What Board Directors Must Know Regarding Indemnification and Insurance
(Originally appeared in the October 16th, 2019 'Across the Board' publication, a Board Director, Board Advisor, C-Level, and Business Newsletter reaching 25,500+ exceptional business leaders in over 65 countries with articles focused on leadership, strategy, and governance topics - sign up here)
The business world has undeniably become a more litigious environment over recent decades. Liability and risk at all levels of business have increased, with 2018 becoming a record-breaking year for the amount of securities class actions filed against public companies in the US. According to Woodruff Sawyer’s 2019 Mid-Year DataBox Update report, plaintiffs filed 217 securities class action cases in 2018 alone. It is believed, judging by the pace of the first half of this year, 2019 could reach 268 cases. The report reflects "unprecedented levels of Directors’ and Officers’ (D&O) litigation, both from a frequency and a cost perspective. Unfortunately, there are many drivers of this trend, including a very frothy level of securities class action lawsuits, as well as an increasing interest in plaintiffs using derivative suits (breach of fiduciary suits) to sue Directors and Officers.” (note: a shareholder 'derivative suit' is a lawsuit brought by a shareholder on behalf of a corporation against a third party. Often, the third party is an insider of the corporation, such as an Executive Officer or Director.)
The suing of Directors and Officers is nothing new, however, the frequency of this action has greatly increased. Claims have historically been brought against corporate officials for a host of widely-varying legal suppositions, including breach of fiduciary duty and securities law violations. These types of lawsuits are amazingly messy and expensive - and can even expose company Officers and Board Directors to significant personal liability. It seems that 'piercing the corporate veil' has become more commonplace.
So, how does a Board Director know that they are covered properly within an organization's indemnification clauses and D&O insurance? An existing or aspiring Board Director needs to keep proper indemnification and D&O insurance at top of mind at all times. Companies aim to protect their Officers and Directors from legal expenses and liability exposures through a combination of both indemnification as well as insurance, but this is not always sufficient to properly cover a Board Director. It is the proper melding of these protections that is most important in limiting your liability as a Board Director. Let me explain...
A Board Director's first line of protection when it comes to liability is indemnification. Corporate indemnification, better described as securing or compensating someone from harm, legal responsibility, or loss due to their actions, is commonly included in the organization's articles of incorporation and/or bylaws. Importantly, it should also call for the rights of a Board Director to receive advancement of funds for any legal defense expenses.
A Director considering joining a Board should review the indemnification clauses very carefully, even looking for a separately written indemnification provision which typically provides much greater specificity. A thought that comes to mind when thinking of details I look for in indemnification clauses includes providing 'fees on fees' (costs incurred in order to enforce rights to fee advancement or overall indemnification) and protections against wrongful withholding of indemnification.
It must be noted that although corporate indemnification is usually very broadly defined in its protections, there are instances, such as insolvency, where an organization may not be able to indemnify an individual. Therefore, the burden of a Board Director's proper due diligence as it relates to indemnification AND the organization's financial stability should be weighed simultaneously.
A common misconception of Directors & Officers (D&O) insurance is that it runs in parallel to indemnification clauses - this is typically not the case. One of the most important functions of D&O insurance is to protect individuals when the company has become insolvent and unable to honor its indemnification obligations. In other words, D&O insurance frequently runs in series and follows any indemnification statutes - if needed. D&O insurance can also provide protection for company Officers and Directors when corporate indemnification is not available, whether due to legal restriction or insolvency. There are, however, situations where organizations leverage D&O insurance to provide an outlet for reimbursement when they do not specifically indemnify their Officers and Directors. It is worth mentioning, at a high level, three specific areas of a robust D&O insurance policy:
Another term commonly uttered when discussing D&O insurance is 'exclusions,' or areas that specifically are not covered under the policy. Common exclusions include Insured vs. Insured Exclusions, Derivative Shareholder Action Carve-Back, Antitrust Exclusion, Prior Knowledge Claims Exclusions, Misconduct Exclusions, and Defense Cost Exclusions. Pay close attention to any Defense Cost Exclusions as D&O suits commonly include extensive allegations. With this in mind, you cannot be certain all aspects of the claim will be insured by the policy. Technically, the insurance company is only responsible to defend your interest based on the actual coverage the policy affords. To avoid any conflicts or coverage gaps, be sure to look for a '100% Defense Cost Allocation Clause.' This stipulates that defense coverage applies as long as a portion of the claim is covered, thus ensuring that all costs will be insured under the policy.
“Maintaining broad, robust D&O coverage is a critical component to any company’s risk management strategy," states John Orr, a Director in the Financial & Executive Risk practice of Willis Towers Watson. "In today’s environment, shareholder litigation frequency and severity are at record or near-record levels, while there are significantly fewer public companies now than two decades ago. With pricing for coverage on the rise, the key to a successful renewal is working with your broker to model your risk, strengthen coverage with enhanced terms, and differentiate your risk in the marketplace.”
Although D&O insurance is most often correlated to large for-profit companies, nonprofit organizations should not be overlooked. There is a common misconception that nonprofit Directors and Trustees have negligible legal exposure within these entity types - this is simply not the case. The legal obligations and requirements for nonprofit Directors is just as high as those associated with for-profit organizations. Recoverable damages and restitution from Directors and Officers of even a relatively small nonprofit organization can easily exceed the net worth of many individuals, making both indemnification and D&O insurance equally important.
A Director considering joining a Board should review the D&O insurance policy closely, preferably soliciting outside counsel for full understanding. This is not something to learn when the coverage is actually needed. Take care in comparing what is covered in the provided indemnification clauses along with the D&O insurance to ensure there are no gaps between the two.
Protection of company leaders, by means of indemnification and D&O insurance, is important for many reasons. An organization's ability to attract and retain strong leaders is just one of many. From a Board Director's viewpoint, it is truly about lowering or eliminating personal risk. Do your homework in researching and validating these areas to ensure your initial elation of joining a Board is not overshadowed by personal exposure to risk and potentially devastating financial liability.
Are you spending the proper time to review your personal liability risks?