When individuals serve on a board or are hired as officers (senior management), they are exposed to personal liabilities under the law. In other words, they run the risk of being personally sued. What are the legal responsibilities of directors and officers? And how does directors and officers liability insurance offer protection to directors and officers?
What is Directors and Officers liability insurance?
Directors and Officers liability insurance (“D&O insurance”) is a liability insurance policy designed to protect corporate directors and senior management against personal financial loss from business-related lawsuits. In some situations, the corporation may indemnify the directors and officers against these liabilities. If the corporation indemnifies the directors and officers, then the corporation would take a hit on their balance sheet. In these situations, the D&O insurance reimburses the corporation for indemnifying the directors. However, in other cases, the corporation may be financially unable to defend the directors or legally not allowed to do it, leaving the directors exposed. In this situation, the D&O insurance policy continues to protect the directors and officers by indemnifying them directly. A claim on a D&O insurance policy would pay the losses associated with lawsuits, for example, defence costs, settlements, or even fines, which are often substantial.
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 do directors and officers need insurance?
When individuals serve on a board or are hired as officers (senior management), they are required to perform specific duties in their roles with the organization. If they fail to fulfill those duties or allegedly fail to meet those duties, they may be personally sued. Without D&O insurance or other indemnification in place, they would be personally on the hook for defence costs, settlements, or even fines.
The question then is, what are those duties—and sued by whom?
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.
Here are some other common claims against directors and officers:
- Errors or omissions in management
- Negligence related suits
- Breach of duties
Rules governing directors and officers
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.
Which statutes 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 data protection act, the General Data Protection Regulation. For corporations listed on a securities exchange there is also the securities commission.
Legal duties of directors and officers
As you can see, many rules govern directors and officers. The principal legal responsibilities of directors and officers include the duty to manage, fiduciary duty, and duty of care. These requirements are dictated by provincial, state, and federal business corporation laws.
Duty to manage
Directors and officers have to manage and supervise the management of the business and affairs of the corporation.
Directors and officers have a legal duty to act honestly and in good faith, acting in the best interests of the corporation. Acting in the best interests of the corporation sounds like a simple task. However, this is not always the case.
Duty of care
Directors and officers must exercise care and diligence in their management of the corporation. This 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.
In our previous example, maybe the daughter-in-law was, in fact, prepared to take on the role and had all the qualifications that made her an ideal candidate. And perhaps it was economic factors that ultimately caused the decline in performance. Even if the claim was false, the directors would still have to defend the allegations of fiduciary duty and duty of care.
What can go wrong?
When directors and officers breach their duties or fail to perform their functions, they may be subject to legal action. Any stakeholder with a business relationship with the corporation, including shareholders, employees, customers, regulatory bodies, vendors, or even competitors may bring a suit against the directors and officers. 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, and is illustrated in the example above.
What’s important to remember is that mistakes happen, and mistakes have consequences. And even when you haven’t made mistakes, you still need to defend against allegations of mistakes or misconduct , which can be very costly. Without a D&O policy or another indemnity mechanism in place, directors and officers would have to pay their own defence, 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 also be subject to other statutes, for example under environmental law, employment law, or even taxation law.
D&O claim example
Here’s a claim scenario showing where and how things can go wrong for directors:
When individuals serve on a board or are hired as officers (senior management), they are exposed to personal liabilities under the law. In other words, they run the risk of being personally sued. Without D&O insurance or other indemnification, they would be personally on the hook for defence costs, settlements, or even fines.
Read all about: Directors & Officers Liability Insurance
Delve into: D&O policy structure and see examples of Side A, Side B and Side C insuring agreements.
Read an article: that reviews the structure of a D&O policy and provides examples for each of the different insuring agreements: Side A, Side B and Side C.