Directors and Officers Liability (Part 1)

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What is Directors and Officers Liability Insurance?

Directors and Officers Liability Insurance provides coverage for the principal, decision-making employees of a company who could be the objects of litigation, and this coverage can extend to those who have close ties to the insured directors and officers.

Directors and Officers Liability Insurance essentially covers three areas:

For profit

Non profit

Public officials

Concerning the for-profit insured, this insurance is suitable for both privately or publicly held companies.

Non-profits, such as homeowners/condo associations and charity/public service organizations, would to do well to be covered by this kind of insurance.

Some think that Directors and Officers Liability should be called Executive and Corporate Management Liability, considering the nature of today's D&O marketplace.

Obligations of directors and officers
Why are directors and officers the target of litigation and scrutiny? Because they are viewed as the individuals either directly or ultimately responsible for company decisions, acts, errors, or omissions that result in financial injury.

Directors and officers can help keep themselves "clean" by adhering to these key obligations:

Duty of care

Duty of loyalty

Duty of obedience

A breach of any of these obligations can incur:

Personal liability to the individual director or officer involved

Allocation of blame to the other directors and officers on the board

Possibly allocation of blame to the corporation itself

Using common sense will help avoid most problems. If a director or officer follows the "prudent person rule", he or she will make informed decisions, perform his or her duties in good faith, and generally act in the best interest of the company. The duty of loyalty can be fulfilled by not trying to further personal interests in an unscrupulous way and by refraining from personal action that could be damaging to the company. As for the duty of obedience, a director or officer should perform his or her duties in accordance with the corporate charter and by-laws and all laws, statutes, and regulations pertaining that particular industry.

In the past, directors and officers were somewhat protected from liability. The Business Judgment Rule protected directors and officers particularly when there was a question about duty of care. However, in recent times, the Business Judgment Rule has lost much of its force and effect.

Indemnification issues
Apart from D&O Insurance, indemnification of directors and officers can protect these individuals from personal liability. Indemnification agreements in corporate by-laws can devised such that individual board members are held harmless for suits arising out of the performance of their duties.

State law defines the types of liabilities for which a company may or may not indemnify its directors and officers. The state of corporation may have common law requirements for indemnification of individuals by the company. The corporate charter or by-laws may articulate indemnification for certain acts or damage amounts. Individuals may have indemnity agreements as a condition of employment.

The parable of the cows
This is what happens in a traditional business model. You have two cows. You sell one and buy a bull. Your herd multiplies and the economy grows. You sell the increased herd and retire on the income.

But here's what happens when you have Enron-style venture capitalism. You have two cows. You sell three of them to your publicly listed company using letters of credit opened by your brother-in law at the bank. You execute a debt-equity swap with an associated general offer.

The result: You get four cows back with a tax exemption for five cows. The milk rights of six cows are transferred though an intermediary to a Cayman company secretly owned by a majority shareholder. He sells the rights to seven cows to your listed company. The Enron Annual report says the company owns eight cows with an option for one more.

The stock prospers. The financial reports are corrected to reflect...in fact...only two cows. The stock tanks! Someone--and all eyes are on the directors and officers--is in a whole lot of trouble.

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Not only are policy forms, clauses, rules and court decisions constantly changing, but forms vary from company to company and state to state. This material is intended as a general guideline and might not apply to a specific situation. The authors, LunchTimeCE, Inc., CEfreedom, and Insurance Skills Center, and any organization for whom this course is administered will have neither liability nor responsibility to any person or entity with respect to any loss or damage alleged to be caused directly or indirectly as a result of information contained in this course.