Directorial Liability:
Tips for Outside Directors on Minimizing
Personal Exposure in Shareholder Lawsuits

 

by Boris Feldman*

 

Historically, outside directors of public companies have had virtually no personal exposure in shareholder lawsuits. Liability rules for federal securities claims and state law derivative suits made it difficult to hold outside directors responsible for problems at a company. Moreover, the combination of corporate indemnification and D&O insurance usually meant that enough money was available to settle a case without requiring outside directors to contribute. So long as a director was not personally involved in a fraud, she had little reason to fear individual financial liability.

The risk calculus for an outside director - even an honest, diligent outside director - is changing. New statutes and regulations will impose greater duties than before on outside directors to prevent fraud and other abuses by management. Regulators and institutional plaintiffs are starting to demand settlement contributions even from directors who were unaware of the fraud.

The wave of corporate scandals and governmental responses makes this an appropriate time for outside directors to rethink their membership on public company boards. If you choose to stay, you should take steps now to enhance your effectiveness as a director and to minimize your personal exposure in the event something goes wrong.

This articles proposes several steps to accomplish both those objectives.

 

"Should I Stay on This Board?"

This is a good time for you to review your board commitments and decide whether you have the time and temperament to continue them. Going forward, you likely will be expected to devote greater time and attention to each board position than in the past. Issues that in the past would have been addressed by management now will be escalated to the board level. Liability exposure has increased, particularly with respect to Audit Committee membership. Compensation for directors is likely to change, especially with respect to options, warrants, and consulting agreements. Ask yourself: Why did I join this Board? Are the reasons why I joined still valid? Do I have time to devote to my responsibilities here? Have any conflicts developed that raise an independence issue? Given how the company has developed, how significant is my contribution? Do the positive aspects of board membership still outweigh the responsibilities and liability risks? Am I confident that management has integrity and will be receptive to greater board involvement?

In my opinion, many outside directors will ask themselves these questions and decide to leave public company boards. In particular, some of the most capable and experienced directors (such as venture capitalists) will eject from public company boards in coming months. As reaction to business scandals continues to alter the liability calculus, we could face a shortage of capable directors willing to serve on public company boards. Those who stay will likely require significantly increased compensation for their greater time commitment.

 

The Zen of Director Responsibility

You're still reading, so one may assume that you have decided to stay on the board. Before getting down to specifics, it's worth pausing for a minute to discuss attitude. Reasonable people may differ as to the policy wisdom of recent measures imposing enhanced duties and responsibilities on boards of directors. In my opinion, even if you would have voted against such measures, you now need to embrace them, not resist them. Directors who view their new role as a burden, or as unwarranted, may well do a poor job in fulfilling that role. Whether you like it or not, this is the new milieu in which directors must operate. The right way to think about these new requirements is that the old system let investors down in preventing corporate fraud, and a key bulwark going forward will be vigilant board oversight. If you can't get comfortable with the new role of outside directors, perhaps you should go back to step one and consider resigning.

 

Controls, Controls, Controls

Outside directors do not make accounting decisions on particular transactions or events, and no one really expects them to do so. What investors do expect is that outside directors will review a company's internal accounting controls to reduce the odds that an errant employee can cook the books. New statutory and regulatory requirements heighten the importance of maintaining adequate controls. In practical terms, what can an outside director do? Here are three suggestions.

Audit of Controls

Obtain an independent audit of your internal controls. Outside accountants (unless specifically engaged to do so) typically do not opine as to internal controls, absent a glaring defect. No matter how good your CFO is, she probably is not an expert on structuring or maintaining controls. Accounting firms are expert on that. You should engage an accounting firm that is not your outside auditor to conduct a thorough audit of your major internal controls. Companies often conduct such audits of other facets of their operation, such as security, but rarely do so with respect to controls. Ask for a detailed report, with specific recommendations. You must be prepared to implement those recommendations, even if they are expensive or the finance department views them as intrusive. If you receive a recommendation and fail to implement it, then your liability exposure will increase substantially in the event of a subsequent problem that the control would have prevented. After the initial comprehensive audit, you should obtain periodic updates.

There are two principal benefits of such audits. One is that improved controls reduce the likelihood of a problem occurring at the company. The other is that, in the event a problem does occur, your risk of personal liability will be greatly reduced by having taken the initiative to improve the quality of internal controls. If management is reluctant to obtain such an audit, that in itself may pose a red flag for the board.

Internal Audit Function

Take steps to create and maintain a strong internal audit function. Many companies, particularly those growing rapidly, have historically neglected the internal audit function. Accounting problems that could have been nipped in the bud have proceeded to full bloom. You should focus on four aspects of internal audit.

Staffing

Third, review the staffing of your finance department. In too many companies, the skill and staffing levels of accounting personnel have historically been a lower priority than the engineering and sales groups. This must change. Companies that pride themselves on zero defects in their products or zero injuries on the work floor now must establish zero accounting errors as a key corporate policy. This will require money and talent. Although it is not the board's responsibility to micromanage individual staffing decisions, it is the board's role to ensure that overall quality levels in finance are adequate.

 

Utilizing Counsel Effectively

Boards of directors historically have had limited involvement with a company's disclosures. Directors receive a copy of the earnings press release hours before it goes out. If they receive the 10-Q in advance, they seldom have enough information to provide comment on the disclosures. Dialogue with outside counsel over the quality of the disclosures is seldom visible to the board.

This pattern must change. Directors need to receive drafts of disclosure documents far enough in advance to have an opportunity to question things that are in them. On important documents, this should include an opportunity to talk with outside counsel about the document. In particular, directors should ask outside counsel whether there are disclosures that counsel thinks should be made differently, and whether counsel suggested disclosures that management rejected.

For reliance on counsel to be effective, counsel must have had meaningful involvement in the process. This means getting drafts to outside counsel early enough for them to review and comment. More important, it means that outside counsel need to know enough about current business conditions to put the disclosures in context. Outside counsel should attend the board meetings to hear the discussion of operations and plans. Moreover, as management starts to review the quarter's results in preparation for the earnings conference call, outside counsel should attend those discussions, so that she can make sure the MD&A section of the 10-Q adequately reflects trends and uncertainties known to management.

The board should regularly meet with the general counsel and outside counsel without management present. Do they have concerns over any integrity or process issues? Are they comfortable with the company's disclosures? Are there potential problems or challenges that management has not communicated to the board? The knowledge within management that the board will be asking these questions can help prevent problems from arising.

 

Get a PUP

Directors have not paid enough attention to insurance issues. They tend to allow management to structure the D&O insurance coverage, with little participation. In light of the liability climate, a more hands-on stance is warranted. Probe to determine whether the aggregate limits are adequate in light of the company's market capitalization. Examine the policies' "severability" provisions (i.e., if one officer commits fraud, does that vitiate coverage for outside directors who were not participants in the fraud?). Explore the company's "Side A" coverage (i.e., coverage for the individual officers and directors in the event of bankruptcy). Who are the carriers? What is their track record on protecting directors in the event that someone in management engages in misconduct?

Apart from asking those questions, you should consider buying a PUP - a "personal umbrella policy." If you serve on several boards, you can obtain an insurance policy that is yours alone, not shared with anyone else. The PUP is excess to all of the D&O insurance at all of the companies on whose boards you serve. It is a true catastrophic disaster policy: if all the other insurance goes away, is unavailable, is used up, you still have a policy that will stand behind you and protect you, at least covering defense costs. PUP's are not common, and you will need the help of a creative broker in obtaining and structuring them.

 

Take Notes

For years, outside counsel told directors to put down their pencils and stop taking notes. I dissent. Forget legal burdens of proof: if a company on whose board you serve blows up, you will be under pressure to show that you did a good job as a director. Often, you will not remember what happened at particular meetings or on particular issues. Board minutes are often less than epic in length or detail. You should keep your own notes to refresh your recollection as to what you considered or reviewed.

You should avoid shorthand phrases that could be subject to distortion (e.g., "b.s."). In general, it's better to note questions that were asked and topics reviewed, rather than to attempt to capture (often incompletely) all the answers. You should also talk to company counsel to get their views on this recommendation, since many will oppose it vehemently and want you to retain nothing. But in my opinion, the days in which a blank slate was a clean slate are over.

 

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To date, most commentary on the new regulatory initiatives has focused on their impact on CEO's and CFO's. As a director, you would be mistaken to conclude that their exposure has increased but yours has not. The new rules of corporate governance will ripple out rapidly to envelope you. You should start planning now on steps to discharge your enhanced responsibilities, and thereby to reduce your enhanced personal exposure.

 

 


*Copyright 2002. Boris Feldman is a member of Wilson Sonsini Goodrich & Rosati, in Palo Alto. This article reflects his views, not his firm's. You are welcome to copy and distribute this article, with express attribution to the author. Revised, August 23, 2002.