Risk Management Considerations for Director and Officer Positions

By: Bob Beyer & Steve Parker

An attorney who has been living in a cave over the past few years might have avoided the debate involving whether or not private practice attorneys should serve as corporate directors or officers, particularly if the corporation is a client. While this debate has progressed, a more narrow issue has been slighted:

The authors recommend against private practice attorneys accepting positions as directors and/or officers of corporations, particularly if the corporation is a client. The many items of concern presented below illuminate the causes of concern. However, notwithstanding this view, we recognize attorneys and firms often find these positions appealing to the point that acceptance is deemed essential. So, given this circumstance, thorough reparation for the D&O assignment becomes crucial.

This note offers some common-sense check-lists of issues which hopefully can help the attorney and firm in this predicament.

1. PREACCEPTANCE ISSUES

Troubled Companies

Financially troubled companies are likely to experience more frequent and severe claims against their officers and directors. Warning signs of difficulty include:

• A sudden increase in litigation against the company.
• A particular lawsuit or serious litigation patterns noted by Auditors either to management or on company financial statements.
• Sudden, frequent, or unexplained auditor changes.
• Sudden or unexplained key officer or director resignations, especially those having responsibilities for financial matters, or outside directors with specialized knowledge of the corporation's industry (who may be able to note early signs of trouble).
• Companies that do not have bylaws providing for indemnification of directors or officers, or companies that change existing bylaws to eliminate such provisions.
• Bylaw changes significantly skewing the balance between inside and outside directors.
• Companies that do not renew existing D&O liability insurance, or that have been unable to obtain such insurance.
• Companies or industries that have experienced a sudden D&O insurance premium increase (affecting either the entire industry or the individual company).
• Companies about which negative stories recently have appeared in the press or those rumored to be in jeopardy.

An attorney who has been asked to serve as a director or officer on behalf of a company exhibiting any of these traits may be well advised to decline.

Additional Issues For Research.

• The applicable sections of the Business Corporation Act of the state in which the company is incorporated and other relevant laws affecting the indemnification and liability of directors and officers.
• The company's articles of incorporation, bylaws and rules, in order to evaluate whether indemnification is provided to the fullest extent permissible by law.
• The company's internal procedures, especially regarding financial transactions.
• The duties of directors as described in the bylaws, as well as the duties and roles of the officers and committees.
• Basic corporate records and minutes of recent board and committee meetings, corporate disclosure documents such as the latest SEC Form 10k Report, recent annual reports to shareholders, recent proxy statements, board structure and board committee organization, biographical data of the current board and management personnel, planning documents and studies, management letters from independent auditors, information concerning corporate facilities (including a tour when possible), and information concerning the corporation's outlook with respect to current prospects and problems, critical issues and long range objectives.
• The views of the corporation's legal and financial situation and problems which should be obtained in individual personal meetings with both independent outside legal counsel and independent outside auditors.
• Consider whether the size and composition of the board are sufficient to accomplish all tasks effectively. Evaluate the mix of outside to inside directors on the board and key corporate oversight committees.
• Learn the details of the company's directors and officers liability insurance policy or other forms of D&O indemnification. Ensure that such insurance or indemnification is provided, is adequate, and continues in effect during the course of the lawyer's tenure as a board member or officer, and thereafter (if possible) for claims later made relating to the attorney's prior conduct as a director or officer.
• Review the director's indemnification rights with respect to the corporation. Look for indemnification mechanisms that operate to strengthen the director's indemnification rights, such as bylaw provisions.
• Require indemnification, rather than merely permitting the corporation to indemnify.
• Require advancement of defense expenses, subject only to an unsecured obligation to repay expenses if a court subsequently determines the indemnification was not permitted.
• Shift the burden of proof to the company to prove that the director or officer is not entitled to the requested indemnification.
• Require corporate reimbursement of the director or officer or any expenses incurred in a claim against the corporation for indemnification if the director or officer is successful in such a claim in whole or in part.
• Provide that the director or officer has a right to an appeal or an independent de novo determination as to indemnification entitlement.
• State that the indemnification rights constitute a contract, are intended to be retroactive to events occurring prior to its adoption, and shall continue to exist after a rescission or restrictive modification of a bylaw provision with respect to events occurring prior to that rescission or modification.
• State that any director or officer who provides services to a subsidiary of the corporation or to any employee benefit plan of the corporation is deemed to be providing such service at the request of the corporation.
• Include shareholder approval of such indemnification to avoid any argument that expanded indemnification protection under the bylaws is unfair.

2. POSTACCEPTANCE ISSUES

It is important to realize that even if all of the foregoing items are addressed to the attorney's satisfaction, due diligence is an ongoing responsibility in order to ensure that the attorney's risk is minimized

Before Each Board Meeting

• Review the agenda for the upcoming meeting, and read the preceding board meeting minutes, related original documents, and management recommendations carefully.
• Note any discrepancies or disagreements with action taken at a previous board meeting to the corporate secretary and request that the discrepancy or disagreement be noted in the minutes.
• Make every effort to segregate the consideration of legal issues from other items on the agenda, in order to preserve the attorney-client privilege, to the extent possible, for any legal advice given.
• Obtain the information needed to make decisions reasonably in advance of voting on all key matters.
• Examine each issue carefully before voting and retain the information upon which the vote was based.

At Each Board Meeting

• Make sure votes are recorded accurately. Even if a minority of one, disagreement should be voiced and noted for the record.
• Abstain from discussion and voting on motions concerning legal fees, pending litigation, and legal representation. Ensure that abstention on these matters is duly recorded in the minutes.
• Scrutinize all major actions of the corporation. Obtain copies of the minutes and documents supporting all major actions, especially financial transactions. Remain alert to violations of the law and violations of internal procedures.
• Be particularly wary of "emergency" or "special" board meetings called at short notice where matters considered are important yet documentation presented for review is incomplete.
• Review carefully all corporate financial statements and other financial information presented at board meetings. Ask all pertinent questions regarding this information.
• Ensure that these questions are adequately reflected in the minutes. Ensure that independent legal and financial advice is sought when warranted.
• Ensure that any advice given or action taken falls within the type of activity covered by the D&O liability insurance policy or any other indemnification arrangement with the corporation.
• Attend Board meetings. When unable to attend, ensure that the minutes reflect such absence. When in disagreement with any action taken, note such disagreement in writing to the corporate secretary and request that it be attached as an exhibit to the minutes of the following meeting.

Take advantage of preventative measures established to benefit the corporation and its directors and officers.

• Educational programs designed to inform nonattorneys of compliance obligations under various securities laws.
• Corporate policies and procedures regarding disclosure of material information and insider trading.
• Adoption of rules designed to prevent unfair business practices by management.
• A "legal audit" by independent outside legal counsel to inspect and evaluate the corporation's legal structure, pending litigation, potential claims, and internal policies, procedures, and guidelines, with a view to avoiding future D&O claims.

3. FIRM CONSIDERATIONS

There are a number of ways in which a firm that has allowed an attorney to serve as a director or officer may ensure that it is doing all it can to minimize its exposure.

Monitor Risk Through Reporting Requirements

• Prior notification to the firm and firm approval of the acceptance and form of compensation to be received by the attorney/director.
• Annual statements from lawyers that:

• Completion of an annual questionnaire regarding the corporate board positions held by each lawyer.
• Prompt response by a lawyer serving in such a capacity to any request by the firm for current information regarding the company or the director or officer position.
• Evidence of continuing and adequate insurance coverage for the lawyer's actions as a director or officer, or, alternatively, indemnification bylaws, agreements, letters of credit, or irrevocable trust funds. Such evidence should by requested annually and maintained on file by the firm.
• Evidence that the corporation has paid all taxes due each year.
• That, should a conflict of interest arise during the course of the lawyer's tenure as an officer or director of a corporation, the corporate minutes reflect the full disclosure thereof and the recommendation by the attorney/director that the corporation retain independent legal counsel.

Additional Preventative Measures

• Develop a list of "red flags" to alert the attorney/director to situations that might lead to malpractice liability, such as internal management disputes, stockholder complaints, financial difficulties, or potential conflicts of interest that might warrant reevaluation of the directorship. The attorney/director should be cognizant of any heightened standard of care to which a director or board committee member may be held under the relevant state law if the company is in financial distress.
• Develop and require attendance at in house or outside continuing education seminars concerning the role and potential liabilities of directors and officers, and ways to minimize those liabilities.
• Develop internal controls against the use by the lawyer or the firm of "inside information" obtained during the lawyer's tenure as a director or officer of the corporation.
• Prohibit service by lawyers as directors or officers of not-for-profit organizations, opting instead to provide legal services to such entities on a pro bono basis.
• Incorporate the name of the corporation, subsidiaries, and directors and officers in the firm's conflict of interest database.
• Prohibit a lawyer from serving on the board of directors of more than one corporation engaged in the same market area or in potentially competitive lines of business, so as to avoid potential conflicts of interest.
• Prohibit the attorney/director from representing the company in any internal investigation of the corporation concerning a potential legal violation.
• Require that, if any significant corporate activity could involve conduct by the attorney/director that might later be interpreted as providing legal advice and not merely as the views of a director, participation in that activity be limited to only one role. The attorney/director should not attempt to act both as counsel and as a director. In all such cases, the decision to act in only one role should be reduced to writing and given to the corporate secretary for inclusion in the corporate records.
• Require that the administrative aspects of the two roles should be separate. For example, mandate that all checks for legal services and expenses be sent by the corporation directly to the law firm's accounting department, and all checks for services as a director or officer be sent directly to the lawyer.
• Execute a separate agreement between the attorney and the corporation defining the attorney's director role and specific duties (disclaiming any legal advisory role) and a separate engagement letter between the firm and the corporation outlining the scope of the firm's engagement for legal services, if any.

A lot of considerations? D&O positions carry a lot of challenges and rewards. If the challenges are managed, pursuant to the foregoing lists, then individual attorneys and their firms should be able to reap the many personal and professional rewards associated with leadership positions.

Bob Beyer is the Administrator of Limbach & Limbach L.L.P. in San Francisco and San Jose, and the Executive Vice President of PilotLegis, a professional liability purchasing group. Steve Parker was formerly  at Minet Insurance Services in Palo Alto.