Corporate law charges Boards of Directors with the job of managing and supervising the affairs of their corporations, together with specific functions, like proposing amendments and mergers, declaring dividends, and conducting annual board elections. How well directors perform their functions is measured largely by fiduciary law; specifically by what is commonly known as a director’s “duty of care.” In performing their functions, directors may be subjected to personal liability for a breach of the duty of care. A director may be found to have beached the duty of care if the director fails to act: (i) in good faith; (ii) in honest belief that an action taken was in the best interest of the company; or (iii) in an informed basis.
The “good faith standard” has been generally understood to require that directors; (i) not have a conflict of interest; (ii) act honestly; and (iii) not approve (or condone) illegal activity. The “best interest” requirement specifies a standard for the substantive review of the merits of a director’s actions. Under this standard, a board decision or an action by a director must be related to the furthering the corporation’s interests. Finally, the “informed basis” requirement imposes on directors a duty of oversight, inquiry, and diligence. This is a procedural standard that requires directors to have at least minimum levels of skill and expertise to be informed in making decisions. Generally, this means that directors must exercise the care that prudent persons would exercise in the management of their own affairs.
Practically speaking, in the 150 years or so during which courts have articulated a duty of care for directors, there have only been a handful of cases in which directors have been held liable for mere mismanagement (uncomplicated by illegality, fraud or conflict of interest). Legally, a rebuttable presumption exists that directors, in performing their function, are honest and well-meaning, and their decisions are informed and rationally undertaken. This operates as an assumption, absent sufficient evidence to the contrary , that directors do not breach their duty of care. However, a director may lose the benefit of this presumption if an individual challenging his or her actions shows conduct of fraud, illegality, or a conflict of interest on the part of a director. If an action undertaken by a board of directors (operating in concert) constitutes a breach of the duty of care, courts have held that each director who voted for the action, acquiesced to it, or failed to object to it becomes liable for all damage that the decision caused the corporation.
Regardless of the legal shields directors enjoy which protect them from liability, becoming a corporate director in our litigious society is a risky proposition. To encourage people to accept such positions and then to take good-faith risks for the corporation without fear of personal liability, statues allow corporations to indemnify directors against liability. In addition, director’s and officer’s (D&O) liability insurance supplements this protection. Indemnification and insurance are in addition to the liability insulation discussed above.
Indemnification is simply the corporation’s promise to reimburse a director for litigation expenses and personal liability if the director is sued becauSe he or she is or was a director. In general, indemnification applies when the director is (or is threatened with being made) a defendant in any civil, criminal, administrative, or investigative proceeding. A director’s indemnification rights may continue even after he or she has left the corporation. Because of the potential that a corporation’s indemnification policy will frustrate other corporate policies and objectives (e.g., the desire for its directors to act in the corporation’s best interests), a director’s right to indemnification, the power of the court, and the power of a given corporation to indemnification may depend on: (i) whether the director was successful in defending the action; and (ii) whether an unsuccessful director can justify his or her actions.
Corporations are permitted to purchase insurance to fund its own indemnification obligations and to fill the gaps in coverage left by corporate indemnification. As mentioned above, such insurance is called D&O insurance. You should contact your insurance carrier for further information regarding such insurance.