Corporate Governance Blog

Is your organization’s Director & Officer Liability Insurance enough?

In an effort to help attract and retain good board members, almost all organizations carry directors and officers liability (D&O) insurance, providing officers and boards with protection against claims for their service to the organization. The questions in the heads of most directors today, given the economic times we are living in coupled with the litigious nature of the business world, is whether the organization’s D&O policy will be enough?

That’s where independent director liability (IDL) may make sense. IDL has been a growing trend over the past couple of years, and received a spike in attention after the Delaware decision in Schoon v. Troy in mid-2009. IDL is a specialized form of D&O that’s sold separately from a standard D&O policy. It protects only the directors and would pay out even if all limits within a company’s D&O policy were exhausted. These policies have been around for several years now.

There are a few reasons that weigh in favor of standalone insurance protection for independent directors and there is an increasing interest by independent directors in coverage that protects only a company’s independent or outside directors, not its officers.

IDL insurance may be a useful tool for protecting and retaining the best talent and attracting high quality independent directors. Among other reasons suggesting the need for IDL protection is the increasing susceptibility of traditional D&O insurance limits to erosion or depletion through defense expense or indemnity protection for other persons insured under the D&O policy.

As we have discussed in a past edition of Acredula, most D&O policies have three broad types of coverage:
• Side A, which pays for claims against directors and officers who are not indemnified by the company;
• Side B, which reimburses the company for indemnified claims; and
• Side C, which covers securities claims against the company.

The biggest concern for independent directors should be when they are named individually in a lawsuit with the officers. Most times the directors are not the initial focus of the plaintiff and they are sitting on the sidelines watching the limits erode as the plaintiff attacks the officers. If this is a concern, then IDL makes sense.

An IDL policy can be designed to cover all the independent directors on a single company’s board, or protect one individual for all the boards on which he or she serves. The most common, though, is the former where the policy covers all independent directors on a single company’s board.
While it will likely take a significant event to erode a policy’s limits, and thus the need for IDL may be small, it is when this significant event occurs that the policy may be needed the most.

Larger organizations with significant financial resources have been the primary purchasers of IDL over the past couple of years. However, more organizations are considering such policies. An IDL policy, in addition to financial benefits, can provide additional peace of mind to directors as well as another tool for an organization to utilize trying to recruit the best and brightest to fill an expertise gap on their board.

The evolving role of the corporate secretary

For most outside of the governance arena, the corporate secretary is viewed simply as the designated minute taker for the corporate board. This could not be further from the truth. Corporate secretaries should be trusted advisors who provide the organization with guidance and ensure the company is in compliance with regulatory issues.

While serving as a governance professional in support of the board of directors and corporation itself, the corporate secretary must maintain traditional responsibilities for entity management, corporate records administration and compliance; however, their role today is much greater.

Today’s business climate’s focus on risk and the current culture of compliance have further impacted the role of the corporate secretary.

With the increased focus on corporate governance practices in light of the financial crisis and the legislative and regulatory response by the Securities and Exchange Commission (SEC) and Dodd-Frank, boards are under pressure to adapt quickly. Failure to adapt and take appropriate steps to create sound governance practices will have a direct negative impact on the entity, its profits, risk management and oversight as well as its perception in its industry.

More than ever, boards are juggling multiple responsibilities, including oversight of the CEO and the organization; succession planning for the board and management; advancing the strategic mission of the organization; and duties to stakeholders, including shareholders for corporations, members or those served by the mission of a tax-exempt entity, or policyholders of mutual insurance companies.

With so much on their plates, how can directors adequately focus on corporate governance best practices? As we have discussed in posts over the past several years director training and education is part of the answer. The other part is as access, whether on the board or through paid advisors, to the requisite expertise needed by the organization to meet its strategic plans. This is where the corporate secretary’s role has evolved. The corporate secretary can play a critical role in the oversight of the board practices, planning of education programs and managing the access to experts.

Beyond taking minutes and other oversight of board practices to ensure appropriate records meet legal compliance, directors should look to the corporate secretary to provide expert counsel on governance issues before taking action, both in and out of the boardroom.

Sarbanes-Oxley and the intense focus on corporate governance have served to give the position a central role in the organization's compliance obligations. Today, there is a recognition that the organization must be able to track and justify every action that occurs as any action could lead to a potential litigation. In order to do so, there must be a process which functions with accuracy and is based on solid governance principles. One thing a corporate secretary cannot do is lock the courthouse doors. That being said, the corporate secretary can ensure that the decision making process followed by the board is appropriate.

In most instances, it is the decision making process of the board that will be evaluated as opposed to the actual decision of the board. Since discovery and trial on the merits of any matter will not occur for several years after the act occurred, the process taken plays a key role. Think “objects in the rear-view mirror may appear closer than they are.” Everything looks different looking back. This is also true with regard to board decisions. Three to five years after a matter finally makes it to trial, it may look different than anyone remembers, but the process will not look different and the corporate secretary can provide a valuable service by overseeing this process.

As with all governance practices, what may be a best practice for one organization may not be a best practice for your organization. As such, the role of the corporation for one entity will be different than a separate company. It is critical that all organizations carefully define (and communicate) the expected role and responsibilities of the corporate secretary to provide appropriate support and training, and to make certain that the right individual occupies that position within the organization. Similarly, this will aid the board in understanding how to properly utilize the corporate secretary.

The corporate secretary is and will continue to play an increased role going forward. Organizations need to embrace this role and start filling the corporate secretary position with those individuals with the appropriate expertise, or access to outside professionals with the appropriate expertise. Directors need to take full advantage of what the corporate secretary can offer.

A chronology showing the Penn State Board of Trustees acted appropriately

Like a board of a corporation, the Board of Trustees of Pennsylvania State University (Penn State) is the highest authority of the university with “complete responsibility for the government and welfare of the university and all the interests pertaining thereto including students, faculty, staff and alumni.” When its president and head football coach apparently ignored and attempted to bypass the Board’s authority, the Board acted quickly and decisively. Through a designated spokesperson, they dismissed both the president and the coach and then appointed a special, independent committee to investigate in order to protect further loss to the university’s most valuable assets – its reputation.

The president’s ill-advised press release

An article entitled “An Icon Falls, a President with Him,” by Brad Wolverton in the November 10, 2011 issue of The Chronicle of Higher Education (Chronicle) contains a detailed and objective account of the incidents and events leading to the actions by the Board. On the same day, November 4, 2011, that prosecutors filed 40 charges against Penn State’s former assistant coach, Jerry Sandusky, for sexual abuse of eight boys over 15 years, Penn State President Graham Spanier issued a statement that, according to the Chronicle, “defend[ed] his top officials but barely mention[ed] the victims:”

Soon after the news broke, on November 4, Mr. Spanier issued a statement defending his top officials but barely mentioning the victims. "Tim Curley and Gary Schultz operate at the highest levels of honesty, integrity, and compassion," Mr. Spanier said. "I am confident the record will show that these charges are groundless and that they conducted themselves professionally and appropriately." Those would be the last words he would say publicly as the university's president.

However, President Spanier’s statement apparently was not authorized by, or reviewed with the Board. Worse still, it ignored facts that he should have known or taken the time to learn. The Chronicle sets forth a chronology showing that Penn State’s Athletic Director Tim Curley and Senior Vice President of Finance and Business Gary Schultz each apparently had knowledge of incidents of sexual abuse by Mr. Sandusky since 1998:

In 1998, the mother of an 11-year-old boy reports to Penn State police, who ultimately reports to Mr. Schultz, that Mr. Sandusky touched the boy inappropriately in Penn State’s football locker rooms.
In 1999, Mr. Sandusky allegedly sexually assaulted a boy multiple times in the newly built Lasch football building.
In 2000, a Penn State janitor told his supervisor that he saw Mr. Sandusky performing oral sex on a boy in football locker room’s shower.
On March 2, 2002, a football graduate assistant advised Coach Paterno that the he saw Mr. Sandusky sexually assaulting a boy who appeared to be about 10 years old in the locker room’s shower. On March 3, 2002, Paterno informs his immediate supervisor, Mr. Curley, about the incident.
In 2008, the mother of a high school freshman reports to high school officials, who informed the police, that Mr. Sandusky had engaged in inappropriate sexual conduct with the boy on multiple occasions.

Pennsylvania’s child-abuse reporting statute mandates reporting to the Pennsylvania Department of Public Welfare when notified by any staff member of an incident of child abuse.

The result of the president’s statement despite the numerous incidents of abuse as well as the statute mandating reporting was significant damage to the university’s most valuable assets – its reputation. According to the Chronicle, in the days following the president’s statement, Penn State received “nonstop pounding in the national spotlight – the New York Time[s] alone had sent four reporters here while hundreds more reporters and cameras parachuted in.” Penn State’s Board of Trustees apparently first learned of the incident through the news media rather than the president.

The coach’s ill-advised attempt to bypass the Board’s authority

On November 9, 2011, Coach Paterno issued statement “announcing my retirement effective at the end of this season,” which is certainly within his right to do and to announce. However, it inappropriately attempted to bypass the Board’s authority by additionally stating:

“At this moment the Board of Trustees should not spend a single minute discussing my status. They have far more important matters to address. I want to make this as easy for them as I possibly can.”

The coach publicly challenged the authority of the Board.

The Board takes action

According to the Chronicle, by the time of Paterno’s announcement, Penn State’s Board “had had enough,” and it dismissed both President Spanier and Coach Paterno effective the evening of November 9, 2011.

The Chronicle cites an article by ESPN commentator, Howard Bryant, Penn State’s culture of “protecting the power” helped prevent “timely reporting the incidents to authorities and the adequate sequestration of Mr. Sandusky from Penn State facilities.” The power being the football program “which brings in more than $70-million a year.”

The Board has a duty of care to protect the university’s assets, the most valuable of which is its reputation. In so doing, the Board is to act in the best interest of the university as whole, and not in the interest of just its football program, its legendary coach, or its popular president. Accordingly, the Board fulfilled its duty by acting quickly and decisively.

The indictments were announced on November 4, the president’s ill-advised press release was also issued on November 4, the coach’s statement attempting to bypass the board was made the morning of November 9, and the Board discharged both the president and the coach during the evening of November 9. The Board made its dismissals without waiting for the results of any investigation or prosecutorial action. It did so through a single spokesperson, the Board’s vice chairman, who was flanked by his fellow Board members.

The Board then commenced its own investigation by appointing a special investigative committee headed by two independent trustees, Kenneth Frazier, CEO of pharmaceutical company, Merck & Co., and Ronald Tomalis, the Pennsylvania secretary of education. On November 21, 2011, the investigative committee announced that it “has engaged former FBI Director and federal judge Louis J. Freeh to lead an independent investigative review into all aspects of the university’s actions with regard to the allegations of child abuse,” and that Mr. Freeh’s “findings and recommendations . . . when completed will be made available to the public.”

An independent investigation by the Board will likely be more valuable to the survival of institution than any prosecutorial investigation if its subject includes the culture of the institution. A prosecutorial investigation will only impose criminal sanctions against those responsible for past actions or inactions. To emphasize that everything is subject to the investigation, Mr. Frazier, the special committee’s head, stated at the time of Mr. Freeh’s appointment:

“The entire Board of Trustees is intent on taking all steps necessary to ensure that our institution never again has to ask whether it did the right thing, or whether or not it could have done more. We are committed to leaving no stone unturned to get to the bottom of what happened, who knew what when, and what changes we must make to ensure this doesn’t happen again.”

The Board’s actions have been quick and decisive. It had to assume responsibility for preserving the reputation of the institution of the university. Time will tell whether these actions will be effective.

Investors and boards are split on separating the roles of board chair and CEO

Since the adoption of Sarbanes-Oxley in 2002, governance commentators, including organizations representing institutional investors, have urged separating the position of the CEO from that of the board chairperson. For example, one of the governance policies of the Council of Institutional Investors is that:

The board should be chaired by an independent director. The CEO and chair roles should only be combined in very limited circumstances; in these situations . . .

Institutional Shareholder Services (ISS) is advocating allowing shareholders to submit proposals for splitting the CEO and chairperson roles and appointing an independent director as chairperson after the current combined CEO/chairperson leaves his or her office. However, a policy survey issued by ISS in September 2011 finds that institutional investors and corporate issuers (principally board members) are diametrically split in whether “companies [should] commit themselves to an independent chair?” 70 percent of institutional investors answer “yes” while 73 percent of issuers and board members answered “no.”

Proponents of splitting the roles fear that the board cannot fulfill its obligations of overseeing the process of hiring, firing, evaluating, and compensating the CEO if the CEO also serves as the board’s chairperson. Although hiring, firing, evaluating and compensating the CEO is a board’s most important responsibility, it is probably best done by a committee of independent directors rather than the board as a whole. The reason for delegating to a committee is the importance of having consistency from meeting to meeting and from year to year. The reason for having the committee’s composition be of independent directors is to remove the direct influence of the CEO.

Opponents of splitting the roles cite additional costs of compensating two persons, one for the role of chairperson and another for the role of CEO without significantly reducing the amount of time the CEO must spend in educating and preparing board members on the organization’s business. A survey of financial institution directors by Harvard Business School after the 2008 collapse found that directors themselves may have suffered from not having a greater presence of CEOs and management in the board room to help boards understand the risks inherent with the business models and strategic direction of the institutions.

The American Bar Association in its Corporate Director’s Guidebook (5th edition) and the Business Roundtable in its Principles of Corporate Governance (November 2005) urge having the independent directors of a board designate one of themselves as a lead or presiding director to have access to the agenda, call for and preside at meetings in executive session, oversee the flow of information to board, and serve, where appropriate, as liaison between the board and the CEO. This is certainly a good practice for boards subject to the scrutiny of shareholders or regulators who have the right to change the direction of the board and for boards having more than eight or nine members.

A better practice for many boards, especially smaller boards that may feel awkward in appointing one of its members and a lead or presiding director, is to enfranchise each director with certain basic rights. These would include the rights to:

Have matters included on the agenda for consideration at any meeting of the board or any committee;
Create a committee of the board composed of members with appropriate independence and expertise, and otherwise cause any matter to be referred to that committee for its consideration;
Cause the board or any committee to meet in executive session of the outside or independent members and with or without legal counsel or other advisers deemed appropriate by those members; and
Cause recusal of any member from consideration by the board or any committee of any matter in which a member has a perceived conflict of interest, including excusing the member not only from speaking or being observed, but also from being able to hear or observe others, during consideration of the matter; waiving the member’s right to withhold approval of any statement in the minutes reflecting the consideration of the matter other than to reflect the member’s absence from the consideration and the member’s absence or abstention in any vote on the matter, and waiving the member’s right for reconsideration of the matter.

These rights could be either written into an organization’s existing bylaws or regulations or set forth in a separate “statement of directors’ rights.”

In any event, governance of any organization includes the culture of that organization. Accordingly, a best practice for one organization may not be a good practice for another. Changing a practice that changes culture generally requires two generations of directors: One to propose the change, and a successor to retain it.

Your basic obligations as a director of any organization

As a member of the board of directors of any organization, you have certain obligations to the organization and the rest of the board. In addition, each of your fellow directors has a right to expect that you and the other directors will respectively observe their director obligations.

The following are some of the basic obligations of a director of any organization. Each director should:

Observe the duty of loyalty to act in good faith, to the extent possible, in the best interests of the organization (1)

When that is not possible, you should disclose to the board any potentially conflicting interest that may adversely affect (2), or have the appearance of adversely affecting, your ability to make independent judgments as a director. You should excuse yourself from participating in consideration of any matter in which you may be perceived as having an interest opposed to the best interests of the organization, and if that opposing interest is with respect to a matter material to the organization and is likely to be ongoing, you should consider tendering your resignation.

Excusing yourself from participating in consideration of a matter generally means: You excuse yourself not only from speaking or being observed, but also from being able to hear or observe others, during consideration of the matter; you waive your right to withhold approval of any statement in the minutes reflecting the consideration of the matter other than to reflect your absence from the consideration and your absence or abstention in any vote on the matter; and you waive your right, discussed below, for reconsideration of the matter.

If a director with a conflicting interest with a matter does not so excuse himself or herself, any other director should have the right to move to refer the matter to a committee that does not include the conflicted director (3).

Abide by the principle that a board speaks with one voice

Your duty of care and loyalty as a director requires you to abide by the decision of a majority of the board at a meeting at which a quorum is present (4). This applies to all matters coming before the board for its consideration. The board speaks with one voice on all such matters, or not at all (4). Occasionally on matters where it is important to have a single message, the board will speak only through its chairperson or the chairperson’s designee.

If you disagree with a decision, your rights are to vote against that decision, to have your negative vote recorded in the minutes (5), and when and if appropriate, to request reconsideration of the decision (6). Because the board speaks with one voice, asking for reconsideration of a matter should be done sparingly. Reconsideration should not be requested when the matter has been executed, even partially, or something has been done that the organization cannot undo, or when party has received notice of the vote and has taken action in reliance upon it.

Unless otherwise determined by the board, the following procedures will be followed with respect to any request for reconsideration:

A request to reconsider can be made regardless of the time that has elapsed since the vote was taken (unless the matter has been executed, or something has been done that the organization cannot undo, or when party has received notice of the vote and has taken action in reliance upon it).

The request can be made by any director, including one who voted with the prevailing side, or one who voted with the losing side, or one who did not vote at all or was absent.

Unless the directors who vote with the prevailing side are present or have received notice that reconsideration will be moved, Roberts Rules of Order requires a two-thirds vote of directors at a meeting at which a quorum is present in order to adopt any motion to reconsider (7).

Generally, “what happens in a board room remains in the board room” unless you believe that your remaining silent will result in a material breach of fiduciary duty or violation of law.

Perform the duties and functions of a director with the care that an ordinarily prudent person in a like position would use under similar circumstances (8)

This is each director’s duty of care under general corporation law (8). Unless consideration of a matter is expressly delegated to a designated committee of the board, you have both (i) the obligation to, and (ii) the right of reliance that each other director will, exercise this degree of care with respect to each matter, and vice versa.

To the extent possible as a best practice, make available to the board and management the benefits of your knowledge, skills and experience

Acting with the care of an ordinarily prudent person is a minimum standard to avoid breaching your duty care. A better practice is for you to make available to the board and management the benefits of your knowledge, skills and experience. Mentorship is one of the major functions of board members. Mentorship is making available your knowledge, skills, and experience of having been there and having done it before (9).

Benefits of mentorship include: Expanding the board’s effectiveness as an “expertise” board making available for the benefit of the organization the collective knowledge, skills and experience of each of its members; making it less lonely at the top of management; providing coaching and fostering relationships between board members and management; and making board members and management each accessible to the other.

Observe the expectation and right of reliance

The foremost principle of corporate governance is that the board and its committees are expected, and Ohio law gives the board and its committees the right, to rely upon:

Officers or employees as to matters for which the director reasonably believes they are reliable and competent;
Professionals such as lawyers or accountants as to matters that the director reasonably believes are within the person's professional competence; and
Duly established committees of directors for matters within their designated authority, which the director reasonably believes to merit confidence (10).

The concept is that the organization is managed “under the direction” of the board (11), and the most important responsibility of the board is to select management, including at least a chief executive officer, whom the board believes is reliable and competent in managing the organization.

A developing principle of corporate governance is that directors who believe that they do not have available to them the expertise to consider a matter have the right for the organization to provide to the board professionals or other consultants having such expertise.

Assure that outside or independent directors have basic rights

Outside or independent directors are not only the first and best line of defense against corporate mismanagement and fraud, but also the best source of best practices for good governance. Therefore, all directors should assure that outside or independent directors have at least the following basic rights under applicable corporate governing documents, including to:

Have matters included on the agenda for consideration at any meeting of the board or any committee;

Create a committee of the board composed of members with appropriate independence and expertise, and otherwise cause any matter to be referred to that committee for its consideration;
Cause the board or any committee to meet in executive session of the outside or independent members and with or without legal counsel or other advisers deemed appropriate by those member; and
Cause recusal of any member from consideration by the board or any committee of any matter in which a member has a perceived conflict of interest, including excusing the member not only from speaking or being observed, but also from being able to hear or observe others, during consideration of the matter; waiving the member’s right to withhold approval of any statement in the minutes reflecting the consideration of the matter other than to reflect the member’s absence from the consideration and the member’s absence or abstention in any vote on the matter, and waiving the member’s right for reconsideration of the matter.

Endnotes

The following endnote are intended as an integral part of this article providing additional guidance to anyone who serves as a director:

Duty of loyalty. The duty of loyalty in Ohio is a statutory duty requiring each director to perform the duties of a director “in good faith, in a manner the director reasonably believes to be in or not opposed to the best interests of the corporation.” A director is given a range in his or her statutory duty of loyalty: i.e., to act in, or not opposed to, the best interests of the corporation. An officer does not have that statutory range, but must act in good faith, in a manner he or she reasonably believes to be in the best interests of the corporation. The reason for this is that corporate law recognizes that directors, especially independent directors, may have different affiliations and, therefore, different loyalties.
Disclosure of conflicting interests. Disclosure of conflicting personal or economic interests is a statutory responsibility of each director to other directors. Under Ohio law, a contract, transaction or other action authorized by a board may be void or voidable if a director has a personal or economic interest in the matter. Ohio law requires procedurally that the conflicted director’s relationship or interest be disclosed to, or otherwise be known by, the rest of the directors and that contract, transaction or other action be authorized by the affirmative vote of a majority of the disinterested directors. If a quorum is present including any interested directors, then the affirmative vote of the disinterested directors is valid to authorize the matter even though the disinterested directors themselves may constitute less than a quorum. If the conflicting personal or economic interest is not disclosed to or known by the other directors, or if there are no disinterested directors to authorize the matter in which there is a conflict, then the board is held to a greater scrutiny in that the transaction must be found as fair to the corporation at the time it is approved.
Right to refer to a committee. Each director generally has the right to move to have any matter laid before a committee of the board unless the governing documents otherwise provide.
Only voice is an act of a majority. Under Ohio law, “the act of a majority of the directors present at a meeting at which a quorum is present is the act of the board, unless the act of a greater number is required by the articles, the regulations, or the bylaws.” Because the act of a majority of the directors present at a meeting at which a quorum is present is the act of the board, there can be only one voice – that of a majority. If there is no majority, there is no voice.
Right to record negative vote, abstention or absence. A director’s right to have his or her negative vote or abstention or absence in consideration of a matter is an American modification of Robert’s Rules of Order. Courts generally require organizations to record such a vote, abstention or absence when timely requested by the director. Timely requested generally means at the time the vote is taken or before the board moves to consideration of the next matter. As a courtesy, many boards will allow the request to be made and honor if done before approval of the minutes of the proceeding.
Reconsideration of a matter. Reconsideration of a matter is an American adaption of the right of a member of a standing committee, such as a board of directors, to move to repeal and amend a prior action taken by the committee or board under Robert’s Rules of Order (10th edition). The traditional interpretation of Robert’s Rules based upon parliamentary law is that there must be two motions, one to repeal and then a second moving adoption resolution stating the desired action. This two-step procedure is considered cumbersome for boards that are not assemblies of a large number of members.
Procedures for reconsideration. Roberts Rules of Order (10th edition) provides an American adaptation of reconsideration differing from traditional repeal and amendment of Parliamentary law in the following respects: (1) A motion to reconsider a vote can be made and taken up regardless of the time that has elapsed since the vote was taken, and there is no limit to the number of times a question can be reconsidered; (2) the motion can be made by any member who did not vote with the losing side; or, in other words, the maker of the motion to reconsider can be one who voted with the prevailing side, or one who did not vote at all, or even was absent and (3) unless all the members who voted with the prevailing side are present or have been notified that the reconsideration will be moved, it requires a two-thirds vote to adopt the motion to reconsider. For better governance, most boards allow any director, regardless of whether or how he or she voted, to request reconsideration.
Duty of care. The duty of care in Ohio is a statutory duty requiring each director to perform the duties of a director “with the care that an ordinarily prudent person in a like position would use under similar circumstances.” Because this duty is a minimum standard that each director must achieve to avoid liability, directors should consider better practices.
Function of directors. The function of the board is to provide "direction"11 to management through: (1) Decision making as to matters of policy, direction, strategy and governance; (2) oversight as to matters of policy, direction, strategy and governance; and (3) Mentorship of the CEO and senior management.
Expectation and right of reliance. Ohio law contemplates that directors will consist of those from outside the organization. Under Ohio law, directors have a range in their duty of care from acting “in” the best interests of the organization on one end, to acting “not opposed to” the best interests of the organization on the other end. As discussed note 1 above, an officer does not have that statutory range, but must act in good faith, in a manner he or she reasonably believes to be in the best interests of the corporation.
Under direction of the board. Ohio law as well as the law of other states provides that all of the authority of a corporation shall be exercised by or under the direction of its directors. The regulations or bylaws of most corporations other than those closely held provide for this authority to be exercised “under the director of the board.”