What Departing: Directors Need to Know

By Wilson, Steve | Risk Management, January-February 2009 | Go to article overview

What Departing: Directors Need to Know


Wilson, Steve, Risk Management


The Sarbanes-Oxley Act of 2002 is the most significant piece of federal securities legislation to impact directors and officers of public companies in the last 50 years. The basic intent of the legislation was to instill a stronger framework for corporate governance, enhance accounting oversight and rebuild investor confidence. This piece of legislation, read in its entirety, is lengthy and complex. An often overlooked section of the Act is Section 804 of Title VIII--Corporate and Criminal Fraud Accountability. Simply stated, Section 804 extends the statute of limitations for securities fraud to five years. In other words, directors and officers can be held personally liable for acts of securities fraud for up to five years after the acts were allegedly committed. This extension of personal liability is cause for concern, particularly for directors and officers who have retired or resigned from the company.

Unfortunately, the protection typically afforded former directors and officers through traditional D&O insurance and corporate indemnity is not designed to cover the long-term exposure imposed under Sarbanes-Oxley, nor can that protection be guaranteed. As a result, it is important that directors and officers fully understand their exposure and how it changes when they retire or resign. Here are four questions every director or officer should ask before leaving a company:

1. Can the company guarantee that it can and will indemnify you for the next five years?

* Indemnification requires a determination. By statute, a director or officer can only be indemnified if disinterested directors, independent legal counsel or a court determines that the director's or officer's conduct meets a statutory standard (e.g., acted in good faith and in the belief the conduct was in the company's best interest). New directors may be disinclined to make that determination in favor of former directors, particularly after a takeover.

* Financial ability to indemnify. A company's financial ability to indemnify a director's or officer's losses is determined when the director or officer incurs the defense costs or settles the claim, which could be many years after leaving the company. A financially strong company today can look far different in five to eight years if an unforeseen risk dramatically changes the company's financial condition.

* Legal ability to indemnify. Federal and state laws prohibit a company from indemnifying directors or officers for certain types of losses, such as settlements in shareholder derivative suits and actual violations of federal securities laws. Recent court decisions have required personal contributions from directors and officers without the indemnification of the corporation even when indemnification was available.

* Indemnification provisions can change. Absent special protections, a company has the right to retroactively change or eliminate its indemnification provisions at anytime. In a March 2008 ruling, the Delaware Chancery Court enforced an amendment to a company's indemnification provision that excluded advancement of defense costs for former directors.

2. Can the company guarantee the limits, terms and conditions of its D&O insurance for the next five years?

D&O insurance is "claims-made" coverage, so future claims against retired directors and officers will be covered (if at all) only under the D&O insurance policies in force at the time of the future claim. The company may not be willing or able to maintain the same level or quality of coverage for the next five years for a variety of reasons:

* No guarantee of renewal. There is no guarantee that your company will continue to renew coverage for the next five years.

* Change in terms and conditions. The terms and conditions of D&O policies can change annually. If the company's risk profile or financial condition changes, it may not be able to purchase the same limits or terms and conditions that exist today. …

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