Reporting Status or Progress by gjmpzlaezgx


									              Director and Officer
              Liability Insurance

          Current Developments

Joseph A. Cialone, II
Baker Botts L.L.P.
3000 One Shell Plaza
910 Louisiana Street
Houston, Texas 77002-4995        1
Events over the past two years have focused
the attention of government authorities and
the investing public on officers and directors
of public corporations particularly in

   Financial disclosure and reporting

   Executive compensation

   Corporate governance

Some of the situations are close to home --
    – Enron
    – Other energy trading companies

Others around the country and in the news --
    – Tyco
    – WorldCom
    – Adelphia

Financial Disclosure Problems
–   Revenue Recognition -- Software, etrade
–   Earnings management -- Hitting the numbers
–   Acquisition accounting
–   ―Cooking the books‖


Executive Compensation
–   Dick Grasso and the NYSE
–   The ―acid test‖ of independence
–   Compensation consultants
–   Public opinion

Governmental agencies, the media and others
describe these situations as, among other
things, ―failures of corporate governance‖ --
 – The White House
 – Congress -- Hearings and Sarbanes-Oxley
 – The SEC -- New rules, investigations and
   enforcement actions.
Invariably, and appropriately, the focus of
corporate governance centers on the board.
Why?                                        6
Because the directors, as a board, are charged
with the responsibility for managing the
business and affairs of public corporations.
– The board has that ultimate responsibility —
     • not the officers--they are appointed by
      and report to the board; and
    • not the stockholders--they own the
      company, of course, but they have
      elected the directors to manage their
      company, ultimately for their benefit.     7
Legal Framework
Despite the risks, directors do have
  substantial defenses available to them
State law provides the basic concepts of
   corporate governance, the relationships
   among the constituents and director
Federal law provides a pervasive backdrop,
   however, primarily through the federal
   securities laws (disclosure, proxy
   regulation, etc.), but now most importantly
   through Sarbanes-Oxley                    8

   Certification of financial statements
    by CEO and CFO
   Increased disclosures and penalties
   Prohibits loans to executives
   Forfeiture of bonuses and profits
   Increased responsibilities of audit
    committees, auditors and lawyers        9
State Law
 Directors are elected by the shareholders and
 specifically charged by state corporate law
 with the management of the “business and
 affairs” of the corporation, as fiduciaries
   Delaware Section 141; TBCA Article 2.31
  Fundamental -- The board is legally
     responsible for the management of the
Question: What are the legal responsibilities
          of directors?                    10
Director Responsibilities
Director duties are fiduciary in nature, derived
from trust law concepts.
    Directors are the caretakers of other
     people’s property.
    The corporate model places that
     primary fiduciary responsibility on
     them, not the management, although
     they too have fiduciary responsibilities.
    What, precisely, is expected of directors?
Director Responsibilities
Easy to state the general rule under state
corporate law:
 In discharging its responsibilities, the
    board and its individual members are
    expected to act in good faith, to be
    fully informed, and make decisions or
    take actions which they honestly
    believe are in the best interests of the
    company and its stockholders.         12
“Fully Informed”
A director
   Should have a working knowledge of the
    company’s business and financial condition, its
    prospects, and its strategic business plan.
   Should seek and carefully consider advice and
    opinions of management and outside advisors,
    and critically evaluate that information.
   Should take as much time as is necessary to
    review and evaluate materials presented to
    the board, asking for additional materials or
    explanations needed.                         13
“Fully Informed”

An aspect of the Duty of Care
     Importance of process
     Reliance on reports and advice of
     Reliance on professional advisors
     Common sense/ prudence elements --
      time and commitment are required
“Good Faith” and “Loyalty”

A director must put aside self-interest
      Essential element of public trust
      Independence is a key element of
       modern corporate governance
      The duty of loyalty
      The duty of good faith (a separate duty
       receiving current attention)
Independence of Directors

    Definitional challenges -- A variety

    “Resume” independence
    An overarching issue in most corporate
     governance discussions
          – Audit Committees
          – Compensation Committees
          – Nominating Committees
Responsibilities and Liabilities

   With this focus on the board, directors have
    increasingly become target defendants in
    both civil and criminal proceedings
   So why would anybody serve as a director
    or officer of a public company?
    – Independent directors now mandated
    – But where do you find them?

   Director Protections
     Business Judgment Rule
     Indemnification
     Exculpation
     Lawsuit advantages
      – Class Actions -- Reform Act (PSLRA)
      – Derivative Suits -- SLC’s (Special
        Litigation Committees)
     Insurance
But each has vulnerabilities, especially now.
Business Judgment Rule
Provides a presumption of regularity when
directors act in good faith, without self-
interest, and on a fully informed basis.
    Directors have to make an initial showing,
      and then
    Burden of proof is on the party
      challenging a decision
 Importance of process, reliance on inside
 and outside advisors, and avoidance of
Question: How strong is the current
             presumption?                    19

State statutes are permissive; most companies
   convert to mandatory indemnification
   through charter, bylaw or contractual

Indemnification limited by
   – law and public policy (e.g., duty of loyalty,
     punitive damages, derivative claims)
   – financial resources of the company itself
     (Enron and Adelphia examples)
   The first line of defense
   Authority to indemnify created by statute
   Statutes are permissive in most respects,
    although indemnification is mandatory when
     – Wholly successful on the merits or
     – ―Otherwise‖ includes procedural defenses
     – ―Wholly‖ excludes in Texas partial
   Statutes distinguish between claims made by
    third parties and those made by or in the right of
    third parties                                   21
   Director must meet the statutory standard of
    conduct to be entitled to indemnification
     – Acted in good faith, and
     – In a manner reasonably believed to have
       been in the corporation’s best interests, or
     – Not opposed to such best interests in
       Delaware, and in Texas when director is
       not acting in an official capacity.
     – In the case of a criminal claim, the director
       must have had no reasonable cause to
       believe the conduct was unlawful.          22
   Determination that standards have been met
    must be made by
    – a disinterested board or board committee,
    – disinterested stockholders, or
    – special or independent legal counsel.
   Determination need not be made, however, for
    advancement of expenses.

Advancement of Expenses

   Perhaps the most important aspect of
    indemnification, and it clearly is the most
    important at the outset of any claim or
   Advancement is permissive unless made
    mandatory by charter, bylaw or
Advancement of Expenses

   The advancement must be made in
    conjunction with an undertaking or
    promise to repay the amounts advanced if
    it is ultimately determined that the director
    is not entitled to indemnification.

   The undertaking to repay the
    advancement need not be secured.
   Several ways to make permissive
    indemnification mandatory

   Bylaw or charter provisions
    – General or Specific
    – Separate Indemnification Agreements

 Indemnification Agreements

An indemnification agreement could provide,
among other things, the following:

    Prompt indemnification to the fullest extent
permitted by law against any and all expenses
(including attorneys' fees), judgments, fines and
amounts paid in settlement of any claim (as
Indemnification Agreements

   Prompt advancement of expenses and
reimbursement thereof if it is ultimately
determined that indemnification is not
permissible under applicable law.
   A mechanism through which a director may
enforce the terms of the agreement, and
indemnification for the costs of enforcement,
whether successful or not.
Indemnification Agreements

    The agreement would impose upon the
 Company the burden of proving that a director is
 not entitled to indemnification in any particular
    The agreement would also provide that the
 rights thereunder are not exclusive of any other
 rights to indemnification or insurance to which
 the director may be entitled, all of which are
 specifically reserved.
Corporate statutes generally permit companies
to include in their charters (therefore,
stockholder approval required) provisions that
protect directors from liability to their
corporations for monetary damages except in
cases of
  –   Breach of duty of loyalty or good faith
  –   Other improper personal benefit
  –   The limits of these statutes have not been
      fully defined.                          30
Lawsuit Advantages
   Securities Fraud Class Actions --
    Reform Act
     – Motions to dismiss frequently granted.
     – Plaintiffs must be able to raise an
       inference that there was actual securities
     – But Enron and other corporate scandals
       may have reversed this trend, and we will
       have to watch the courts closely in the
       coming months.                          31
Lawsuit Advantages
   Derivative Suits -- SLC’s
    – On behalf of the company
    – Special litigation committee procedure
      developed in Delaware, codified in Texas
    – SLC can secure the dismissal of the
      derivative suit if, after a thorough and
      independent investigation, the SLC
      concludes the claims are without merit.
    – Again, Enron could affect these procedures.
Fills the gaps left by indemnification
   – Typically covers more than company can
   – Not dependent on financial health of the
But there are challenges to deal with
  – Cost and coverage
  – Retentions and exclusions -- definitions
  – Application Process -- Rescission       33
D&O Insurance

 Application Process
   – Sarbanes-Oxley Certifications
   – SEC Filings

 Restatements -- Undermines application

 Rescission -- Different legal standards
D&O Insurance

 – Coverage for investigations

 – Definition of “Loss”

 – Definition of “Claims”

 – Definition of “Dishonesty”
D&O Insurance

  Typical coverage would involve both
individual and company reimbursement
  – Coverage A or “Side A” -- directly insures
  – Coverage B or “Side B” -- would
    reimburse the company for amounts paid
    to indemnify directors and officers.

D&O Insurance

 Allocation issues arose when both the
company and individuals were defendants
 – Insurers developed Coverage C, in part
   as a response to the allocation fights.
 – Coverage C or “Side C” -- insures the
   company directly for securities claims.

D&O Insurance

  Recently, problems have arisen in
bankruptcy settings
 – Debtor claims the policy as an asset of the
 – Directors claim that they are entitled to the
   proceeds even if the policy is an asset of
   the estate.
 – With Coverage C, the outcome of that
   debate is less certain.                    38
D&O Insurance

   Possible solutions
     – Side A only
     – Excess for Side A only
     – Priority of payments provisions
     –   Each solution has its problems
   Solution my depend on the purpose of


Congress, the SEC, the NYSE, and Nasdaq
  are now requiring independent directors
  on boards --

But why would a person agree to serve on a
  public company board in this environment?

Liability protection is essential, and insurance
   can fill the gaps left by indemnification and
   other legal protections
              Director and Officer
              Liability Insurance

          Current Developments

Joseph A. Cialone, II
Baker Botts L.L.P.
3000 One Shell Plaza
910 Louisiana Street
Houston, Texas 77002-4995        41

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