The “Myth” of Outside Director Liability and the Critical Importance of D&O Insurance

The “Myth” of Outside Director Liability and the Critical Importance of D&O Insurance

 In the world of corporate governance, there are a number of common presumptions about board structure and practices. However, according to a recent paper, many of these presumptions may in fact represent corporate governance “myths.” In their September 30, 2015 paper entitled “Seven Myths of Boards of Directors” (here) Stanford Business School Professor David Larcker and Resercher Brian Tayan examine several “commonly accepted beliefs about boards of directors that are not substantiated by empirical evidence.”

Among the items that the authors explore is the “myth” that “directors face significant personal legal and financial risk by serving on boards.” The authors cite recent survey results showing that the majority of directors believe that liability risk of serving on boards has increased in recent years; the survey results also showed that a substantial number of directors have considered resigning because of concerns about personal liability.

However, as the authors report, “the actual risk of out-of-pocket payment is low.” In support of this statement, the authors cite a 2006 law review article by Northwestern Law Professor Bernard Black, Cambridge University Law Professor Brian Cheffens, and Stanford Law Professor Michael Klausner.  The law review article, entitled “Outside Director Liability,” can be found here. A prior post on this blog in which I discussed this law review article can be found here.

According to the research in the law review article, in the 25 years between 1980 and 2005, outside directors made out-of-pocket payments that were neither indemnified nor insured in only 12 cases. (The 12 cases are listed in Exhibit 4 to Larcker and Tayan’s recent paper.)

A follow-up study of lawsuits filed between 2006 and 2010 by Professor Klausner and a Stanford colleague  (here) resulted in a finding that there were no cases filed during that period involving out-of-pocket payments by outside directors, although some of these cases are still outgoing.

The key to this low level of out-of-pocket payments by outside directors is the availability of indemnification and insurance. As Larcker and Tayan note in their paper, “directors are afforded considerable protection through indemnification agreements and the purchase of director and officer liability insurance.” These protections, the authors note, “have been shown to be effective in protecting directors from personal liability.”

Of critical interest to readers of this blog, Larcker and Tayan quote the law review article’s authors as saying that “directors with state-of-the-art insurance policies face little out-of-pocket liability risk.” As a result “the principal threats to outside directors who perform poorly are the time, aggravation and potential harm to reputation that a lawsuit can entail, not direct financial loss.”

Discussion

Every June, I participate as a faculty member at the Stanford Law School Directors’ College, leading a class with my good friend Priya Cherian Huskins of the Woodruff Sawyer firm on the topic of indemnification and insurance. Based on the discussions with the attendees of this class over the years, I can confirm the point that Larcker and Tayan make that many directors are quite sure that they face a substantial risk of personal liability as a result of their corporate board service. However, as the academic research substantiates, this risk of personal financial liability is indeed, as Larcker and Tayan put it, a “myth.” But while the facts are well-substantiated, there are still a number of important issues to understand about these facts.

First and foremost, the reason that directors so infrequently are called upon to contribute out of their own personal financial assets in response to private civil litigation is that their companies’ D&O insurance is there providing them with protection. As Professor Klausner and his co-author noted in their 2006-2010 follow-up study, “D&O insurance pays substantial portions of settlements in a large majority of cases” as a result of which “both corporate and individual defendants are highly protected.” D&O insurance “effectively transfers liability risk from officers, directors, and companies to the insurer.”

It is particularly important to note with respect to these academic studies’ conclusions about the protective effect of D&O insurance that it is not just the presence of D&O insurance alone that affords directors substantial protection; it is the presence of a “state-of-the-art” policies that afford the critical protection for corporate officials. As the law review article puts it, “directors with state-of-the-art insurance policies face little out-of-pocket liability risk.”

In other words, directors concerned about their potential liability exposures will not only want to make sure that their companies have sufficient D&O insurance in place, but will also want to confirm that the insurance program incorporates the best available terms. These conclusions underscore the importance for companies and their boards to make sure that a highly knowledgeable and experience professional is guiding their insurance placement processes.

There is one further note about this analysis and the authors’ conclusions that bears emphasis here, and that is that this discussion is addressed to liability exposures that corporate board members may face as a result of private civil litigation. The authors’ analysis is not directly addressed to the separate exposure that corporate board members may face as a result of enforcement action from the Securities Exchange Commission or other regulatory authorities. As I noted in a recent post, although it is “rare,” there are several significant recent example of cases where the SEC has pursued enforcement actions against outside board members. The risk of this type of enforcement action may represent a different category of liability exposure for directors, as I discuss in greater detail in my recent post.

 Read other items of interest from the world of directors & officers liability, with occasional commentary, at the D&O Diary, a blog by Kevin LaCroix.

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