Issues in Directors & Officers Liability Litigation

In a rapidly evolving corporate environment, directors and officers are constantly faced with difficult strategic decisions. While it has always been understood that these decisions would affect the bottom line of their corporations, it has become uncertain to what extent these decisions may affect directors and officers personally. In the wake of corporate scandals such as Enron, Tyco, Global Crossing, Parmalat and WorldCom, there is growing fear among directors and officers that they will be held personally liable for decisions made in their corporate capacities.

Public opinion of directors and officers is near an all-time low. Their integrity is being questioned. The dramatic downfall of the stock market in 2000 eroded trillions of dollars of investors' equity. It also eroded investor confidence in the men and women at the helm of the world's largest corporations. Inevitably, the result has been increased litigation. Directors and officers of both public and private companies are being sued more frequently and for more money than in the past. In response to corporate scandal and market demise, it appears that courts may be questioning their historic deference to the decisions of corporate executives.

The issue of director and officer liability, while not new, has become a serious concern in boardrooms across Canada. Outside directorships, once sought as a reward for success in business, are now being shunned. Although courts continue to say that they are not judging the decisions of directors and officers against the perfect vision of hindsight, the reality is that the past is coloured by the present. Predictably, some recent judgments in Canada and the United States have demonstrated a greater willingness to question the decisions of directors and officers. This has led to understandable fear and uncertainty about which corporate actions will attract the scrutiny of the courts. The law is clearly evolving.

Corporate Law Duties

Where directors or officers have breached their duties to the corporation, an action may be commenced against them pursuant to relevant corporate legislation.¹ For corporations incorporated under the laws of Canada, the duty of loyalty and care owed by directors and officers is set out in section 122(1) of the Canada Business Corporations Act (the "CBCA"):

Every director and officer of a corporation in exercising his or her powers and discharging his or her duties shall:

• act honestly and in good faith with a view to the best interests of the corporation; and
• exercise the care, diligence and skill that a reasonably prudent person would exercise in comparable circumstances.

A similar provision can be found in most provincial corporate statutes, such as the Business Corporations Act (Ontario ) (the "OBCA"). This duty cannot be circumvented. No provision of a contract, corporate resolution or corporate bylaw can exempt a director or officer from this duty. Consequently, the only way this duty may be discharged is by acting honestly and in good faith with a view to the best interests of the corporation, and by being appropriately diligent.

In the U.S., there is a common presumption, known as the Business Judgment Rule, that:

"…[B]usiness decisions are made by disinterested and independent directors on an informed basis and with a good faith belief that the decisions will serve the best interests of the corporation. If the presumption has not been overcome, then the Business Judgment Rule prohibits the court from going further and examining the merits of the underlying business decision."²

Essentially, the Business Judgment Rule "protects both the directors and the decisions they make."³ The approach makes sense for two reasons. First, shareholders elect directors to exercise their business judgment. The shareholders choose the directors, not the court, to make the company's decisions. Second, it is unfair and improper for the courts, with the benefit of hindsight, to paternalistically set aside and second-guess the business expertise of directors.

The Business Judgment Rule has been adopted in Canadian courts in actions brought against directors alleging a breach of the duty of care. The effect of the Business Judgment Rule in Canada is that the corporation has an uphill battle if it intends to prove that its directors or officers breached their duty of care. Courts in this country have continued to rely on this approach, as illustrated in the recent Supreme Court of Canada decision in Peoples Department Store Inc. (trustee of) v. Wise.⁴

However, in 2002, in UPM-Kymmene Corp. v. UPM-Kymmene Miramichi et al.⁵ (known as "Repap," because that was the defendant's name when the case was originally filed), the Ontario Superior Court of Justice set aside a generous executive employment agreement that had been granted to the chairman of the company. It did so in spite of board approval, the affirmative opinion of an independent consultant and the support of a compensation committee. In February of 2004, the Ontario Court of Appeal upheld the trial court's decision.⁶

The court of appeal agreed with the trial decision that the board could not rely on the Business Judgment Rule to uphold the contract because the approval procedure was inadequate and the chairman had breached his fiduciary duties in failing to ensure that the board was properly informed of salient facts. The court of appeal concluded that the trial judge, Madam Justice Lax, was well aware of the law and applied it correctly. In her reasons, Madam Justice Lax stated that:

"…[D]irectors are only protected to the extent that their actions actually evidence their business judgment. The principle of deference presupposes that directors are scrupulous in their deliberations and demonstrate diligence in arriving at decisions. Courts are entitled to consider the content of their decision and the extent of the information on which it was based and to measure this against the facts as they existed at the time the impugned decision was made."⁷

In concluding that the board could not rely on the Business Judgment Rule to uphold the contract, Madam Justice Lax relied on the following facts:

• The company was going through financial difficulties and could not afford the agreement;
• the chairman employed a law firm to draft the agreement on his behalf without involving the company in the process;
• when the agreement was placed in front of the board for the first time, two directors resigned in protest;
• the chairman replaced those directors with new directors who were sympathetic to him;
• the chairman did not inform the new or existing directors that management had expressed strong written disapproval of the agreement;
• although the board hired an independent consultant to review the employment contract, due to time constraints, the consultant's opinion was based on "high-level observations," and she was unable to provide a proper and thorough report;
• the board saw the finalized version of the agreement for the first time at the board  they voted on the agreement;
• the compensation committee recommended approval of the agreement without having the time or expertise to properly review it; and
• at the meeting where the agreement was approved, the only long-standing director on the compensation committee resigned.

Admittedly, in light of those findings of fact, the decision to set aside the agreement seems to have been reasonable. However, under similar facts, would a court four years ago have arrived at the same result? Historically, courts have set aside decisions of directors where they found that the board had not acted honestly, prudently, in good faith and on reasonable grounds. In practice, these situations arose when a board was presented with a clear conflict. This commonly occurred when the jobs of the board were at stake, as during a takeover.

This was not the situation in Repap. Clearly, the chairman had not acted properly. However, there were no claims of bad faith made against the board.⁸ There was no evidence that the board had acted in self-interest. In the past, reliance on an independent consultant and a compensation committee had been considered a sure-fire defence against liability. Was it appropriate for the trial court to consider the level of sophistication of the compensation committee? Simply put, Madam Justice Lax substituted her own business decision for that of the board, and the Ontario Court of Appeal upheld her substitution.

The degree of deference afforded to boards appears to be shifting south of the border as well. In re The Walt Disney Co. Derivative Litigation,⁹ the Delaware Court of Chancery considered the circumstances of Disney's approval of Michael Ovitz's "non-fault termination." As in Repap, the issue of an excessive employment agreement was at issue. The court expressed its general reluctance to impose liability on directors for breach of the duty of care. It expressed hesitation in second-guessing the business judgment of directors. However, this was a preliminary motion brought by the defendant, Disney, to dismiss the action. The court was under an obligation to assume that the allegations in the statement of claim were true. If the allegations in the statement of claim were true, the court believed that it demonstrated that the Disney directors did not conduct themselves honestly and in good faith in the best interest of the corporation. The board's actions would take them outside the protection of the Business Judgment Rule. While the Canadian court in Repap focused on the duty of appropriate diligence to set aside a business decision, the Delaware court focused on the duty of good faith in identifying defects in the board's procedure.

In February 2004, in another Delaware decision, the Del-aware Chancery Court blocked Conrad Black's attempted sale of Hollinger Inc.¹⁰ This decision raised the bar for the acceptable standard of conduct for directors and controlling shareholders. In his judgment, Vice-Chancellor Leo Strine wrote:

"If there was ever a time when [the board's] approval process would be deemed 'proper,' that time is long distant. At worst, the [Hollinger] International board was purposely duped and there was fraud on the board. At best they were entirely uninformed. In either instance, the International independent directors did not properly approve the non-compete payments under Delaware law."¹¹

In issuing this ruling, the court in the very same jurisdiction that originally developed and expanded the Business Judgment Rule made it abundantly clear that the deference paid to directors has definite limits. Only time will tell how courts in Canada will respond to these two judgments.

Meanwhile in Peoples,¹² the Supreme Court of Canada established that creditors and other stakeholders may not bring an action against directors for a breach of fiduciary duty. The Supreme Court of Canada was clear that the directors' fiduciary duty is owed only to the corporation itself. Although this recent decision appears to have taken a positive step in limiting the potential exposure of directors, the Court was quick to point out that directors still owe duties to creditors and other stakeholders. A breach of these duties will expose directors to oppression and derivative actions. As such, it is debateable to what extent this decision was truly director-friendly.

Liability to Third-Party Plaintiffs in Tort

When a director or officer is sued for breach of duties owed to the corporation, good faith may be invoked as a defence. In contrast, when a director or officer is sued by a third party for a wrongful action, there is no such defence. Instead, the defendant must demonstrate, on the balance of probabilities, that the conduct was reasonable according to an objective standard. Consequently, in respect of third-party plaintiffs, the Business Judgment Rule is not a defence. The rationale behind this is that the third-party plaintiff has not elected the directors to make decisions on his or her behalf and does not stand to benefit from such decisions. A director or officer may not hide behind the "corporate veil" for protection from independent wrongs, even if committed while acting in the best interests of the corporation.

In ADGA Systems International Ltd. v. Valcom Ltd. et al.,¹³ a plaintiff corporation brought an action against its competitor, the sole director and two senior employees of the competitor. The allegation against the defendants was that they had raided the plaintiff's employees and caused it economic damage. The plaintiff sought damages for inducing breach of contract and inducing breach of fiduciary duty. The defendant director and employees moved for summary judgment dismissing the claim against them. The Ontario Court of Appeal had to address the question of "whether the (defendants) could be sued for their actions as individuals, assuming those actions were genuinely directed to the best interests of their corporate employer."¹⁴

On reading the pleadings, the court of appeal recognized the allegation that the sole director and employees developed a "recruitment plan" and were successful in luring the plaintiff's employees away from his company. After reviewing relevant case law, the court held that "employees, officers and directors will be held personally liable for tortious conduct causing physical injury, property damage, or a nuisance, even when their actions are pursuant to their duties to the corporation."¹⁵ The court concluded by stating that there was "no principled basis for protecting the director and employees from liability for their alleged conduct on the basis that such conduct was in pursuance of the interests of the corporation."¹⁶

In  ADGA, the court turned its attention to the fact that the actions of the defendants were intentional. However, in a case that should be watched by directors and officers, Suguitan v. McLeod,¹⁷ the court considered whether an officer could be held liable for an unintentional tort. Specifically, the latter part of the decision addressed whether or not a claim against a branch manager at Scotia McLeod could succeed on the basis that he negligently supervised his subordinate. The subordinate allegedly caused the third-party plaintiff economic harm. A motion was brought to dismiss the plaintiff's claim as failing to disclose a cause of action. The pleadings did not allege that the branch manager, Mr. Seyers, had ever met or dealt directly with the plaintiffs. It did not allege that Mr. Seyers made any representations to them of any kind. However, the plaintiffs claimed that Mr. Seyers owed them a direct duty. The claim against Mr. Seyers overlapped entirely with the claim against Scotia McLeod. There were no allegations that Mr. Seyers had acted outside the scope of his duties.

Despite the fact that there was no intentional tort (as was the case in ADGA), Justice Molloy recognized that the court in ADGA left the door open for negligence claims against employees, officers and directors of companies. Justice Molloy did not address the two-stage "proximity and policy" test set out by the Supreme Court of Canada in Cooper v. Hobart¹⁸ and Edwards v. The Law Society of Upper Canada.¹⁹ However, the court found that it was not plain and obvious that the plaintiffs' claim against the branch manager did not disclose a cause of action and therefore did not dismiss the claim. Since this case never went to trial and no subsequent cases have cited it, the question remains as to whether a claim of this nature would succeed at trial.

Statutory Liability

A growing number of statutes impose liability on sometimes unsuspecting directors and officers. Directors and officers must make themselves aware of applicable legislation and take affirmative action to avoid liability under such statutes. Although some statutes provide for absolute liability, most provide for some form of due diligence defence. It is therefore critical that directors and officers have an understanding of relevant statutes and demonstrate careful thought, planning and documentation to avoid liability.                            

Director and Officer Insurance Policies

Any discussion of director and officer liability would not be complete without a brief description of the role of directors' and officers' liability insurance. Not surprisingly, in the wake of corporate scandal, the market for liability coverage, known as D&O coverage, has flourished. In response to some large payouts, premiums have soared.

Importance of Coverage

Corporate statutes in Canada provide that under certain circumstances, directors and officers may be entitled to indemnification. As a general rule, the good faith standard is fundamental to determining whether a director or officer is entitled to indemnification. The CBCA broadly provides that a company may indemnify a director or officer for liability only if the director or officer acted honestly and in good faith with a view to the best interests of the corporation.20 It further states that a company must indemnify a director or officer if, in acting honestly and in good faith with a view to the best interests of the corporation, the director or officer is found by a court, or other competent authority, not to have done anything that he or she ought not to have done.²¹

As a result of these provisions and of individual corporate bylaws, which have more liberal indemnification policies, corporations are well-advised to purchase insurance to protect themselves from the costs of indemnifying their directors and officers, and directors and officers are well-advised to protect themselves by insurance where the corporation, by virtue of insolvency, is unable or unwilling to indemnify them.

Costs

In recent years, premiums have risen dramatically. In particular, as a result of increased litigation, the passage of Bill 198 in Ontario and the Sarbanes-Oxley Act of 2002 in the U.S., publicly traded companies have seen the largest increase in premiums.²² In order to control the costs of insurance, directors and officers of a corporation should consider the following factors:

• Is the company willing to meet or exceed existing and pending corporate governance statutes?
• Does the company ensure timely issuance of financial data and material information?
• Is the company profitable?
• Does the company have a proven and stable business strategy?
• Is the entity coverage premium worth the erosion in individual coverage?
• Is the company prepared to accept more financial risk for lower premiums?
• Should separate outside director coverage be purchased?

Conclusion

The risk of liability that directors and officers face for breach of duty, tortious acts and statutory malfeasance or nonfeasance is a very real concern. In fact, it appears that the events of recent years have only increased the uncertainty and risk that directors and officers face. Investor confidence has been undermined. In response, new legislation has become more rigid and courts have demonstrated less deference to the decisions of boards. It is uncertain where the social/judicial equilibrium will be reached. In the meantime, the most effective method for avoiding liability continues to be for directors and officers to develop an increased awareness and knowledge of the relevant statutes, case law and financial instruments available to insure against risk and to govern themselves accordingly.

1  For corporations incorporated under the laws of Canada, see sections 239 and 241 of the CBCA.

2  D. Block, N. Barton, S. Radin, The Business Judgment Rule: Fiduciary Duties of Corporate Directors, 5th ed. (Aspen Law & Business, 1998, vol.1)

3  Ibid.

4  [2004] S.C.J. No. 64

5  (2002), 214 D.L.R. (4th) 496 (Ont. S.C.J.)

6  [2004] O.J. No. 636

7  Supra, note 7 at para. 153

8 It is important to note here that the board in Repap was not held liable for its decision to approve the contract. However, the case is significant because of the finding that the board did not act diligently in its approval process. It is for that reason that the court intervened to set aside the agreement.

9 Disney II, 825 A.2d (Del. Ch. 2003)

10 Hollinger International Inc. v. Conrad M. Black, Hollinger, Inc. and 504468 N.B. Inc., 2004 WL 360877 (Del.Ch.)

11  Ibid.

12  Supra, note 4.

13  43 O.R. (3d) 101

14  Ibid.

15  Ibid.

16  Ibid.

17  [2002] O.J. No. 878

18  [2001] 3 S.C.R. 537

19  [2001] 3 S.C.R. 562

20  s. 124 of the CBCA.

21 The OBCA does not permit insurance coverage "where the liability relates to the person's failure to act honestly and in good faith with a view to the best interests of the corporation."

22 M. Leclair, "Insurance Coverage: Getting What You Want" (New Risks, New Rules, Directors' & Officers' Liability, Four Seasons Hotel, Toronto, 28 January 2003) [unpublished].