BAILEY CAVALIERI LLC
AT T OR NE YS AT LAW
One Columbus 10 West Broad Street, Suite 2100 Columbus, Ohio 43215-3422
telephone 614.221.3155 facsimile 614.221.0479
SIDE-A ONLY COVERAGE
Dan A. Bailey
PLUS D&O Symposium
New York, New York
February 11-12, 2004
The material in this outline is not intended to provide legal advice as to any of the
subjects mentioned but is presented for general information only. Readers should consult
knowledgeable legal counsel as to any legal questions they may have.
Table of Contents
I. Need for “Clause A” D&O Insurance ..............................................................................1
II. Benefits of Side-A Only D&O Coverage ..........................................................................3
A. No Limit of Liability Dilution ...............................................................................3
B. Broader Coverage ..................................................................................................3
C. Financial Inability to Indemnity ...........................................................................6
D. Derivative Settlements/Judgments .......................................................................6
III. Emerging State Law D&O Exposures..............................................................................8
A. Business Judgment Rule ........................................................................................9
B. Liability Limitation Statute................................................................................. 11
C. Independent Directors .........................................................................................12
I. NEED FOR “CLAUSE A” D&O INSURANCE
The perceived need for “Clause A” D&O insurance (i.e., insurance for non-indemnifiable
loss) is based upon the premise that financial protection through an applicable state
indemnification statute may be inadequate. Historically, the primary areas in which
indemnification has been deemed inadequate to provide sufficient protection are as follows:
A. The ability to indemnify for derivative suit judgments or settlements is severely
limited or prohibited by most state indemnification statutes. The Delaware statute
does not authorize indemnification of settlements or judgments in suits brought by
or on behalf of the corporation (including derivative suits). This limitation is
intended to avoid the circularity which would result if funds received by the
corporation were simply returned to the person who paid them.
1. D&O insurance policies typically provide coverage for derivative suit
settlements or judgments, subject to various “conduct” exclusions.
2. A few states amended their indemnification statutes in the late 1980s to
limit or eliminate this indemnification restriction, at least under certain
circumstances. See, e.g., Indiana Code § 23-1-37; New York Bus. Corp.
Law § 722.
B. Indemnification against claims under the registration and anti-fraud provisions of
the federal securities laws may be precluded by public policy or by preemption.
The SEC’s long-standing view is that such indemnification is against public
policy and unenforceable. See 17 C.F.R. §§ 229.510 and 229.512(i). That
position has received some judicial support. See, e.g., Globus v. Law Research
Service, Inc., 418 F.2d 1276 (2nd Cir. 1969), cert. denied, 397 U.S. 913 (1970);
Baker, Watts & Co. v. Miles & Stockbridge, 876 F.2d 1101 (4th Cir. 1989); First
Golden Bancorporation v. Weiszman, 942 F.2d 726 (10th Cir. 1991); Eichenhotlz
v. Brennan, 1995 U.S. App. LEXIS 6134 (3d Cir. 1995); Odette v. Shearson,
Hammill & Co., 394 F. Supp. 946 (S.D.N.Y. 1975); Ades v. Deloitte & Touche,
1993 U.S. Dist. LEXIS 12901 (S.D.N.Y., Sept. 17, 1993). However, a settlement
of federal securities law claims may be indemnified. Raychem Corp. v. Federal
Insurance Co., 853 F. Supp. 1170 (N.D. Cal. 1994).
1. The SEC does not regard the maintenance of D&O insurance to be
contrary to public policy, even where the corporation pays the premium
for such insurance. See 17 C.F.R. § 230.461(c).
2. Public policy may limit indemnification under other federal statutes (e.g.,
RICO anti-trust laws) where Congress intended personal liability as a
deterrent. See, Sequa Corporation v. Gelmin, 851 F. Supp. 106 (S.D.N.Y.,
1993) (indemnification for RICO liability prohibited as against public
policy). Also, Congress expressly prohibited indemnification of
individuals adjudged liable under the Foreign Corrupt Practices Act of
1977. 15 U.S.C. § 78ff(c)(4) and § 78dd-2(b)(4). Public policy may also
prohibit indemnification for liability based on failure to pay payroll taxes.
Plato v. State Bank of Alcester, No. 19580 (S.D., Nov. 6, 1996).
However, neither Congress nor public policy prohibits indemnification for
liability under CERCLA. See, 42 U.S.C. § 9607(e); Witco Corp. v.
Beekhus, 38 F.3d 682 (3d Cir. 1994); U.S. v. Lowe, 29 F.3d 1005 (5th Cir.
3. D&O insurance policies typically provide coverage for certain securities
and other federal law claims, subject to various “conduct” exclusions.
C. No indemnification is permitted unless certain standards set forth in the applicable
indemnification statute are satisfied and a determination thereof is made by the
designated person or body. The Delaware statute requires the director or officer
who seeks to be indemnified to have acted in good faith and in the reasonable
belief that his actions were in, or at least not opposed to, the best interests of the
corporation. A determination whether indemnification is proper in a given
circumstance is to be made by the disinterested members of the board, by special
counsel appointed by the board, by shareholders, or by a court.
1. D&O insurance may provide protection for acts which do not satisfy the
“good faith” and “reasonable belief” standards, so long as the insurance
coverage does not otherwise violate public policy.
2. D&O insurance may provide protection for a director or officer when the
incumbent board chooses, for whatever reason, not to make the required
determination and further refuses to submit the question to special counsel
or the shareholders. This circumstance is apt to arise, for example, in the
aftermath of a hostile takeover.
D. The corporation may be financially unable to fund the indemnification, either
because it is insolvent or because of cash flow restraints. The recent explosion in
D&O defense costs and settlement severity has resulted in an environment today
in which even corporations that are financially healthy may be challenged to fund
some large D&O losses. When evaluating this risk, one should consider the
financial strength not only of the parent company, but also each of its direct and
indirect subsidiaries since the D&Os of a subsidiary may have indemnification
rights only against the subsidiary, not the parent company. Also, because the
ability to indemnify is determined when the loss is incurred, one must predict the
financial condition of a company for this purpose over the next 5-6 years, since it
frequently takes that long for a newly filed lawsuit to be settled.
1. Subject to the coverage limitations and exclusions, a D&O insurance
policy ensures that adequate resources will be available to fund the
defense of the corporate managers and any settlement or judgment
incurred by them.
2. Establishing a trust fund to pay the company’s indemnification obligations
is not an adequate substitute for D&O insurance since creditors or a
receiver may be able to repudiate the establishment of the fund or
otherwise attach fund assets. Gibson v. RTC, 1995 U.S. App. LEXIS
10469 (11th Cir. 1995).
E. Either the applicable law or the corporation’s articles of incorporation or code of
regulations may be modified to reduce or eliminate indemnification for directors
or officers. Because protection is probably determined by the indemnification
provision in effect at the time the indemnification is sought, rather than when the
act giving rise to the claim occurred, such subsequent modification may reduce or
eliminate protection otherwise expected by directors or officers.
1. A D&O insurance policy cannot be unilaterally changed to reduce or
F. Unique regulations applicable to certain types of financial institutions also limit
the ability to indemnify directors and officers. See, e.g., 12 C.F.R. §7.5217; 12
II. BENEFITS OF SIDE-A ONLY D&O COVERAGE
A typical D&O Insurance Policy which affords both Side-A coverage for non-
indemnified loss and Side-B coverage for indemnified loss is perceived by many to adequately
respond to these non-indemnifiable exposures. However, under certain circumstances such a
typical D&O Insurance Policy may not afford the desirable protection for the D&Os. In order to
avoid that risk of inadequate D&O coverage, Companies should consider purchasing a Side-A
only DIC Policy excess of its standard D&O insurance program. The following discussion
identifies several areas where a D&O policy affording only Side-A coverage can provide greater
protection to D&Os than a typical D&O insurance policy.
A. No Limit of Liability Dilution
The limits of liability under a Side-A only policy are available to fund only non-
indemnifiable loss incurred by the D&Os. In contrast, the limits of liability under a traditional
Side A/B/C policy are also available to fund indemnifiable loss and corporate losses in a
securities claim. In other words, D&Os can lose their personal protection under a traditional
Side A/B/C policy if the corporation incurs significant covered losses. That risk does not exist
under a Side-A only policy.
B. Broader Coverage
Despite the typically huge difference between the resources and insurance needs of the
Company and the individual D&Os, traditional D&O Insurance Policies afford essentially the
same coverage for D&Os under Side-A and for the Company under Side-B of the Policy. Only
the amount of the Retention and perhaps the applicability of a couple of exclusions will vary
depending upon whether the loss is indemnifiable by the Company. Because loss under the Side-
B coverage is far more frequent and generally far more severe, the scope of coverage afforded
under a traditional D&O Policy is crafted by the Insurers primarily with a view towards creating
a reasonable underwriting response to a Company’s D&O indemnification exposures.
Since the vast majority of Claims covered under a D&O Policy are indemnified by the
Company, a Side-A only D&O Policy allows Insurers to afford much broader coverage terms
than reasonably possible under a Side-B policy. For example, the following summarizes some of
the features in the CODA Side-A Policy form that provide broader coverage protection than the
typical D&O insurance policy form:
1. Scope of Coverage
No presumptive indemnification (coverage applies without any
deductible if the Company rightly or wrongly refuses, or is
financially unable, to indemnify);
Broad definition of “Insureds” (includes not only directors and
officers, but also (i) LLC managers, in-house general counsel,
comptroller, risk manager and their functional equivalent in a
foreign Company, and (ii) non-officer employees while co-
defendants in a Claim with D&Os);
Broad definition of “Loss” (expressly includes exemplary, punitive
and multiple damages, which are more likely to be insurable
because the Policy is issued and construed in Bermuda);
No express exclusions regarding:
Section 16(b) of the Securities Exchange Act of 1934,
prior litigation, or
defamation or other personal injury;
Narrow “personal profit” and “remuneration” exclusions:
not applicable to Defense Costs,
not applicable to illegal “advantage,”
applies only if adjudication or if illegal remuneration is
repaid in settlement;
Narrow “dishonesty” exclusion:
not applicable to Defense Costs,
applies only if adjudication of active and deliberate
dishonesty committed with actual dishonest purpose and
Narrow “bodily injury/property damage” exclusion:
not applicable to pollution claims;
Narrow “insured v. insured” exclusion:
applies only if the Claim is (i) by or on behalf of Company,
and (ii) at least two current senior executive officers
approve or assist in prosecuting the Claim;
not applicable to Claims by Insured Persons;
not applicable to Claims outside US or Canada;
not applicable after Parent Company has change of control;
Narrow “other insurance” and “prior notice” exclusions:
apply only to the extent Loss is actually paid under other
Consent by CODA to defense counsel not required;
Mandatory binding arbitration of any coverage dispute;
Policy non-cancelable except for non-payment of premium;
If Parent Company acquired, Insureds entitled to 3-year run-off
coverage for no additional premium;
Notice of Claim to CODA required after in-house general counsel
or risk manager of Company first learns of Claim;
Policy may not be rescinded based upon the restatement of any
financial statements of the Company included within the
Limit of Liability reinstated for Discovery Period if CODA non-
Protective bankruptcy provisions
Policy not subject to automatic stay under bankruptcy law;
Policy proceeds first applied toward pre-bankruptcy
Difference-in-Conditions drop-down feature if CODA Policy is
C. Financial Inability to Indemnity
If the Company becomes subject to a bankruptcy proceeding, the Company will likely be
unable to fund its D&O indemnification obligation. In that circumstance, Side-A coverage will
be the only financial protection available to the D&Os. If that coverage is unavailable, the
personal assets of the D&Os will be at risk. An issue will likely arise in the context of the
bankruptcy proceeding as to whether the D&O Policy is an asset of the bankruptcy estate. If it
is, the automatic stay applicable to all assets of the bankruptcy estate will effectively freeze the
policy and may preclude the D&Os from accessing the policy’s proceeds.
Courts have disagreed as to whether a typical two-part D&O Insurance Policy constitutes
an asset of the bankruptcy estate. Some courts have concluded the Policy is such an asset since
the Policy affords coverage for the Company’s D&O indemnification obligation. Although other
courts have either ruled that the D&O Policy is not an asset of the estate or have ruled that the
proceeds of the D&O Policy (as distinct from the Policy itself) are not assets of the estate, it is
unclear what result will occur in any particular bankruptcy proceeding. This uncertainty is
exacerbated if the D&O Policy also affords securities entity coverage since insurance policies
that afford coverage for claims against the Company are typically considered by courts as assets
of the bankruptcy estate.
In other words, under a typical D&O Insurance Policy, it is uncertain whether D&Os will
have access to the Policy proceeds in the event of the Company’s bankruptcy. However, that
uncertainty is virtually eliminated under a Side-A only Policy since the Company is not an
insured under that type of Policy, either with respect to its D&O indemnification obligation or
with respect to securities claims against the Company. Stated differently, a Side-A only Policy
can afford more predictable and potentially more protective coverage for D&Os in the event of
the Company’s bankruptcy.
D. Derivative Settlements/Judgments
Shareholder derivative lawsuits can be filed either in tandem with a shareholder class
action lawsuit or as an isolated lawsuit. A typical two-part D&O Insurance Policy will respond
to a settlement or judgment in either type of lawsuit, provided that the class action lawsuit (or
any other Claim in the same Policy Period) does not exhaust the available limit of liability before
the potentially non-indemnifiable derivative lawsuit settlement is paid. Because tandem class
action and derivative lawsuits are frequently settled at the same time, prior exhaustion of the
limit of liability is typically not a problem.
However, there is now a somewhat greater tendency to settle the larger class action
lawsuit quickly, even if, for whatever reason, the tandem derivative lawsuit cannot be settled at
the same time. For example, in one recent case, a company elected to settle a securities class
action within a few months after its filing for more than $100 million (thereby exhausting the
D&O Policy’s limit of liability) even though the tandem derivative lawsuit could not then be
settled for a reasonable amount. Approximately 18 months later, the tandem derivative lawsuit
was settled for approximately $15 million. Fortunately for the D&Os, the company maintained
an excess Side-A only D&O policy, which was not implicated in the indemnifiable class action
settlement and therefore was available to fund the non-indemnifiable derivative settlement.
In those types of situations where the Company wants to settle a large class action but
cannot yet settle the tandem derivative lawsuit for a reasonable amount, the Insureds are faced
with a difficult dilemma under a standard two-part D&O insurance program. On the one hand,
the Insureds can use the proceeds from the D&O insurance program to fund the class action
settlement, thereby creating potentially significant benefits to the Company by eliminating the
risks, distractions and adverse publicity associated with such a potentially catastrophic claim.
However, such a strategy may leave the defendant D&Os with inadequate insurance protection
for a subsequent non-indemnifiable derivative settlement. On the other hand, the Insureds can
preserve the D&O insurance proceeds for a subsequent derivative settlement. However, such a
strategy would deprive the Company of a large source of funds to pay the early class action
Many standard D&O insurance policies with securities entity coverage now contain a
Priority of Payment provision which, depending on its language, usually mandates that all
proceeds under the Policy be maintained for the non-indemnifiable derivative settlement,
regardless of the size of the D&O insurance program, the amount of the class settlement or the
likely amount of the subsequent derivative settlement. Thus, if the Company desires or is
compelled to settle the class action early, it must fund the entire settlement amount out of its own
assets and seek reimbursement under the D&O Insurance Policy for the covered Loss at some
unknown subsequent date when the derivative lawsuit is settled. As demonstrated by the case
described above, this result can require the Company to advance tens of millions of dollars, if not
hundreds of millions of dollars, to resolve the class action, even though much or all of such a
settlement is otherwise covered under the untapped D&O insurance program.
From the perspective of the defendant D&Os, this dilemma is especially frightening. If
the current Company management is not sympathetic to the defendant D&Os, the Company may
choose to access the D&O insurance program to fund the indemnifiable class action, thereby
leaving the defendant D&Os with little or no insurance to settle the subsequent non-
indemnifiable derivative lawsuit. Although the defendant D&Os would likely object to that use
of the Policy, at best a difficult controversy will exist which will create uncertainty as to the
extent of the defendant D&Os’ financial protection under the Policy.
These problems can be greatly mitigated, if not eliminated, by the purchase of Side-A
only DIC coverage excess of the Company’s standard D&O insurance program. Such excess
coverage assures the existence of insurance protection for non-indemnifiable claims against
D&Os even if the rest of the D&O insurance program has been exhausted by indemnifiable or
entity losses. In addition, such coverage may allow for deletion of the Priority of Payment
provision in the underlying D&O policies, thereby enabling the Company to access the
underlying D&O insurance proceeds for an early settlement of the class action even if the
tandem derivative lawsuit is not settled at the same time. Obviously, the larger the limits for this
Side-A only coverage, the greater the likelihood that this type of insurance program structure will
accomplish the goals of both the Company and the insured D&Os.
III. EMERGING STATE LAW D&O EXPOSURES
The primary liability exposure for directors and officers has been and continues to be
under the federal securities laws. Particularly over the last 25 years, Sections 11 and 12 of the
Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934 have been
interpreted broadly by courts, resulting in a growing number of large D&O settlements for tens
and at times hundreds of millions of dollars. The main reason for the more restrictive D&O
insurance market in the last several years is these escalating federal securities class action
Corporations, directors, officers and D&O insurers are already well aware of these
potentially catastrophic federal securities law exposures. However, far less attention has been
given to an apparently parallel expansion during the last year of liability exposures under state
law causes of action. Largely as a result of the numerous corporate debacles over the last two to
three years, state courts (which are primarily responsible for overseeing state corporate
governance laws) are now demonstrating unprecedented antagonism towards defendant directors
and officers in a variety of contexts, thereby creating judicial precedent for heightened D&O
liability exposure for violations of state and common law fiduciary duties.
This increased focus on state law claims against directors and officers is attributable to
several factors. First, many state court judges, particularly in Delaware, appear to believe that in
order to restore public confidence in the corporate governance process, directors and officers
need to be subjected to greater culpability and accountability. As a result, these judges are now
more willing than in the past to criticize director and officer conduct.
Second, as a result of the Private Securities Litigation Reform Act of 1995, fewer plaintiff
lawyers are being selected as lead counsel in the more lucrative federal securities class action
litigation. In order to justify a claim for some level of attorney fees, the plaintiff lawyers who are
excluded from the securities class action litigation are more frequently filing tandem state court
lawsuits against directors and officers.
Third, in order to leverage a higher settlement for themselves, many institutional
investors are filing state court claims against directors and officers rather than participate as a
member of a large class in the federal securities class action litigation.
Fourth, many of the cases now being presented to state court judges involve bad facts for
the defendants. Consistent with the adage that bad facts make bad law, these cases provide a
good record for courts to apply a more critical legal analysis and to find D&O wrongdoing.
Although the severity of state court D&O claims settlements has not materially increased
yet, it seems reasonable to believe that such a result will be a natural consequence of these
factors. Since state court judges and plaintiff lawyers now apparently want to give these state
law claims more vitality, it is likely that significant additional settlement payments will be
required in the future to resolve these cases. Because in most states settlements in state court
shareholder derivative suits are not indemnifiable, this development will result in more loss
payments by D&O insurers under Side-A of the D&O insurance policy. The fear by insurers of
that development is one of the main reasons why the pricing for Side-A Only policies continues
to be relatively high.
The following discussion summarizes some of the judicial developments during the last
year which evidence this increasing importance of state law claims against directors and officers.
In light of the prominent role Delaware law plays in the area of corporate governance, exemplary
recent rulings under Delaware law and pronouncements by the Delaware judiciary, who appear
to be at the forefront of this movement, are particularly noted.
A. Business Judgment Rule
The Business Judgment Rule is one of the most important defenses for directors and
officers in claims for mismanagement or breach of their duty of care. In essence, this defense
prohibits courts from second-guessing the quality of the defendants’ business decisions, and
allows the court to examine only the procedures followed by the defendants in reaching those
Today, board decisions relating to executive compensation receive some of the greatest
attention and scrutiny. It is therefore not surprising that the Business Judgment Rule has
received the greatest challenge over the last year in cases dealing with executive compensation
decisions. The following two cases under Delaware law appear to materially erode this
important defense in several respects.
In In re The Walt Disney Company Derivative Litigation, 825 A.2d 275 (Del. Ch. 2003),
the Delaware Chancery Court held that the Business Judgment Rule does not protect directors of
The Walt Disney Company with respect to allegations that the directors failed to evaluate,
negotiate or approve a lucrative employment agreement with Michael Ovitz, who was a close
personal friend of the company’s chair, Michael Eisner. The plaintiffs alleged the following
Eisner unilaterally made the decision to hire Ovitz as president, despite the protest
of three directors who believed that Ovitz did not have the necessary experience.
One month later, Ovitz’ employment proposal was presented to the compensation
committee of the board, but the proposal did not include detailed information
about the employment or compensation terms.
The compensation committee met for less than one hour, spent most of its time on
two other topics, asked no questions about the employment agreement and did not
receive a draft of the employment agreement before approving its general terms.
The compensation committee directed Eisner to carry out the negotiations with
Ovitz regarding various unresolved and significant employment details.
At the board meeting at which Ovitz’ employment was approved, no presentation
was made regarding the terms of the employment agreement and no questions
were raised regarding the terms of employment.
No expert consultant was present to advise the compensation committee or the
board regarding the employment agreement or its terms.
The Court concluded that the directors simply delegated to Eisner the decision to hire his
good friend, Ovitz, as president, and the terms of that employment relationship. Less than one
year later, Ovitz resigned as president (following criticism of his performance) and received
more than $140 million in severance payments pursuant to the employment agreement.
According to the Court, these allegations, if true, indicate that the directors did not exercise any
business judgment or make any good faith attempt to fulfill their fiduciary duties. The defendant
directors consciously and intentionally disregarded their responsibilities, adopting a “we don’t
care about the risks” attitude concerning a material corporate decision. As a result, the Business
Judgment Rule did not protect the directors’ conduct. The Court stated:
It is of course true that after-the-fact litigation is a most imperfect device
to evaluate corporate business decisions, as the limits of human
competence necessarily impede judicial review. But our corporation laws’
theoretical justification for disregarding honest errors simply does not
apply to intentional misconduct or to egregious process failures that
implicate the foundational directorial obligation to act honestly and in
good faith to advance corporate interests. Because the facts alleged here,
if true, portray directors consciously indifferent to a material issue facing
the corporation, the law must be strong enough to intervene against
Although one can read the Disney decision as a logical extension of prior case law which
criticizes inadequate procedures by directors and officers, this decision demonstrates the very
thin line between a court second-guessing the quality of the board’s procedures (which courts
may do under the Business Judgment Rule) and a court second-guessing the quality of the
board’s decision itself (which courts historically cannot do under the Business Judgment Rule).
By finding the procedures by the Disney board in approving Ovitz’ employment terms to be
“egregious process failures,” the court in essence ruled that the directors can be liable for
approving unreasonable employment terms. Arguably, such a result eviscerates much of the
protection afforded to directors and officers by the Business Judgment Rule.
In Pereira v. Cogan, 2003 WL 21039976 (S.D.N.Y.) a New York court interpreting
Delaware law found the former directors and officers of a bankrupt privately-held corporation
liable for breaching their fiduciary duties in connection with compensation paid to the company’s
CEO. Following a bench trial, the Court found the director defendants liable for the company’s
payment of excessive compensation and illegal dividends to the CEO because the two-person
compensation committee that purported to ratify the payments lacked true independence from the
CEO, did not seek or obtain outside consultation from an executive compensation expert, and did
not review any comparable data regarding the salaries and performance of other executives with
similar responsibilities. As a result, the Court determined that the board should not have relied
upon a report from the compensation committee that was so obviously insufficient and
incomplete. Because the Court ruled that the directors completely failed to exercise any
diligence in performing their duties regarding compensation, dividends and loans to the CEO, the
directors were not entitled to the protections of the Business Judgment Rule, and were personally
liable to the company for about $14 million in illegal dividends and excessive compensation
which had been paid to the CEO. According to the Court, directors cannot rely on the Business
Judgment Rule to escape liability if they either knew about improper or questionable transactions
yet unreasonably failed to take action, or if they did not know about such transactions but should
have taken steps by which they would have been informed of the transactions. Like the Disney
decision, the Court cited the lack of proper board procedures to find the directors liable for
approving a level of CEO compensation which the Court in hindsight believed to be excessive.
Perhaps most troubling, the Court found not only the directors, but also certain non-
director officers, jointly and severally liable for the improper payments to the CEO. In adopting
a potentially dangerous “prevention” test for determining officer liability, the Court held that an
individual who has discretionary authority in a relevant functional area and the ability to cause or
prevent the challenged action can be held liable for damages resulting from such action. Here,
the Court concluded that the general counsel and CFO could have prevented the company from
extending illegal loans and making certain illegal payments to the CEO by notifying the directors
of the improper transactions. Because those officers failed to prevent the wrongful conduct, they
were found to have breached their fiduciary duties and were held liable, with the directors, for
the challenged transactions.
Both the Disney and Cogan decisions demonstrate the need for directors and officers to
remain fully engaged and involved in the affairs of the company. If defendant directors and
officers cannot demonstrate their diligent management and oversight, there now appears to be a
greater willingness by at least some courts to second-guess their business decisions and to hold
those individuals personally liable for any resulting harm to the company.
B. Liability Limitation Statute
In response to the corporate governance crisis in the mid-1980s, virtually all states
adopted statutes which limited the liability of directors and, in some instances, officers under
state law. The Delaware provision (Section 102(b)(7), Delaware General Corporation Law)
served as a model for most other states and allows corporations in their certificate of
incorporation to limit or eliminate the personal liability of directors for damages in claims by the
company and its shareholders. Notably, though, the statute does not limit or eliminate liability
for conduct not taken in good faith or for breach of the directors’ duty of loyalty. These state
liability limitation statutes, like the Business Judgment Rule, have played an important role in
minimizing director liability exposures in state law claims during the past 15 years.
However, some recent court decisions have evidenced an erosion in the level of
protection afforded by these statutes, similar to the erosion described above with respect to the
Business Judgment Rule. For example, in both the Disney and Cogan cases, the defendant
directors argued that they should not be liable not only based upon the Business Judgment Rule,
but also based upon their company’s respective Section 102(b)(7) exculpatory clause for
directors in their certificates of incorporation. However, both courts found that defense
inapplicable because the defendant directors’ alleged wrongdoing constituted conscious and
intentional disregard of their responsibilities and thus constituted a breach of the directors’ duty
of loyalty, as well as conduct undertaken not in good faith. Both types of wrongdoing are
expressly excluded from the statutory exculpation in Delaware and most other states.
The Seventh Circuit Court of Appeals recently reached a similar conclusion in In re
Abbott Laboratories Shareholders Der. Lit., 325 F.3d 759 (7th Cir. 2003), finding the exculpation
protection under an Illinois statute virtually identical to the Delaware statute not available to
directors. In a somewhat tortured analysis, the Court first assumed the directors knew of various
operational problems at the company since the company’s corporate governance procedures
should have identified those problems for the directors. The Court then further assumed the
directors decided no action was required to address those problems since no action was in fact
taken. Based on these assumptions, the Court ruled that the directors consciously disregarded
their duties, which constitutes conduct “not in good faith.” Therefore, the Court found the
statutory exculpation provision does not apply to shield the directors from liability.
Because the “duty of loyalty” and the conduct “not in goof faith” exceptions to the state
liability limitation statutes can be rather subjectively applied by courts, it appears clear from
these recent cases that courts can easily sidestep this statutory defense by directors in most cases
if the court is otherwise inclined to hold the directors personally liable.
C. Independent Directors
A centerpiece to the many corporate governance reforms mandated by Congress and
regulators is the heightened expectations for the role of independent directors. Congress has
mandated that public audit committees be made up exclusively of independent directors. Several
national securities exchanges support the requirement that a majority of directors on public
boards be independent and that certain corporate actions, such as the nomination of directors, be
approved by independent directors or a committee entirely made up of independent directors.
Certain types of special committees of the board, such as committees charged with negotiating a
transaction with one or more officers or approving a business combination or evaluating potential
litigation against directors and officers, must be composed solely of independent directors to be
effective. If independent directors, following a reasonable investigation, make informed and
disinterested decisions regarding certain matters, the independent directors and the other officers
and directors of the company will typically be insulated from liability relating to those matters.
A critical question when those decisions are subsequently challenged is whether the
independent directors who approved the decisions were in fact “independent.” In the past, courts
have looked primarily at whether those directors had a direct economic interest in the matter to
determine whether they were independent. However, in In re Oracle Corp. Derivative
Litigation, 824 A.2d 917 (Del. Ch. 2003), the Delaware Chancery Court raised the bar
significantly regarding who can qualify as an independent director. In that case, two outside
directors on the Oracle Corp. board of directors were selected by the board to serve on a special
litigation committee (“SLC”) formed to investigate whether the company should bring an insider
trading lawsuit against certain other directors. The Court found that the two SLC outside
directors, who were prominent Stanford professors with no economic ties to the company or any
of the other directors, did not qualify under Delaware law as independent directors for purposes
of the investigation, and therefore the Court refused to dismissed shareholder derivative lawsuits
which were brought on behalf of the company against those other directors for insider trading
since the company failed to conduct an independent analysis as to whether the prosecution of
those derivative suits was in the best interest of the company.
Although neither of the two outside directors who served on the special litigation
committee were directors at the time of the alleged insider trading, and although the special
litigation committee hired a prominent independent law firm, interviewed 70 witnesses and
reviewed numerous records before producing a 1,110 page report that concluded that the
company should not pursue the insider trading claims against the other directors, the Court
concluded that the SLC investigation and analysis were not truly independent and therefore
refused to follow the recommendations of the committee.
Although the two committee members had no significant financial ties to the defendant
directors and received no direct compensation from the company other than in their capacity as
outside directors, the Court concluded that the common ties among the committee members (who
were Stanford professors), the defendant directors and Stanford were so substantial that they
created reasonable doubt about the independence of the committee members. For example, the
One of the defendant directors taught one of the committee members as a student
at Stanford, and both of those directors now serve on a steering committee at
Another defendant director had individually contributed about $4.1 million to
Stanford, a small portion of which went to support research by one of the
One of the defendant directors chaired a foundation which donated $11.7 million
to Stanford over the last 20 years, and another defendant director participated in a
foundation which donated nearly $10 million to Stanford;
One of the defendant directors was considering a $150 million contribution to
Oracle contributed $300,000 to Stanford.
Although the Court recognized that the livelihood of the two committee members would
not be threatened if the SLC decided the company should pursue the insider trading lawsuit
against the other directors, the Court found these connections sufficient to call into question the
SLC’s independence. In doing so, the Court rejected the committee’s attempt to define
independence as simply the absence of domination or control. Instead, the Court found that
factors other than just economic relationships should be considered:
At bottom, the question of independence turns on whether a director is, for
any substantial reason, incapable of making a decision with only the best
interest of the corporation in mind. That is, the Supreme Court cases
ultimately focus on impartiality and objectivity.
This test requires a court to consider a wide variety of factors, including social and
personal connections between people, that might make one person feel beholden to the interested
party. Such a test goes beyond the independence requirements for audit committees recently
adopted by the SEC and the proposed national securities exchanges’ independent director
requirements. The focus of those requirements is economic and familial independence, not
social independence. The Oracle Court’s consideration of social and personal relationships may
greatly reduce the number of truly independent directors on most boards, thereby significantly
limiting the legal protections available from independent director approval. To be an effective
board, directors are encouraged to behave in a collegial fashion and develop social relationships
in order to enhance a constructive working environment. Such relationships apparently now
must be analyzed to determine if some of the directors are independent from other directors.
Such a result will, at best, create a chilling effect on the creation of social relationships among
board members and, at worst, result in the disqualification of virtually all directors as
independent directors for purposes of state law issues.
In summary, based upon these and other similar recent rulings, it is becoming increasing
more apparent that courts, like most others, now view director and officer performance with
greater skepticism and will likely react to alleged wrongdoing by directors and officers with
greater antagonism than before. Unfortunately, this type of significant change in mindset by
particularly the Delaware judiciary is not likely to be temporary or short-lived, but will probably
continue for many years to come. Although the overall quality of corporate governance has
unquestionably improved in this post-Enron era, the legacy of heightened expectations and
responsibilities for directors and officers under state law appears destined to result in higher and
higher D&O losses in state law claims.