While serving on a board of directors can be at times prestigious and rewarding, board service is not without potential pitfalls: unanticipated demands on your time; fractious, intractable colleagues; and the possibility – or rather, the likelihood – that you may be named as a defendant in a lawsuit filed by a company shareholder, competitor, or acquisition target. In today’s litigious climate, these suits are an all-too-common occurrence, and if mismanaged, the financial and reputational consequences can be severe. It is important that directors facing allegations of wrongdoing fight the understandable urge to panic and concentrate instead on formulating a considered and appropriate response, which often begins before the litigation is even filed.
Preventative Measures
Directors need not, and should not, wait until they are served with a complaint to take steps to mitigate the potential consequences of lawsuits. At a minimum, directors should work with in-house counsel to ensure that corporate matters that are likely to generate litigation, such as mergers and divestitures, or the sale of stock by corporate insiders, are conducted in a way that limits the ability of potential plaintiffs to assert credible claims. By expressing their views – setting the “tone at the top” – directors can make it known that litigation prevention is an important corporate goal that will, in the long run, save the company expense and reputational damage.
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Directors should also be advised of the status of the liability insurance (often referred to as a D&O policy) purchased for their benefit and ensure state-of-the-art coverage for the directors is secured. Directors should, at a minimum, insist that their company purchase insurance that provides them with direct coverage for any losses they incur as a result of litigation.
Directors should also review their company’s charter and corporate bylaws to ensure that the provisions providing for the indemnification and advancement of legal fees are sufficiently robust. In particular, directors should satisfy themselves that the company’s indemnification and advancement provisions are broad and mandatory (to the extent allowed by the law of the state in which their company is incorporated) rather than narrow and permissive: i.e., that they require the company to cover directors’ litigation expenses in the widest possible range of circumstances and from an early stage of the suit. This will minimize, and in many cases eliminate, the financial burden directors may otherwise need to bear if they are sued personally.
When the Lawsuit is Served
The first step directors should take upon finding out that they have been sued is a basic one: notify the appropriate parties. Directors should notify senior management at their company, including the company’s General Counsel, so that the company can begin planning its response to the lawsuit and make any public disclosure it is required to make. In order to invoke D&O insurance coverage, the directors should ensure that the insurance carrier is notified promptly. It is also important to know whom not to tell: directors should refrain from discussing the suit itself or the claims at issue with anyone other than their counsel. Barring exceptional circumstances, any conversations with non-lawyers about the litigation will not be protected by the attorney-client privilege. Venting to friends or colleagues about the underlying facts can potentially create witnesses who may ultimately be called to testify about the conversation.
A few other basic steps are also in order. First, directors should ask for a detailed memo outlining the pertinent provisions of the applicable D&O insurance and indemnification policies – although directors should already be generally familiar with their terms. Second, directors, working with company counsel, should ensure that they and the company preserve all documents (including emails) that relate to issues raised in the lawsuit (including copies of documents that they possess personally). Third, depending on the nature of the lawsuit, directors should consider informing any other companies on whose boards they sit. These companies may also need to disclose the lawsuit publicly.
Obtaining Counsel
The directors’ next task is to obtain appropriate legal representation. In most instances, directors will not need to retain counsel independent of the company. The company’s outside counsel will be able to represent both the directors and the company, so long as this dual representation does not create a conflict of interest. However, when there is such a conflict – such as when the case is brought derivatively on the company’s behalf against the directors – separate counsel may be necessary. If that occurs, the company can assist or even spearhead the directors’ search for their own independent counsel, but directors can and should suggest potential candidates and participate actively in the process, including reviewing the backgrounds of potential candidates and participating in interviews.
It will often be in a director’s best interest to share representation (and therefore conserve corporate resources) with other director (or officer) defendants, but this depends on the role the director played in the events that gave rise to the litigation and whether the director has defenses that are unique or unavailable to co-defendants. For example, the director may not have attended the board meeting at which the challenged conduct took place, or a co-director may be accused of having a unique pecuniary interest in the challenged conduct; in such circumstances, it might be in the director’s interest to distance herself from those directors who were at that meeting or are benefiting from the conduct. Because lawyers cannot pursue a defense strategy on behalf of one client that implicates another client, directors facing such a situation should think seriously about securing independent representation for themselves or for a similarly situated group of defendants.
Assessing the Claims
Directors should also make sure that they thoroughly understand the nature of the claims so that they can respond to them appropriately. The most common form of claim filed against a director is a suit by a shareholder, and such claims fall into one of two broad categories. Either they are “direct” claims, brought by a group of shareholders who allege that director misconduct has injured them uniquely; or they are “derivative” claims, as mentioned above, such as a claim that directors have wasted or misappropriated corporate assets and thus harmed the company itself. Certain kinds of alleged wrongdoing often generate both direct and derivative lawsuits (such as at companies alleged to have improperly back-dated stock options). Shareholders, however, do not determine whether a particular claim is direct or derivative. This question is objective, fact-sensitive, and governed by state law.
A fundamental precept of corporate law is that the decision whether to pursue derivative litigation on behalf of a company is a business judgment belonging to the board. This has created a unique set of legal rules and responsibilities for directors. For example, where the claims at issue are derivative, directors may need to investigate and then decide whether the company should pursue the case, or where certain directors may lack independence, directors may need to create a special committee to make this determination. In this situation, the directors as a whole or the special committee will need independent counsel to guide them through this process.
Stay Involved
Regardless of the type of claim alleged, directors should remain personally involved in the litigation. Directors should not wait passively for infrequent or ad hoc updates on litigation strategy and factual development. Rather, directors should stay abreast of the progress of the litigation and receive regular updates from counsel to ensure that the claims are being dealt with in a way that is measured, minimally disruptive, and most likely to achieve a successful result.
Douglas H. Flaum and David Hennes are litigation partners in Fried, Frank, Harris, Shriver & Jacobson LLP’s New York office. Zachary Hall, a litigation associate, also contributed to this article.