Directors and Officers liability insurance (“D&O insurance”) is an insurance policy designed to protect corporate directors and senior management against business-related lawsuits.
When individuals serve on a board or are hired as officers (senior management), they are exposed to personal liabilities under the law. Meaning they run the risk of being personally sued. Without D&O insurance or other indemnification, they would be personally on the hook for defense costs, settlements, or even fines.
In some situations, the corporation may indemnify the directors and officers against these liabilities. In these situations, the D&O insurance would reimburse the corporation for indemnifying the directors. However, in other cases, the corporation may be financially unable to afford to defend the directors or legally not allowed to do it, leaving the directors exposed.
A D&O policy is a wise purchase for the directors and officers’ protection, or to protect the corporation’s balance sheet when the corporation indemnifies the directors.
Why is D&O insurance important?
Directors and officers are required to perform specific duties in their roles as management members of the organization. If the directors or officers fail to fulfill those duties or allegedly fail to meet those duties, they may be personally sued. If the corporation indemnifies the directors, then the corporation would take a hit on their balance sheet. A claim on a D&O insurance policy would pay the losses associated with lawsuits, for example, defense costs, settlements, or even fines, which are often substantial.
The question is, then, what are those duties—and sued by whom?
Here’s an example.
A small private company promoted an employee to the role of CEO. The employee happened to be the daughter-in-law of the chairman of the board. The performance of the company declined over the next few years under the new leadership. At the request of a shareholder, the corporation sued the board of directors for breach of fiduciary duty and duty to manage. The allegations were that the board was careless in overseeing the appointment of the CEO, and that the chairman acted in the best interest of his family, rather than the corporation.
Other common claims against directors and officers include:
-Wrongful acts such as error or omission in management
-Negligence related suits
-Breach of duties
Different rules govern the duties and responsibilities of directors and officers. Examples of these rules include corporate bylaws, provincial, state, and federal corporation laws and regulations. These rules apply to non-profit and for-profit, as well as private and public companies.
The statutes that apply to an organization depend on where the organization is registered and where they do business.
In Canada, for example, we have the Canada Business Corporations Act. A Delaware registered corporation would be subject to the Delaware General Corporation Law.
In terms of regulators, consider Europe’s new data protection act, the General Data Protection Regulation. Another example would be securities commissions for corporations listed on a security exchange.
As you can see, many rules govern directors. Worth mentioning is the duty to manage, fiduciary duty, and duty of care. These are the principal legal responsibilities of directors, which are enacted by business corporation laws of provincial, state, and federal governments. These duties state that directors and officers have a legal duty to act honestly and in good faith, acting in the best interests of the corporation. They also have to exercise care and diligence in managing and supervising the business and affairs of the corporation.
Acting in the best interests of the corporation sounds like a simple task. However, this is not always the case. In our previous example, perhaps the daughter-in-law was, in fact, prepared to take on the role and had all the qualifications that made her an ideal candidate. Perhaps the decline in performance was ultimately caused by economic factors. Even if false, the directors would still have to defend the allegations of fiduciary duty and duty of care.
Duty of care is measured by what a reasonably prudent person would have done. So even when a director acts carefully, his/her actions may fall short against how a reasonably prudent person would have done in a similar situation.
When directors and officers breach their duties or fail to perform their functions, legal action can be brought against them by different parties. The suit may be brought forward by any stakeholder with a business relationship with the corporation, including shareholders, employees, customers, regulatory bodies, vendors, or even competitors. The corporation itself may sue – well, not really because a company can’t file an action. However, shareholders can step in the shoes of the corporation and sue the directors. This is called a derivative suit, as illustrated in the example above.
What’s important to remember is that mistakes happen, and mistakes have consequences. And even when mistakes haven’t occurred, allegations of mistakes or misconduct have to be defended, which can be very costly. Without a D&O policy or another indemnity mechanism in place, directors and officers would have to pay to defend themselves, settlements, or even fines out of their own pocket.
Aside from the duty to manage, the duty of care and fiduciary duty under corporate law, directors may be subject to other statutes under environmental law, employment law, or even taxation law.
Here’s a claim scenario, on where and how things can go wrong for directors:
In the next article, we will review the structure of a D&O policy, and provide examples for the different insuring agreements: Side A, Side B and Side C.