Imagining the Unimaginable Risks of Being a Director or Officer
By CYRIL TUOHY, managing editor of Risk & Insurance®
The Great Recession is resulting in increasing governmental regulation piled on top of an already vast array of corporate legal responsibilities.
At the same time, Department of Justice charging standards have evolved to the point that corporations that in good faith seek to comply with Sarbanes-Oxley and similar duties no longer get indicted. Instead, individual directors and officers do.
The internal corporate investigation is the centerpiece of the process. Typically, that investigation seems directed initially at lower-level corporate personnel, not directors and officers. But directors and officers who bear some oversight responsibility ineluctably get asked to speak to the outside counsel investigator.
When asked to speak to such an investigator, directors and officers assume that their existing corporate indemnity rights and their directors' and officers' liability (D&O) insurance will pay their legal costs, and that they will be able to assert their critical right to remain silent under the Fifth Amendment should their own counsel so advise.
These assumptions, as it turns out, are often wrong, according to attorney James Wing, a Miami- and Chicago-based partner of Holland & Knight LLP.
Risk & Insurance®
Managing Editor Cyril Tuohy interviewed Wing about whether corporate indemnity and D&O programs really protect directors and officers.
Q: Are there major flaws in directors' and officers' coverage plans as they exist today?
Yes, particularly as they relate to a director's and officer's ability to get his legal costs paid if any kind of claim is made against the company that results in an internal investigation of potentially criminal conduct of any employee that the D&O supervises.
To understand how this works, you must first understand how these D&O protection programs are structured. Typically, directors and officers have an employment agreement, corporate by-law or separate contract that requires the company to "advance" (i.e., loan) them their legal defense costs should they become involved in a suit or investigation that could have criminal law implications for them. This is a director's and officer's first line of protection.
The programs then also typically insure directors and officers under D&O insurance policies. "Side A" of such policies insures them directly. "Side B" reimburses the company if it advances them money for defense costs under the company's by-law or contract. And "Side C" covers the company's fees if it is a defendant in a securities case.
Because all the coverages fall under a single limit, whatever is paid to the company under one side reduces the total coverage available. Plus, if there's a big self-insured retention--a deductible--the directors and officers may have to pay it out of their pockets.
It's for that reason (among others) that the industry invented what's known as dedicated limits--sometimes called difference-in-conditions--coverage. This coverage sits on top of and is excess to both the indemnity contracts and the company's general D&O policy and is specifically intended to cover the situation where the company cannot or simply will not advance the director and officer his defense costs for matters with criminal law implications or otherwise.
Most companies, however, do not have this coverage. Perhaps this complicated structure may have caused directors and officers in the past not to investigate their protection in great detail.
But that has changed. Now directors and officers are asking in-house counsel to focus on their protection. They are no longer content to merely ask, "Do I have indemnity and advancement rights and D&O coverage and for how much?" Rather they are now asking, "How does this really work, and are we really protected?"
Who, exactly, is talking about this?
It's a big issue everywhere, and where it is not an issue, it should be. As a result of a multiyear evolution in Department of Justice criminal charging standards, directors and officers are now in the frontline of corporate legal risk.
The compliance revolution provides responsible companies avenues to escape criminal charges so that innocent stakeholders are not penalized. Generally, if a company can show that it's been a good corporate citizen, has credible risk assessment and ethics programs, cooperates with the government if an inquiry is made, and agrees to investigate any potential charges and turn the results over to the government, the company does not get criminally charged.
But this leaves directors and officers at great personal risk. The biggest fear of a director and officer is not that he might become a personal defendant in a securities or employment case. The big risk is when a criminal charge is threatened, going to the fundamental structure of an industry or its business methods. The director and officer can face bankruptcy, can go to jail and see his family dissolve, while believing at the time (with all the frailties of human nature) that he was only doing the accepted and right thing. He truly needs counsel, and right away.
Q: When does a need for coverage first arise for a director and officer?
A: Typically, it arises at least as soon as the director and officer is invited to meet with an outside lawyer the company has hired to investigate potential wrongdoing of anyone, and usually not the director and officer. The director and officer has the option to get separate counsel as soon as he is asked to talk to that lawyer and is told that anything he says can be turned over to prosecutors, then or later.
He wants to be helpful to his company and be a team player, but he also needs to be careful if the matter has any possibility of having criminal law implications for himself. His personal counsel, assuming he retains one, will generally instruct him to assert his Fifth Amendment rights and refuse to participate in such an interview without certain protections that are generally not obtainable.
Directors and officers are amazed to find that the assertion of their Fifth Amendment rights may cause them to lose their job and their health insurance. A director and officer will soon learn that his assertion of these critical rights may also defeat his right to get his legal costs paid, so that he must be prepared to pay them out of his own pocket. These costs can be very substantial.
When he turns to his D&O policy (and even if he has a dedicated limits policy), he can find that he has no protection there either because there has been no "claim" against him as the policy defines it. He is in a very bad place.
What is the remedy?
First, companies and their directors and officers need to improve their private indemnity agreements to close these and other gaps. The interests of companies and directors and officers are aligned at this stage: i.e., before there is any threatened claim with criminal implications, because directors are voting on their own protection and because all corporation statutes permit, if not require, that designated directors and officers be protected "to the fullest extent provided by law."
Strengthening indemnity agreements takes specialized counsel who has seen these agreements "stress-tested," as they say today, in the courts and in negotiations. And then the company's D&O broker, also working with specialized insurance counsel, needs to concentrate on and negotiate out, to the greatest extent possible, the myriad of conditions and exclusions that can frustrate companies' and directors' and officers' joint desire to have directors and officers protected.
These days, this is even more important than it ever was due to the globalization of business. Directors and officers who sit on the boards of foreign subsidiaries are exposed to legal environments, claims and remedies that they cannot imagine even exist.
Q: When and how do directors and officers and their companies proceed from here?
At the time an indemnity and D&O program renews is the ideal time. Follow the above approach and enlist the correct professional resources. And give yourself plenty of time because this is not a simple job, and failing to do it correctly can lead to severe adverse consequences. Don't wait.
May 1, 2010
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