Erik Sherman

It has been suggested that directors who seek to protect themselves by getting more involved in company activities may in reality be putting themselves at greater risk. What's more, the precautions that many company directors and officers once relied upon may not be as sound as they once were.

Directors have historically depended on a legal safety net of indemnification and exculpation. 'That's all backed up by the insurance policy,' says Michael Morgan, a partner with Seattle law firm Lane Powell and the attorney who represented Cutter & Buck. 'Now everybody's wondering, Do I have insurance? - and for good reason.'

Many corporations have been concerned about increased personal liability and are looking at Sarbanes-Oxley as the culprit. For directors, there's good and bad news. The good? SOX actually doesn't increase the liability of directors at all. The bad? Lawsuits are more likely in today's business and investing climate, D&O policies may not cover what corporations and their lawyers think they do, and the longer oversight hours that boards spend can actually make them more vulnerable to civil actions.

SOX scare
Certainly, Sarbanes-Oxley has changed the way boards operate. 'We're spending substantially more time on compliance-related issues and education issues to make sure that all directors understand their obligations and responsibilities,' states Cary McMillan, CEO for True Partners Consulting and a member of the board of directors for McDonald's and Hewitt Associates. McMillan adds that the board members he knows aren't worried about perceived increased liability under SOX, but he believes that 'they need to spend more time to execute the responsibilities.'

The irony - especially with all the complaints about Sarbanes-Oxley that one can hear in corner offices and boardrooms - is that directors actually face no more liability than they have for years under the Securities Act of 1933, the Securities Exchange Act of 1934 and 1977's Foreign Corrupt Practices Act as well as their various modifications over the years.

At the end of the day, although Sox focuses its sanctions on CEOs and CFOs, directors do face a new source of danger: an increased and relentless scrutiny that brings together duty and fear into one neat package. 'Directors are being sued personally more,' says Albert Adams, a partner with Cleveland law firm Baker & Hostetler LLP who has served on corporate boards for the last decade. 'There's much more process in place now.'

Relying on existing legal protections and concepts like the business judgment rule - in which the law presumes that, absent a breach of fiduciary duty, directors act in good faith and in an informed manner and therefore are not liable for making bad decisions - as a defense is insufficient.

'As a by-product of all the recent focus on corporate governance issues, it seems that the scope of the protection afforded by the business judgment rule is eroding,' says attorney David Rosen, partner with Murphy Rosen & Cohen. 'At the very least, it seems that the public - i.e., jurors - are less willing to accept as an excuse that the director was just trying to do the right thing.'

Document torment and unpleasant trends
The answer would seem simple: Dot the i's, cross the t's and document everything. Unfortunately, things aren't quite that simple. There are two schools of thought when it comes to the minutes of board and committee meetings. One is to have little.

However, what had been a sound practice in the past is now 'under attack from several fronts,' he says. Lawyers representing shareholders suing a company will look for discrepancies in which the board seems to give as much attention to something minor as to other things, like executive compensation. In sparse minutes, everything can seem to have the same degree of importance - and some courts have begun to take this view.

The dangers lurking in documentation don't end with board minutes. Though it is difficult in practice to sue directors under Section 10b-5, according to Tankersley, because directors typically wouldn't know 'if a CEO was cooking the books,' there is another area of liability from Section 11 of the 1933 Securities Act. 'It says that the director is liable for misstatements that are included in a prospectus unless the director establishes that by exercising reasonable diligence, they could not find the misstatement,' he says. 'Historically, in IPO transactions, the lawyers for the company would directly take on the work to establish for the directors the due-diligence defense. In the last ten years, people seem to have lost sight of that.'

The danger isn't only in an IPO, but in other regulated transactions such as secondary and debt offerings. There are time limits, though. Shareholders must sue within twelve months of an offering. Although problems usually take longer to emerge, should things go bad within that period of time, directors face a burden of strict liability. That means a suit's plaintiffs don't need to show actual fault or negligence, just a problem with the prospectus. The only defense is to establish clear due diligence on the part of the board, which means having 'qualified lawyers go through all the statements in the disclosures and report back to them on it,' Tankersley says.

Insurance headaches
One might think that expanding D&O insurance to cover employees would be a possible, though expensive, answer. That can actually work against a company, says Tankersley. Over the last five years or so, prosecutors have created a system where companies, if they cooperate, get highly reduced penalties, which keeps the legal system from effectively punishing shareholders. 'One of the things that is not cooperation is funding the defense of employees,' he says.

So directors had best be certain that their own insurance is unassailable. That, too, has become difficult because carriers, interested in bolstering their own bottom lines, are often following an old practice of finding ways to deny claims. In the D&O world, the landscape has become particularly treacherous, as the experience of Cutter & Buck shows. The problem is that insurance companies are increasingly using complex industry language - often not even understood by corporate attorneys - to stack the decks in their favor. 'Many D&O policies are written in almost a foreign tongue, like old English, and it's very hard to understand them,' says Adams. Boards need to bring in insurance experts to help them understand just what coverage they are getting.

If there is a bright side for directors, it's that the problems they potentially face are on the civil front, not criminal, and are therefore subject to indemnification and exculpation. But shoring up personal protection will mean spending more attention to process and more time with experts and lawyers - just what directors were probably hoping not to hear again.