issue to be raised while litigating the underlying cases is the scope of fiduciary duty standards for not-for-profit organizations set by each state. Surprisingly, not-for-profit organizations may face a higher exposure to the underlying claims since the standard of care for not-for-profit corporations set by each statute is likely to be higher than the fiduciary standards of business corporations.

 

Personal Liability—Volunteers

 

In 1997, Congress passed the Volunteer Protection Act, which provides protection to not-for-profit organizations described in Section 501(c)(3) of the Internal Revenue Code of 1986 and any not-for-profit organization that is organized and conducted for the public benefit for charitable, civic, educational, religious, welfare, or health purposes.

 

The act defines “volunteer” as an individual performing services for a not-for-profit organization or governmental entity and who does not receive compensation for his services or anything of value, in lieu of compensation, in excess of $500 per year. This definition includes those who serve as a volunteer director, officer, or trustee. The act limits coverage to volunteers' acts that are within the scope of their responsibilities and only to ordinary negligence and do not constitute willful or criminal conduct, gross negligence, or reckless misconduct. Volunteers are also granted immunity from awards of punitive damages. Intentional torts, grossly negligent acts, or omissions of not-for-profit directors and officers are not covered by the act.

 

Personal Liability—Directors and Officers

 

Directors and officers of not-for-profit organizations can face personal liability for their grossly negligent acts, omissions, and intentional torts.  Additionally, directors and officers may also face liability exposure to derivative suits brought on behalf of the not-for-profit organization by persons who believe the organization has been damaged by acts of its directors or officers. Even though the majority of derivative suits are brought by such persons, these suits are unlikely to succeed since the plaintiffs usually do not have the standing to bring such actions.

 

Directors and Officers Liability Insurance

 

Directors and Officers Liability insurance for not-for-profit organizations is generally broader than similar policies written for for-profit organizations. While traditional D&O policies cover directors and officers as well as a limited number of managers, D&O policies for not-for-profit organizations generally extend their coverage to all employees, volunteers, and committee members of the organization.

 

As with for-profit D&O policies, not-for-profit D&O policies do not provide standardized coverage and there can be significant coverage differences between policy forms. The market for D&O liability coverage for non-profits continues to be robust, allowing agencies of all sizes to obtain broad coverage at reasonable premiums. With easy access to affordable D&O liability coverage, no nonprofit organization should put their board of directors and organization at risk by ignoring this critical insurance product.

 

Key desirable features of not-for-profit D&O liability insurance include the following:

 

·A broad definition of “insured” that covers all directors, officers, employees, staff, volunteers, and committee members

·Coverage limits from $1 million to as high as $25 million or more

·Small retentions for both entity reimbursement coverage and for individual directors and officers ranging from $0 to $2,500; larger risks retentions ranging from $10,000 to $25,000 for their corporate reimbursement coverage

·Full entity coverage to include coverage for claims made against the organization itself, even if no directors or officers are named in a claim or lawsuit

·Employment practices coverage for all insured persons of the organization against damages from claims including, but not limited to, wrongful termination, sexual harassment, discrimination, and unfair hiring/firing practices

·An affirmative duty to defend insureds

·Defense expenses paid in addition to the limits of liability; most not-for-profit D&O policies now provide for unlimited defense expenses that do not diminish the overall limit of liability under the policy. Some policies have a separate limit for defense expenses.

·Prior acts coverage. Look for policies that have no “retro dates” that would limit coverage for prior wrongful acts, as long as such acts were unknown at policy inception.