Complete Guide to D&O Insurance

FRENCH PREMIER GEORGES Clemenceau famously said that "war is too important to be left to the generals." It is particularly apt with respect to Directors and Officers (D&O) insurance and corporate indemnification: They are far too important to be left entirely to management. Boards should be concerned with D&O insurance and corporate indemnification because they both protect directors' personal assets and contribute to good corporate governance in meaningful ways.

A properly structured and implemented D&O insurance and corporate indemnification program serves the same purpose as the business judgment rule but in some ways more broadly.

As the Delaware Supreme Court has noted, "the business judgment rule exists to protect and promote the full and free exercise of the managerial power granted to Delaware directors."¹ The rule is justified "as being necessary to protect 'directors and officers from the risks inherent in hindsight reviews of their business judgment' and [to] avoid 'the risk of stifling innovation and venturesome business activity.'"² As a corporate governance mechanism, the business judgment rule promotes decision- making in a manner that optimizes high returns to shareholders. Typically, risk and return are directly proportional. The business judgment rule frees directors to choose risky projects— the ones most likely to yield high returns—without fear that their choice will lead to personal liability.

So, too, a properly structured D&O insurance and corporate indemnification program frees directors and officers to do their jobs without significant risk of personal liability. In some ways, such a program provides broader protection to corporate decision-makers. Unlike the business judgment rule, D&O insurance and corporate indemnification insulates directors and officers not only from duty of care litigation, but also some of the more nettlesome aspects of duty of loyalty litigation, securities fraud litigation, and Securities and Exchange Commission (SEC) and Department of Justice (DOJ) investigations.

What to protect against

The key to properly structuring a D&O insurance and corporate indemnification program is recognizing the activities that pose the greatest threat of liability to directors and officers. There are four: (1) securities fraud class action lawsuits, (2) derivative actions for breaches of a director's or officer's duty of care or loyalty to the corporation, (3) SEC investigations, and (4) DOJ investigations and indictments.

Securities Fraud Class Actions
Typically, securities fraud class actions pose the greatest potential danger of monetary liability to directors and officers.

These cases are generally brought by a sophisticated plaintiff's bar (see cover story this issue, "Risky Business") and many follow a similar pattern. A company learns of mistakes or misrepresentations in its financial disclosures to investors and announces that it intends to restate those financial disclosures. The company's stock price drops significantly as a result of the announcement. Shortly after, numerous lawsuits are filed against the company and its directors and officers by investors represented by major plaintiff securities class action law firms.

Derivative Actions Shareholders can bring derivative actions— those actions brought on behalf of the corporation—against directors and officers whom shareholders allege to have breached their fiduciary duties to the corporation.

There are a number of procedural and substantive hurdles involved in bringing such lawsuits, but they appear to be on the rise, particularly given the recent stock option backdating cases.

Derivative actions pose the greatest danger to directors and officers who have engaged in any type of self-dealing behavior— that is, behavior contravening their duty of loyalty to the corporation. Stock-option backdating potentially falls within this category.

It is much more difficult for shareholders of most corporations to bring a claim for breach of a director's duty of care. Most corporations have a certificate of incorporation that absolves or exculpates directors for monetary liability for all but the most egregious breaches of the duty of care.