Summary: Adopting and implementing an effective D&O risk management program can substantially reduce the corporation's exposure to loss as well as the personal liability of its directors and officers. Also, by identifying potential risks and by taking measures to control those risks, corporate directors and officers better ensure the survival and growth of the organization.

As previously discussed, corporate directors and officers can be held personally accountable for their actions by a wide array of potential claimants, including the corporation they have chosen to serve. Certain federal statutes, especially those that deal with securities violations, may even hold directors and officers liable in instances where decisions and actions were undertaken in good faith and in the belief that they had acted in the best interests of the corporation. While the potential for personal liability might appear to outweigh the personal benefits of acting in the capacity of a corporate director or officer, protection is generally available for personal liability except for the most egregious forms of misconduct.

Topics covered:
Corporate Indemnification of Directors and Officers
Exclusive versus Nonexclusive Indemnification
Mandatory versus Permissive Indemnification
Expansion of Corporate Indemnification Provisions
Legislative Reform
Business Judgment Rule Expanded to Include Considerations of Outsider Interests
Insurance and Other Risk-Financing Techniques
Alternate Indemnification-Funding Methods
Insurance
Stand Alone Side-A Insurance Policies
Risk Retention
Amount of Risk Retention
Not-For-Profit Organizations

State corporate-indemnification laws, legislative reform, and D&O liability insurance and other risk-financing techniques can combine to provide what has been referred to as a “three-legged stool of protection,” as depicted in the following illustration as provided in Veasey, Finkelstein, Bigler, “Delaware Supports Directors With a Three-Legged Stool of Limited Liability, Indemnification, and Insurance,” 42 Business Lawyer 399-42.

Corporate Indemnification of Directors and Officers

Public policy dictates that directors and officers should not be able to immunize themselves completely from personal liability. However, they should be entitled to indemnification by the corporation if they can establish that they acted in good faith and in the best interests of the corporation. Corporation laws of all states, except for cases involving certain flagrant conduct, grant authority for the corporation to indemnify its directors and officers for liability and expenses they might incur in the discharge of their duties to the corporation. The purpose of such laws generally has been to provide an inducement to attract competent people to serve as corporate directors and officers by limiting their exposure to personal liability.

For many years most states have authorized indemnification of directors, officers, and other persons in an effort to alleviate the potential financial burdens of personal liability for alleged and actual wrongdoing. The extent to which corporations are permitted to advance costs incurred in defense of a claim or lawsuit, and to reimburse or hold harmless a director or officer against actions that result from their performance as directors or officers, is established by state law, by corporate charter or bylaw, and by contract.

Exclusive versus Nonexclusive Indemnification

State laws sometimes prohibit the indemnification of directors and officers beyond the indemnification allowable by statute. In such cases the law is considered to be exclusive. Most state statutes, however, are nonexclusive, allowing a broad range of indemnification beyond that which the state specifically requires or allows.

The indemnification laws of some states, such as Delaware, permit indemnification of directors, officers, employees, and agents of the corporation not only for legal and miscellaneous expenses, but also for judgments and settlements of civil third-party actions. For example, the Delaware statute requires that the person or persons subject to such indemnification must have acted in good faith and have reasonably believed that his or her actions were in the best interests of the corporation. When fines are involved, such as in criminal cases, the standard of conduct may further require that the director or officer had no reason to believe such conduct was illegal.

Mandatory versus Permissive Indemnification

Statutes may provide that indemnification of directors and officers is mandatory or permissive. Mandatory indemnification, as stated in the revised Model Business Corporation Act, provides for indemnification of expenses where the directors and officers have been successful in defending allegations of wrongdoing:

Unless limited by its articles of incorporation a corporation shall indemnify a director who was wholly successful, on the merits or otherwise, in the defense of any proceeding to which he was a party because he is or was a director of the corporation against reasonable expenses incurred by him in connection with the proceeding. [REVISED MODEL BUSINESS CORPORATION ACT § 8.52 (85)]

Permissive indemnification statutes deal primarily with the extent to which the corporation can provide indemnification when the directors and officers have been unsuccessful in defending derivative actions. The law in many states specifically precludes the corporation from indemnifying its directors and officers if they have been found to be liable to the corporation. However, indemnification of expenses and attorneys' fees is allowable if the directors and officers have successfully defended a derivative action. Most states allow indemnification beyond what is allowed by law through charter, bylaw, or separate contract. Where such extrastatutory benefits are allowed, they are often conditioned on specific standards of conduct.

Even when the law is exclusive or provides only for limited indemnification beyond statute, the courts in almost all states can order indemnification of expenses and settlements where the corporation would not otherwise have the power or discretion to indemnify.

Expansion of Corporate Indemnification Provisions

Even states with the most limited indemnification statutes now require that the corporation indemnify its directors or officers when they have been successful in defending themselves against shareholder-derivative-action claims. Some jurisdictions have expanded the extent to which the corporation is allowed to indemnify to include judgments and settlements where defense of such actions has not been successful. At least one state has adopted a position requiring that the corporation indemnify for judgments and settlements in derivative actions except in situations involving willful misconduct, improper personal profit, and other specified offenses.

Legislative Reform

During the 1980s a number of forces acted to limit the availability, and in many instances the affordability, of D&O insurance. There have been many theories as to the specific nature of these forces, but most authorities concur, at least in part, that a severe contraction in the global reinsurance market, an increase in merger and acquisition activities, and an increase in business failures made the problems of providing adequate insurance protection particularly acute. Out of this crisis emerged new legislation that attempted to further enhance the already liberal protection provided directors and officers. The ensuing state legislative response was quite broad and often included the following statutory provisions:

•Many states adopted statutes that further limited liability for directors and officers in specific situations.

•Indemnification provisions were expanded to include reimbursement of judgments and settlements in shareholder derivative actions.

•The criteria directors and officers use in their business judgment was expanded to allow consideration of nonshareholder interests.

Most state statutes hold directors responsible for the duty of care and the exercise of informed business judgment. This means that directors are to avail themselves of all information reasonably available and, in so doing, to act with care in the discharge of their duties. On July 1, 1986, the state of Delaware adopted legislation authorizing corporations to limit, and in some cases eliminate, through the use of a shareholder-approved charter amendment, a director's personal liability for money damages based on breaches of the duty of care, including gross negligence. This charter option allowed the certificate of incorporation to be amended to contain the following.