Increased Liability
Sarbanes-Oxley and proposed SEC regulations increase the potential for individual liability of corporate officers and directors for alleged corporate wrongdoing or breaches of fiduciary duty, in civil, regulatory and criminal claims, investigations and enforcement actions.
New Requirements
Sarbanes-Oxley requires attorneys and employees to report possible wrongdoing or breaches of fiduciary duty "up the ladder." It requires the CFO and CEO to certify the accuracy of the company's financial statements. It also requires the CFO or CEO to investigate whistleblower reports and take appropriate action. If they fail to do so, the audit committee must step in and investigate. The audit committee is also responsible for ensuring the accuracy of the company's financial statements and for hiring and overseeing outside accountants. Failure to perform these responsibilities gives rise to personal exposure for officers and board members. These responsibilities raise complex issues of privilege and conflicts of interest that corporate counsel may not be able to resolve.
Conflicting Interests
This complexity arises from the relationship among corporate management, directors and shareholders. Corporate counsel represents the corporate entity, not the individual managers or directors with whom they have substantial contact. Because corporate counsel represents the company, they may have a conflict of interest if they advise directors and officers concerning their individual exposure, rights and duties. Counsel's advice must put the interests of the corporate client first, and those interests may differ from the best interests of the individual officers and directors.
Indemnification Issues
Officers and board members also need independent legal advice when reviewing the indemnification provisions of a corporation's articles or bylaws. These provisions raise a number of issues, including:
- Are standards for indemnification as broad as possible under applicable state law?
- Is indemnification mandatory or within the company's discretion?
- Do the articles or bylaws require the company to advance attorney's fees and costs (or do they merely require it to reimburse directors and officers for amounts they expend, and then only if successful)?
- Do indemnification arrangements extend after the director's term has ended?
Is the maintenance of D&O coverage contractually required? At adequate levels?
Insurance Coverage
Most D&O policies exclude claims for acts of dishonesty and fraudulent or criminal conduct. These exclusions also raise a number of questions for officers and board members, including:
- Are the D&O exclusions triggered by mere allegations of dishonest, fraudulent or criminal conduct? If so, the insurer will refuse to pay defense costs, even to a frivolous claim.
- Does the criminal conduct exclusion require proof of willful or merely negligent conduct?
- Does the policy exclude coverage of innocent officers and directors by imputing to them the wrongful knowledge or acts of others?
- Can coverage for the company's own liability be forfeited if an applicable exclusion applies to claims against an officer or director?
- Are the policy limits segregated to prevent them from being used to cover the entity at the expense of the individual officers and directors?
- Will a restatement of the company's earnings cause the D&O carrier to rescind or not renew coverage?
Conclusion
The increased obligations of officers and directors in today's world require individuals serving in those capacities to take care in accepting and performing corporate obligations. Before accepting or retaining corporate positions, individuals should carefully evaluate the issues raised here with their independent legal advisors.
In future articles, we will address ways officers and directors can limit their personal exposure.