May 5, 2014

Once the directors' and officers' risks of loss have been identified, existing corporate policies and procedures should be evaluated to determine the extent of protection afforded against those risks. If necessary, changes in governing policies and procedures should be made to eliminate or reduce remaining risks.

A brief discussion of several areas where D&O risk management practices should be applied is provided in this article. Also included are specific recommendations for reducing or eliminating certain D&O liability exposures. At the end of the discussion, a checklist is provided that the reader may find useful in evaluating the corporation's current D&O risk management efforts and designing

a more effective risk management program.

Managing Corporate Risk Management Policies and Procedures

Many D&O claims arise out of ignorance. This problem may be the result of inappropriate or outdated company policies and procedures or from those policies and procedures not being properly communicated to the board of directors. Because the board of directors has the ultimate responsibility for protecting the corporation's assets and managing its financial resources, it must ensure the corporation establishes a coherent risk management program along with clear guidelines for its implementation.

Clearly written policies and procedures should be available for the purpose of resolving problems quickly. Even if a formal corporate policy manual exists, the contents of the manual must be periodically evaluated, revised and communicated to those who may be held liable for violations of those policies or procedures.

The risk management policies and procedures that the directors and officers must be knowledgeable about include the following:

∙Corporate charter and bylaw provisions

∙Channels of communication between the board and top management

∙The corporation's method of identifying risks and the systems in place to manage those risks

∙Corporate provisions for indemnification of directors and officers

Guidelines and procedures as respects selection, education, duties and monitoring of directors

∙Existing systems for the control of management information and records retention

∙Coverage provided by directors and officers liability insurance

Compliance with Corporate Charter and Bylaw Provisions

All corporations, whether for-profit or not-for-profit, are governed by the statutes of the state of incorporation, as well as the organization's own charter and bylaws. Black's Law Dictionary (6th Ed., 1991) defines “Charter” as “an instrument emanating from the sovereign power…to a corporation…assuring to them certain rights.” A charter is an act of a legislature creating a business corporation, or creating and defining the franchise of a corporation and is usually granted the state secretary of state. In most states, corporations have the authority to formulate reasonable rules and regulations to govern its actions and affairs, so long as those rules and regulations do not conflict with state or federal laws or the company's articles of incorporation. According to Black's Law Dictionary (ibid), the articles of incorporation contain information prescribed in the state's general incorporation statutes and serve as the basis for the state's issuance of a certificate of incorporation. While the specifics contained in the articles of incorporation can vary from state to state, they usually include a general description of the corporation, the corporate name, intended duration of the corporation, the purpose for which the corporation was formed, powers of the corporation, classes and authorized number of shares of stock, the number and term of founding board members, and other conditions of the company's operation.

A corporation's bylaws are the rules and regulations that are adopted by a corporation for its internal governance. The following are common bylaw provisions:

∙Defining the rights and obligations of various officers, persons or groups within the corporate structure, including fiduciary responsibilities;

∙Describing officer positions and how officers are selected or elected;

Requiring the establishment of certain committees;

∙Setting forth the times and locations for various meetings affecting corporate activities, including regular board and shareholder meetings and quorum requirements;

∙Guidelines and procedures for indemnification of directors and officers;

∙The nature of business to be discussed at board meetings;

Voting and proxy provisions;

∙Procedures for filling board vacancies, resignation and removal of board members; and

∙The nature of the corporation's books and records, including how such records are to be prepared and maintained and who is responsible for preparation and maintenance.

Nonprofit corporations, while usually subject to many of the same general requirements as for-profit corporations, also may be subject to additional or different laws and regulations that govern the operations of the organization and the conduct of its board of directors.

It is the board's responsibility to ensure the company complies with the corporation's charter and bylaw provisions and that appropriate systems are in place to maintain that compliance.

Corporate Indemnification

Directors should be fully aware of, and understand, the nature and extent of any corporate indemnification that may potentially be available. The promise of indemnity can exist in the form of charter provision, a separate agreement with the corporation, or an adopted bylaw.

The laws of the state of incorporation should be reviewed carefully to determine what, if any, affirmative action is required of the board of directors or shareholders in order to implement a limitation of liability, including indemnification of the directors and officers. If corporate action is required to obtain a statutory immunity from personal liability, directors should make sure the corporation takes the necessary steps. Where shareholder approval is required in order to adopt liability limiting provisions, a full disclosure must be made to the shareholders as to the effects of adopting such provisions.

Comprehensive indemnification provisions may

∙Require, rather than permit the corporation to indemnify its directors and officers;

∙Require the advancement of legal defense costs, subject only to an unsecured obligation to repay the expenses if a court subsequently determines the indemnification was not permitted;

∙Require the corporation to prove that the director or officer is not entitled to the requested indemnification;

∙Require the corporation to reimburse the director and officer for any expenses incurred in a claim against the corporation for such indemnification if the director or officer is successful in whole or in part;

∙Give the director or officer the right to an appeal as to indemnification entitlement;

∙State that the indemnification right constitutes a contract, is intended to be retroactive to events occurring prior to its adoption and shall continue to exist after the rescission or restrictive modification of the provision with respect to events occurring prior to that rescission or modification; and

∙State that any director or officer who serves a subsidiary of the corporation or any employee benefit plan of the corporation or such subsidiary is deemed to be providing such service at the request of the corporation.

To avoid any argument that an expanded indemnification provision is unlawful or excessive, the corporation may obtain shareholder approval of the indemnification provision even if such approval is not required by law. It should be noted, however, that the Securities and Exchange Commission (SEC) considers indemnity for liabilities under securities laws to be contrary to public policy.

Keep in mind, too, that the protective features of even the most favorable indemnification provisions exist only to the extent that the corporation is financially able to provide the indemnification. A bankrupt or insolvent corporation may leave individual directors and offices with little or no protection regardless of what the corporation has promised to do.

Selection of Directors

Corporation bylaws usually prescribe the size and constituency of the board of directors. If the organization is to survive and flourish, effective director selection criteria must be established and observed. Desirable personal qualities of board members may include but are not limited to the following:

∙Appropriate intellect to comprehend problems facing the corporation

∙Awareness of the business and social environment in which the corporation operates, as well as the directors' obligation to protect shareholder interests by seeing that the corporation operates profitably

∙The ability to be a collaborative member of the directors' team and where warranted supportive of management, yet an inquiring and independent mind to question management's assumptions

∙Integrity, experience, good business judgment and an understanding of business fundamentals (finance, law, marketing, accounting, investments, etc.)

∙The ability to make decisions

∙The time to devote the necessary energies to the required job

A majority of board members should be from industries unrelated to the corporation's business and should have no personal interest in the corporation or any connection with significant shareholders. Obviously, major customers, suppliers, and competitors should not be asked to serve on the board to avoid a potential conflict of interest situation.

Education and Training

Unless the directors and officers receive education and training in the corporation's policies, rules and procedures, they should not be expected to miraculously know what they are. Initial and ongoing education and training makes the directors and officers better able to detect and prevent wrongful acts before they become a problem. In addition, a full and complete flow of information from management to board members is vital if the board is to make informed decisions. Board members therefore must have complete access to senior management. Conversely, management must feel free to properly disclose pertinent information about the company's policies, procedures and activities to board members.

An orientation should be provided for all new directors that includes a detailed description of the organization, the general and specific duties required of directors by applicable state and federal laws and an introduction to corporate management personnel. The orientation should also include making directors aware of any potential conflicts of interest between them and others with whom the corporation does business or as respects matters under consideration by the board.

Board members should also be required to continue their education as respects the company's operations and policies. Such education is particularly important for boards of corporations who issue securities or who may be subject to takeover actions.

Specific Duties of Directors

In addition to being aware of their statutory and corporate obligations to the corporation, directors should be aware of their specific duties as directors. Among the duties commonly required of board members by the states are the following:

∙Attend board meetings

∙Elect directors and officers of the company

∙Authorize important corporate actions

∙Provide advice and counsel to management, especially the CEO

∙Establish effective auditing procedures so that the board will be adequately informed of the corporation's financial status

∙Review corporate operations, including investments, at regular intervals to ensure compliance with all applicable provisions of the laws governing the operation of the organization

∙Monitor management's performance by setting objectives and measuring results against those objectives

Prospective board members must be aware of exactly what is expected of them. Generally, directors must keep up with the corporation's business activities on an ongoing basis, not just be updated at regular board meetings. They should be required to do, and document, sometimes extensive research before making decisions and should not blindly rely on corporate records, such as management memos or opinion letters. In fulfilling their requirement of due diligence, board members should question information obtained from outside sources and make sure that any reports upon which decisions are based are adequate.

To limit their personal liability, directors should formally dissent, rather than simply abstain from voting as respects any board action that they feel is inappropriate. Most state corporation laws require a director to formally register a dissent from any resolution if he or she is not convinced that the proposed action is in the best interests of the corporation. The notation of such dissent in the board meeting minutes can document the dissent. Unless a dissent is formally recorded, however, many courts presume the director concurred with the resolution and may hold the director personally liable for any action taken by the board or the corporation.

If a potential conflict of interest exists as respects a particular director and the action being considered by the board, that director should refrain from voting on the issue and should be excused from any board discussion involving the proposed transaction. If the director must unavoidably participate in the discussion or in the decision, full disclosure of the conflict must be made not only to other persons involved in the decision-making process, but also to shareholders when appropriate.

In addition to the duties discussed above, directors also may have other duties prescribed by the corporate bylaws, such as

∙Periodic assessment of the company's management, including adequacy of internal accounting controls;

∙Taking action to minimize potential exposures to liability as evidenced by past experience and problems faced by others in the same industry;

∙Preventing criminal conduct by employees, management, or individual directors by establishing guidelines and compliance standards;

∙Establishing and enforcing disciplinary programs by responding appropriately to any offense and taking steps to prevent reoccurrence; and

∙Reviewing the adequacy of employee benefit and compensation programs, including compliance with ERISA regulations.

The responsibilities of directors should be reviewed periodically and clearly communicated to ensure each director's compliance with corporate objectives and with state and federal laws governing the conduct of the board.

Although it may be easy to tell board members what they are required to do, it is somewhat more difficult to tell them how to do what is required.

Board Committees

All state statutes allow for committees to be appointed by the corporation's board of directors. While an executive committee is specifically referred to in many state statutes, other committees also may be referred to. The three additional committees most often considered critical to the board's operations are an audit committee, a compensation committee and a nominating committee. State law also governs the delegation of board powers to committees; hence, the powers of each committee must be considered in the light of the particular state statutes under which the corporation exists. As a general rule, however, all such statutes will be interpreted to allow directors the right to rely on committee reports, unless they have knowledge that makes such reliance unwarranted.

The committees most commonly referred to in corporate bylaws are the following:

∙An executive committee that exercises some of the powers of the board of directors to ensure continuous supervision of management when the board is not in session. Some states permit the committee to exercise all of the board's powers as provided in the corporation's governing documents or other board resolutions, subject to restrictions that vary by state. The executive committee is typically composed of both directors and executive officers of the corporation.

∙An audit committee that is usually composed of three or four directors and serves as a liaison between the board, the corporation's independent auditors and shareholders. The audit committee reviews, monitors and provides recommendations as respects the corporation's internal financial data and controls.

∙A nominating committee that recommends qualified candidates for the board of directors. The nominating committee also may establish criteria for board membership, set the term of directorship and determine a mandatory retirement age for board members.

∙A compensation committee that reviews and approves the compensation of senior executives and board members. Compensation may include salaries, bonuses, stock options or other benefits.

Because of the increasing complexities of the matters board members must understand, discuss and decide upon, additional committees may be needed to address specific problems or concerns of the corporation. Examples of such additional committees are a public relations committee, a securities committee and a risk management committee.

Committees need not be composed solely of board members. Rather, where appropriate, outside experts or professionals should be included on board committees. In addition, board members should be periodically rotated between committees to broaden their experience and understanding of the organization. If a director has special qualifications in a particular area, that person could be retained on a committee for a longer period than directors without special qualifications.

Conduct of Board Meetings

Corporate bylaws usually contain provisions relating to the notice, conduct and recording of regular and special meetings of the board of directors, board committees and shareholders. Meetings should be scheduled on a regular basis and as frequently as prescribed in the bylaws or as deemed necessary.

Directors and committee members should be given an agenda and any relevant materials and information at least a week or two prior to each board meeting. Where specific board action is to be discussed, directors should be provided with written reports or memoranda describing the subject action and that set forth management's recommendations and the reasons therefore. Copies of documents such as merger agreements, contracts, letters of intent, and an executive summary of particularly long or complex reports from outside advisors should also be provided in advance of the meeting.

Ample time should be set aside at the meeting for both informal and formal discussion of the agenda. Because unchallenged reliance upon management's recommendations may subject directors to personal liability, board members should have the opportunity to actively question and challenge management and outside advisors in connections with transactions under consideration. Company officers, other key management personnel or legal counsel should be invited to attend the meeting when necessary.

Accurate and complete minutes of all board and committee meetings should be taken and retained. The minutes should describe the matters discussed and the authorities relied upon in reaching the board's decision. The minutes should clearly and concisely set forth exactly what action occurred during the meeting, including any limitations placed on the action taken or authority granted and any decision not to act. If a vote is taken, a dissenting director must affirmatively vote against a proposal if a legal defense based upon such dissent is to be established. Any documents referred to at the meeting should be described in or attached to the minutes. The minutes should then be reviewed prior to finalization by both the directors and by legal counsel.

All documents prepared by or relating to directors and officers should be prepared with the expectation that they will be closely scrutinized in the future for evidence of wrongdoing. Imprecise wording, inflammatory, vulgar or ambiguous language should be avoided.

Document Retention

Both the corporation and individual directors and officers should establish a document retention program. Typically retained documents include minutes of board and committee meetings, information related to issues and actions considered by the board, financial reports, etc. Retained documents should be periodically reviewed to determine which should continue to be retained and which may be destroyed. The determination of whether to retain a document should be made in light of state document retention laws, evidentiary rules that may apply, the degree to which the documents are superfluous or unnecessary, and the possibility that the documents may be misconstrued or confusing. If there is doubt, the document should be retained.

Managing Takeover and Acquisition Related Issues

(Information on claims and run-off insurance coverage in takeover and acquisition situations was provided by Dan A. Bailey, Esq. Mr. Bailey is a member of the Columbus, Ohio, law firm of Bailey Cavalieri LLP. He specializes in D&O liability insurance and corporate and securities law.)

Directors and officers may have an inherent conflict of interest in any potential takeover situation, whether such takeover is hostile or friendly. A takeover is the assumption of control or management of a company (called the “target”) by an outside corporation or group (called the “aggressor.”) Takeover attempts may involve the purchase of shares, a tender offer, a sale of assets or a proposal that the target company merge voluntarily with the aggressor company. As respects takeovers, the terms “hostile” or “friendly” describe whether the takeover is opposed or not opposed by the target company. Directors and officers may have at least the perceived self-interest of remaining in office and the desire to prevent an outsider from obtaining control of “their” corporation. In addition, employees who lose their jobs following a takeover or shareholders who find their share value is declining may sue the directors alleging that the board took improper action.

Directors must exercise great care and caution when evaluating and responding to any potential takeover. Directors should seek input from qualified experts to ensure that all areas of concern have been evaluated before taking action to defend against or accept a takeover bid. Legal counsel, investment bankers and other financial advisors should be consulted as necessary before any final response to the bidder.

If a group of management personnel is bidding for the company, the process must be handled in an especially evenhanded manner to avoid charges that the management group received preferential treatment. Outside opinions should be secured regarding both antitrust implications as well as the assessment of the fair market value of the organization's stock.

If the board considers acquisition of another company, employees and shareholders may again be concerned. Employees may lose their jobs and shareholders may find their investment declining in value if the acquisition does not achieve the anticipated financial results or if the corporation's assets are drained beyond repair. Once again, directors must exercise due diligence when evaluating a potential acquisition and should make use of qualified experts to ensure that all areas of concern have been evaluated before taking action.

Claims Exposure

Although directors and, to a lesser extent, officers of the target company are the most likely defendants in takeover and acquisition litigation, directors and officers of the acquiring company may also be sued for perceived wrongdoing under certain circumstances. Examples of the types of D&O claims that may be filed in a takeover and acquisition context include the following:

Disclosure

The greatest liability exposure of target company directors and officers relates to alleged misrepresentations to investors regarding the negotiation, terms, or effects of a takeover or acquisition. Lawsuits may allege that the defendant D&Os did not accurately, completely, and timely disclose the existence of the takeover or acquisition negotiations or other material information about the transaction. If disclosure is too early and the transaction does not occur as disclosed, shareholders who purchased stock after the disclosure may allege the defendants artificially inflated the stock price by the premature disclosure. If disclosure is too late, shareholders who sold their stock prior to the disclosure may allege they were injured because they sold their stock prior to the large price increase following the merger announcement.

Securities class action lawsuits can also be brought against the D&Os of the acquiring company, alleging the defendants failed to fully and timely disclose the takeover and acquisition negotiations or misrepresented the future prospects or likely effect of the acquisition on the acquiring company. Like other types of securities class actions against D&Os, these suits can involve huge potential damages and result in large settlements.

Resisting a Hostile Takeover

If the organization is the target of a hostile takeover bid, the directors who resist the hostile takeover attempt may be sued. Disgruntled shareholders often allege that the directors breached their fiduciary duty by resisting the takeover proposal, thereby denying the shareholders the opportunity to sell their shares at the much higher offer price. The amount of recoverable damages in such a claim can be enormous, and the settlement value of such a claim can be quite large, even if the liability exposure is relatively small in light of the broad discretion courts now give directors in such a situation.

Approval of a Friendly Takeover

Directors who approve an acquisition of their company also may be sued by shareholders who allege that the directors failed to make an informed decision regarding the adequacy of the purchase price or failed to “shop” the company. Shareholders in this type of litigation frequently seek a bump up in the purchase price, as opposed to the entire acquisition premium that is at issue in D&O lawsuits involving hostile takeovers. These types of cases usually either settle for a relatively modest amount or eventually are dismissed for lack of merit.

Pre-Acquisition Mismanagement

After a company is acquired, the new owners and their appointed managers may determine that the directors and officers of the acquired company mismanaged the company prior to the acquisition and therefore may sue the prior D&Os for the injury caused to the company. These claims are not common since the acquiring company typically conducts a thorough due diligence investigation before agreeing to purchase the company. However, this type of claim is brought occasionally and is particularly problematic for the defendant D&Os since they no longer control the company or its indemnification or insurance programs when the claim is made.

Financial Protection

Unique and sometimes difficult issues arise when structuring a comprehensive D&O financial protection program in a takeover or acquisition context. As with any D&O financial protection program, indemnification and insurance issues should both be addressed. Depending on whether the target will remain in existence as a subsidiary of the acquiring company or will become part of the acquiring company, the source of the target D&Os' financial protection after the acquisition will vary.

Indemnification Issues

Indemnification issues in a change-in-control situation are challenging because the right to indemnification is determined when the directors and officers incur the loss, not when the alleged wrongdoing occurs or when a claim is made. Because losses arising out of pre-acquisition wrongdoing can be incurred years after the acquisition, and because D&Os of the target organization will no longer be in control following the acquisition, they need to lock in their future indemnification rights before the acquisition is finalized. That can be accomplished in several ways.

First, if the target will remain as a subsidiary of the acquiring company, its mandatory bylaw indemnification provision should, prior to the acquisition, include a clause recognizing that the bylaw indemnification rights and obligations are contractual in nature. The clause should also prohibit the company from retroactively amending or repealing the indemnification rights of the directors and officers with respect to any alleged wrongdoing taking place before such amendment or repeal. With such a bylaw clause, there would be no need for separate indemnification agreements with each director or officer.

Second, the acquisition agreement should include a provision requiring the acquiring company as well as the target (if the target survives as a subsidiary) to unconditionally indemnify the former D&Os of the target company to the fullest extent permitted by law. That provision should contain all of the protective concepts included in a broad bylaw indemnification provision, such as the following:

∙The company is obligated to advance defenses costs until a determination is made whether the director or officer is entitled to indemnification.

∙The mandatory indemnification should apply to directors and officers serving at the request of the company as directors or officers of other entities or as directors or officers of the Company's subsidiaries.

∙If a dispute arises between the company and a director or officer regarding indemnification, the company has the burden to prove the director or officer is not entitled to indemnification and must pay the director's or officer's legal fees and expenses incurred in enforcing his or her indemnification right if he or she is successful in whole or in part in the dispute with the company.

∙In any legal proceeding relating to the company's obligation to indemnify, the court must address the issue of indemnification de novo, and there is no presumption arising from the company's refusal to indemnify.

Insurance Issues

In takeover and acquisition transactions, a number of insurance issues can arise because of the inherent conflict between the interests of the target company's former D&Os and the surviving company. Some of those issues with respect to coverage for wrongdoing before and after the transaction are summarized in the following paragraphs.

Subsequent Wrongful Acts

If the target survives, the acquiring company will obviously need to include it in its ongoing D&O insurance program for wrongful acts committed after the acquisition. The principle issue is the extent to which the acquiring company's D&O insurer is entitled to receive a notice of, and to underwrite, the acquisition mid-term. If the target will not survive, there should be no issues.

Most D&O policies provide automatic coverage to newly acquired subsidiaries unless the acquired subsidiary exceeds a defined reporting threshold. That threshold is usually based on the value of the target's assets and can range from 10 percent to 25 percent of the parent company's assets. If the threshold is exceeded, policies vary as to whether the insurer is entitled to charge an additional premium only or to also impose additional terms and conditions to the policy as a condition to future coverage for the acquired company's D&Os. Also, some policies afford automatic coverage for some limited time period (e.g., sixty days) even if the threshold is exceeded. In any event, coverage for the newly acquired subsidiary typically applies only with respect to wrongful acts taking place after the date of the acquisition.

Because takeover and acquisition transactions often arise with little advance warning, companies should anticipate these issues when purchasing their D&O insurance program even if there is no expectation that the company will be acquiring another company during the policy period.

Prior Wrongful Acts

The most difficult insurance issues arise with respect to coverage for claims made post- acquisition for wrongdoing by the directors and officers of the target company that occurred prior to the acquisition. Because the target's D&Os may be replaced or removed following the acquisition, they should, prior to the acquisition, purchase a prepaid, noncancelable extended run-off insurance policy that cannot be amended or affected in any way by the acquiring company or subsequent management. In light of the applicable statute of limitations in various jurisdictions, the term for this run-off policy should be from four to six years. Fortunately, many D&O policies provide that in the event the Company is acquired, the insurer is obligated to issue a quotation for an extended run-off policy.

From the perspective of the target company's directors and officers, this type of run-off policy is much better than an acquisition agreement provision which requires the acquiring company to maintain D&O insurance for the former directors and officers of the target company. If the acquiring company intentionally or inadvertently breaches that provision or is unable to maintain such coverage (due to its financial condition or market conditions), the former D&Os of the target company can be left uninsured through no fault of their own. That risk is eliminated if a prepaid, noncancelable long-term run-off policy is purchased by the target company prior to the acquisition.

Other Run-Off Coverage Issues

When structuring a D&O run-off policy, a fundamental conflict frequently arises regarding the primary purpose of that coverage. The target company's directors and officers, many of whom may not remain with the company after the acquisition, will want to maximize their personal protection under the policy and will have little if any concern for protecting the target company or acquiring company for claims made after the acquisition. Those directors and officers are best served by purchasing a broad-form Side-A policy, which covers only nonindemnified loss incurred by the directors and officers. Such a policy can afford far broader coverage than may be available under a standard D&O policy. In addition, the limits under a Side-A policy would not be diluted by company losses, and the policy would not be frozen in the event the company later filed for bankruptcy (unlike a regular D&O policy).

From the acquiring company's perspective, though, a Side-A policy leaves it uninsured for potentially large indemnification and securities losses. As a consequence, it would prefer that any run-off policy contain Side B (Directors and Officers reimbursement) and perhaps Side C (Entity) coverages for wrongful acts taking place prior to the acquisition. Representatives of the target and acquiring companies should therefore discuss and hopefully agree upon an acceptable structure for the run-off D&O insurance program prior to the closing.

If Side B and/or Side C coverage is included in the run-off program, it is important to name the correct entity as the Insured Company in the policy. If the target company becomes a subsidiary of the acquiring company, the Named Company should be at least the target company. However, if the acquiring company is also obligated to indemnify the former directors and officers of the target company pursuant to the acquisition agreement, then the acquiring company may want to be added as an additional Insured Company with respect to that indemnification obligation.

If the acquisition is structured as a merger, and thus the target company disappears, the Insured Company in the run-off policy should be the acquiring company, but only with respect to prior wrongful acts of the target company's directors and officers. The run-off policy should clearly recognize that no coverage is afforded for directors and officers of the acquiring company by virtue of the acquiring company being an insured company.

Because claims by an insured company are typically excluded from coverage pursuant to the D&O policy's insured versus insured exclusion, which entities are included as insured companies can have a profound effect on the scope of coverage for the target company's directors and officers under the run-off policy. As noted previously, claims by the acquiring company against former directors and officers of the target company for pre-acquisition mismanagement or misrepresentations present a serious exposure to those former D&Os. That exposure may be excluded from coverage if the acquiring company is not included as an insured company on the run-off policy. Some broad Side-A polices do not contain this gap in coverage because their Insured vs. Insured exclusion expressly does not apply to claims made after a change-in-control. Although difficult to obtain, a similar carve-out to the insured vs. insured exclusion should be sought if the run-off policy contains Side B and/or Side C coverages.

If the run-off policy includes Side B coverage, another potential concern for the target's directors and officers relates to the presumptive indemnification provision commonly contained in a D&O policy with that coverage. Pursuant to the provision, if the Insured Company is legally and financially able to indemnify the insured directors and officers, the Side B retention applies even if the Insured Company does not indemnify the directors and officers. In other words, if the Insured Company wrongfully refuses to indemnify the D&Os, then the D&Os must personally pay that large Side B retention before they can access coverage under the policy. Such a result can be disastrous for the former directors and officers. Given the potential conflict between prior management and new owners in the aftermath of a change-in-control, it is at least conceivable such a disastrous result could occur under a standard run-off policy.

Again, a broad Side-A policy can rectify that problem by not including a presumptive indemnification provision and, if written as an excess DIC coverage, by dropping down to pay the Side B retention in the underlying policy on behalf of the directors and officers (subject to the insurer's subrogation rights against the company for wrongfully refusing to indemnify the directors and officers). Although difficult to obtain, deletion of the presumptive indemnification provision in the Side B run-off policy should also be requested.

Yet another complication under run-off policies is the treatment of continuous wrongful acts that commence prior to the acquisition and continue after the acquisition. Because the run-off policy typically covers only wrongful acts taking place prior to the acquisition and the acquiring company's ongoing policy typically covers only wrongful acts taking place after the acquisition, the insurers of the run-off and ongoing policies, as well as the insureds, are usually required to negotiate a mutually acceptable allocation arrangement for losses resulting from continuous wrongful acts which span the acquisition date. Not surprisingly, it is often very difficult if not impossible to get all of the divergent parties to agree on such an allocation. In the absence of an agreement, the insureds are usually left with only a portion of their losses paid by the insurers, pending some type of dispute resolution process.

This allocation problem can be minimized if not eliminated in some instances by providing in one of the competing policies that all loss resulting from such continuous wrongful acts is covered under that policy and by providing in the other competing policy that all loss resulting from such continuous wrongful acts is excluded.

If the target company is a subsidiary being divested by the parent company, additional complications arise since the run-off coverage should be independent from and unaffected by both the selling parent company and the acquiring company. A claim for pre-acquisition wrongdoing may implicate both the run-off policy and the policy issued to the selling parent company. If the same insurer issued both policies, the insurer may insist upon a coordination of limits provision between the two policies to avoid the insurer being exposed to a multiple limits loss for the same wrongdoing. Alternatively, if different insurers issue the policies, difficult allocation fights between the insurers regarding their respective obligations should be expected.

Companies are encouraged to analyze and negotiate with their D&O insurer(s) at least some of these issues before the takeover or acquisition transaction arises. Because a crisis management atmosphere may develop once an acquisition is announced, waiting until that time before any of these issues are considered further increases that crisis atmosphere and potentially jeopardizes the quality and availability of an appropriate risk management response to the transaction.

Managing the Securities Exposure

It is important for directors to know when the company is actually dealing with transactions subject to requirements of state and federal securities laws. Because the courts are inconsistent in their application of securities laws, directors should not assume the transaction is too small or personal to attract SEC notice. Information disclosure, analyst communications, insider trading and periodic reporting requirements are all areas of concern that must be carefully addressed by the board of directors and the corporation's management. Clear guidelines and procedures for communicating with shareholders, governmental regulatory agencies and other parties that deal with the corporation are essential.

Information Disclosure

Liability for violation of federal securities laws governing information disclosure represents one of the greatest areas of exposure for directors and officers. The corporation should have well defined and well understood assignment of responsibilities with respect to securities laws and various disclosure issues. Top management should be involved in even routine communications to make sure that all “important factors” are “meaningfully” disclosed. Directors should personally review all important securities filings and disclosure statements and assure themselves that the corporation has taken reasonable steps to accurately and completely disclose all relevant material information. If the board of directors has established a securities committee, that committee should review all filings made to the Securities and Exchange Commission.

Institutional investors must be kept informed of and comfortable with the company's disclosure practices, as well as notified of significant developments. Care must be taken not to provide the selective disclosure of material non-public information, because such disclosure could be interpreted as illegal “tipping.”

The board should determine if the process of preparing, publicizing and issuing registration and offering materials complies with SEC requirements. All information must be truthful and properly presented, and any restrictions on offers prior to effective registrations must be carefully followed.

The board should carefully monitor any statements or other activities that could be construed as an offer to sell the securities prior to the effective date of registrations. Since publicity of the offering is prohibited until the offering is registered, such publicity (advertising, press releases, etc.) should be avoided.

The board also should review carefully all materials associated with a potential or actual proxy solicitation for accuracy and completeness to make sure they comply with procedural requirements of securities laws and SEC regulations. Pending registration statements or prospectuses should be periodically updated to avoid misrepresentation and to make sure no material facts are omitted or misstated.

Companies also should make sure that all written and oral forward-looking statements include the statute-required information disclosure. Such disclosure can allow the company to qualify for safe harbor protection under the Private Securities Litigation Reform Act of 1995, even if the plaintiff alleges the company had actual knowledge of the falsity of any statements made.

In addition, The Sarbanes-Oxley Act of 2002 requires certification by the company's Chief Executive Officer (CEO) and Chief Financial Officer (CFO) of the accuracy of all company financial statements filed with the SEC after July 30, 2002, imposes strict guidelines as respects disclosure of insider trading, and mandates disclosure of off-balance sheet transactions and adjustments to financial reports. See the discussion of the Sarbanes-Oxley Act of 2002, for more information.

Analyst Communications

Many large stock brokerages and financial managers employ securities analysts to track, report on and forecast a company's stock performance. Companies frequently comment on such analyst's reports in their own annual reports, or in other published materials describing the company's financial status. When a company comments on an analyst's projections, those projections may become attributable to the company under federal securities laws. In a lawsuit, the plaintiff may argue that company officials knew, but failed to disclose, that performance would not meet the analyst's expectations and thus defrauded the market. Issues related to Initial Public Offerings (IPOs) are discussed in more detail in the “Introduction” section.

The safest response to a securities analyst's inquiry is for the company to simply decline to release internal projections or not to comment at all on the analyst's projections. If the company chooses to release projections or comment on an analyst's projections, however, the following steps should be taken to help reduce the likelihood of securities fraud allegations:

∙In conjunction with the release or discussion of any estimates or projections, disclose any adverse risks, trends or uncertainties that might have a negative impact on expectations. This practice is sometimes referred to as “defensive disclosure.” “Defensive disclosure” is the strategy of communicating the known factors that might cause actual results to vary from projections. Factors affecting estimates or projections might include competitive or technological forces that could affect revenue, the uncertain needs of key customers, or anticipated regulatory or accounting changes that might affect the business or its financial results.

∙Have a sound basis for, and document, all comments or disclosures made. The documentation should include contrary opinions within the company as well as why the opinions were rejected.

∙Retain a copy of all documents released to analysts, as well as transcripts of all statements given or comments made. Such copies help avoid ambiguity over what information was actually communicated.

∙Prepare and release updated or revised projections as soon as previously published comments are no longer consistent with projections.

Insider Trading

A company's directors or officers may sell personal holdings in company securities or pass material nonpublic information to outsiders who subsequently sell their stock. If such sales precede a price drop, class-action plaintiffs may allege that the insider trading or tipping is proof that the company and its directors or officers intended to defraud investors. Even if the allegations are eventually disproved, the fact that insider trading or tipping may have occurred could prevent early dismissal of the lawsuit and instead result in expensive and protracted litigation.

Reasonable safeguards should be implemented and monitored to protect against the misuse of confidential information. Employees who have access to confidential information should be given a policy statement informing them of their obligation to safeguard that information and instructing them not to trade on the basis of the information. Availability of material non-public information should be limited only to those persons who need to know the information in order to participate in relevant discussions.

Documents containing confidential information should be carefully maintained and not left in plain sight for others to read. When draft documents must be given to others for typing or printing, code names should be used to protect the identity of parties to the transaction.

A comprehensive insider trading policy with detailed procedures regarding trading in the company's stock should be adopted. At a minimum, the policy should incorporate the following elements:

∙A prohibition of any trading in the company's securities by insiders who are in possession of material non-public corporate information;

∙A central authority or compliance committee within senior management established for the purpose of monitoring insider-trading of company securities;

∙Clearly defined “trading windows,” periods when trading is permitted by insiders who are not in possession of material non-public information and who have obtained pre-trade approval by the designated internal authority; and

∙Clearly defined “blackout periods” during which all insider trading is strictly prohibited, such as immediately prior to and after the company's announcement of quarterly or annual results.

The policy also should conform to the provisions governing the conduct and disclose of insider trading as specified in the Sarbanes-Oxley Act of 2002. See the discussion of the Sarbanes-Oxley Act of 2002, later in this section, for more information.

Periodic Reporting

Persons within the company who are to be responsible for risk identification and disclosure as part of the company's periodic reporting process should be clearly identified in the reports. The reports should also include a separate “risk factor” section that contains a discussion of the risks, trends and uncertainties that the company faces. Factors a company may be required to disclose can include known uncertainties concerning future liquidity or credit; anticipated net sales, revenue or income declines; known changes in an important customer's orders; and known uncertainties surrounding new product development or release.

SEC filings and periodic reports are common vehicles for supplying meaningful disclosure as respects oral forward-looking statements. While SEC regulations have long required companies to disclose known risks, trends and uncertainties, few companies actually include such disclosure in their 10-K or 10-Q reports. Companies that want to have their oral forward-looking statements qualify for safe harbor protection under the Securities Reform Act should begin using the 10-Ks and 10-Qs to disclose the required information.

Complying with the Sarbanes-Oxley Act of 2002

The Sarbanes-Oxley Act of 2002 constitutes the most sweeping corporate governance legislation in decades. Although the Act does not create any new bases for civil lawsuits against directors and officers, it affects the legal environment in which D&Os must operate. The Act also offers directors and officers an opportunity to improve governance practices and to restore credibility in their company's financial and business disclosures.

The following are actions that D&Os should consider in response to various key provisions of the Act. By adopting and documenting these actions, companies can reduce the potential for litigation, can establish helpful evidence in defense of litigation and can potentially comfort D&O insurance underwriters in a difficult insurance market.

Develop procedures to support CEO/CFO certifications

The Act requires contemporaneous certification by the company's Chief Executive Officer (CEO) and Chief Financial Officer (CFO) of the accuracy of all company financial statements filed with the SEC after July 30, 2002. To ensure compliance with this provision

∙Make sure the company's CEO and CFO receive drafts of all SEC reports with sufficient time to adequately review them before they are filed.

∙The CEO and CFO should both document their active involvement in revising and shaping such reports.

∙The CEO and CFO should consider delegating portions of the reporting process to appropriate subordinate individuals. These individuals should be given the responsibility to report, in writing, directly to the CEO or CFO, including the possible certification by that individual as to all facts and circumstances under that person's supervision that affect the applicable portion of the report.

∙The CEO and CFO should each retain independent financial and legal advisors (funded by the company) if significant issues arise regarding the content or accuracy of the certification or the due diligence related thereto.

∙The CEO and CFO should meet with the company's audit committee to allow for questions and answers on any issues that have come up during the report preparation, particularly questions about accounting practices and internal controls management.

∙Each CEO and CFO should maintain a comprehensive file containing all of the back-up information, reports and certifications relied upon in giving the CEO/CFO certification.

Take steps to timely report securities trading by company insiders

The Act requires insiders to disclose trading in the company's securities within two business days of the trade, and no longer allows insiders to defer certain transactions, such as qualifying stock option grants, in the company's securities. To ensure compliance with this provision, companies should

∙Make sure the affected officers and directors have been given written material describing the revised reporting rules.

∙Review any automatic option grants to make certain the Act's provisions do not result in unintentional reporting violations.

∙Require “pre-clearance” of all insider trades with a specifically designated compliance officer.

∙Require insiders to conduct transactions with a single broker who is aware of the company's pre-clearance policies.

∙Have insiders grant the company a Power of Attorney to allow it to sign Section 16 reports on their behalf, giving the company the ability to quickly file such reports on their behalf.

∙Retain a complete list of insider EDGAR filing codes to allow for faster electronic filing.

∙Consider adopting a policy requiring all pre-established Rule 10b5-1 trading plans of its insiders be publicly disclosed. This is in anticipation of stricter disclosure requirements relating to such pre-established trading plans.

Develop guidelines for management and internal accounting staff to flag events or circumstances requiring immediate public disclosure

The Act requires a public company to disclose to the public, on a “rapid and current basis,” material changes in the company's financial condition or operations in accordance with specific rules to be developed and issued by the SEC. Until the SEC publishes regulations defining these new “real time” disclosure obligations, directors and officers should consider establishing a general policy on what items and events it considers to be “material” and therefore appropriate for immediate disclosure. These items and events include the following:

∙A specific list of events requiring disclosure. In this regard, it is good practice to examine the disclosure documents of similarly situated companies to determine how they are addressing common concerns. If other companies are disclosing a certain level of information, an implication may be created that such information is material and should be disclosed.

∙Categories of events to be brought to counsel and management's attention for determination of materiality. Dollar thresholds may be useful guides in some circumstances.

∙Items the SEC has indicated to be likely material, such as earnings information, new products or discoveries, changes in control or in management, calls of securities for redemption, adoption of repurchase plans, stock splits or changes in dividends or other changes to the rights of security holders, entering or terminating material agreements outside the ordinary course of business, or terminating or reducing a material business relationship with a customer; or reaching a conclusion that security holders should no longer rely on the company's previously issued financial statements or any related audit report.

Determine if a conflict of interest exists sufficient to replace the company's independent auditor

The Act prohibits conflicts of interest between a company's independent auditor and certain of its executive officers. The Act also prohibits the same accounting firm from providing audit and non-audit services to public companies. To ensure compliance, public companies should

∙Survey the company's directors and officers to determine if the accounting firm that currently serves as the company's independent auditor has previously employed any of them. Consider obtaining certifications from the accounting firm as deemed necessary.

∙Replace the company's independent auditor if the company's CEO, CFO, controller and/or chief accounting officer was previously employed by the independent auditor within the twelve months prior to the most recent audit year.

∙Consider replacing the independent auditor if any of the preceding individuals were employed by the independent auditor outside of this one-year period or if any other executive officer or a director has been employed by, or has a significant relationship with, the independent auditor.

∙Review all services that the company's independent auditor has provided to the company to determine if it has provided any non-audit services, including bookkeeping or accounting services; appraisal or valuation services, fairness opinions; actuarial services; internal audit outsourcing services; management or human resources functions, including compensation consulting; broker or dealer, investment adviser, or investment banking services; and legal services or other expert services unrelated to an audit. If so, consider whether to appoint a new independent auditor and allow the existing firm to continue providing the non-audit services; or maintain the company's existing independent auditor and seek a separate accounting firm to provide it with the non-audit services.

Replace members of the company's audit committee who are not “independent” under the new SEC guidelines

The Act requires the Audit Committee to be composed entirely of independent directors. Public companies should

∙Identify any member of the Audit Committee who has accepted any consulting, advisory or other compensatory fee from the company other than as a director.

∙Until the SEC adopts rules that further define “independence,” carefully consider whether any members of the Audit Committee have other relationships with the company that might call their independence into question.

∙Obtain resignations from directors who are not independent and appoint individuals to fill the resulting vacancies who qualify as independent.

Revise audit committee charter

The Act imposes many additional requirements on a company's Audit Committee. By adopting the following requirements in an Audit Committee charter, the company can demonstrate its good faith attempt to comply with such rules. Such adoption also “institutionalizes” the new requirements into the audit review process.

∙Require pre-approval of all audit and non-audit services performed for the company by any accounting, auditing or other financial services company.

∙Require the audit committee to approve any transaction between an officer or director and the company, or any subsidiary or affiliate of the company, to ensure that such “related-party” transactions have been approved by an independent body as an “arm's-length” transaction that benefits the company.

∙Require independent auditors to report to the audit committee in writing all of the critical accounting policies to be used and all alternative treatments of financial information within GAAP that have been discussed with the company's management, including the treatment the independent auditor has recommended.

∙Provide the audit committee with the authority to directly appoint, supervise and compensate the company's independent auditors.

∙Require the audit committee to discuss annual and quarterly financial statements during one-on-one meetings with each of the company's auditors, management, internal accountants, and outside counsel.

∙Circulate a specific agenda for each meeting, prepare detailed records of each meeting, and consider having financial and legal advisors attend.

∙Require the review of any representation letter that management provides to the independent auditor.

∙Require periodic review of the company's risk management and risk assessment policies.

∙Establish procedures for the audit committee to receive, retain, investigate and respond to complaints relating to the company's accounting controls.

∙Establish procedures for the audit committee to receive submission of confidential and anonymous information about the company's financial controls from the company's employees.

∙Provide the audit committee with the authority and funds to engage independent counsel and other advisers regarding accounting or audit practices.

Take no action as a board or as an individual director or officer that can be construed as interfering with the audit process

The Act prohibits any officer or director of a public company from fraudulently influencing, coercing, manipulating or misleading an independent auditor engaged in auditing the company. Directors and officers should therefore avoid any action that could be construed as an attempt to exert improper influence over the independent auditor, including the following:

∙”Suggesting” to the company's independent auditors, either directly or indirectly, a “preferred” accounting treatment for any specific item or transaction;

∙Using the incentive of additional or increased use by the company of the independent auditor's services to induce the independent auditor to utilize a “preferred” accounting method in the company's financial audit; or

∙Providing any information to an independent auditor that is false or misleading in order to achieve a specific accounting result.

Determine if any member of the audit committee is a financial expert and if not, consider appointing one

The Act requires the SEC to adopt rules which will require that a company to disclose in its Exchange Act reports whether it has a “financial expert” serving on the company's audit committee, and if not, why. In anticipation of these rules, the following actions are recommended:

∙Determine if any of the audit committee members qualify as a “financial expert” based on (1) their understanding of GAAP and financial statements; (2) experience in preparing or auditing financial statements of similar companies and applying such principles in connection with accounting for estimates, accruals, and reserves; (3) experience with internal accounting controls; and (4) understanding of audit committee functions.

∙Appoint at least one financial expert if none is currently serving on the audit committee.

∙Require all members of the audit committee to possess a defined minimum level of financial skills.

Disclose all material off-balance sheet transactions and any material correcting adjustments

The Act requires disclosure of off-balance sheet transactions and accounting adjustments. It also directs the SEC to adopt specific requirements for the presentation of pro forma financial statements. Companies should therefore do the following:

∙Inform directors and officers of the need to disclose in the company's periodic Exchange Act reports whether the company has any off-balance sheet transactions, arrangements, obligations (including contingent obligations) or other relationships with unconsolidated entities or other persons that may have a material current or future effect on financial condition, changes in financial condition, results of operation, liquidity, capital expenditures or resources.

∙Inform directors and officers of the need to disclose in the company's periodic Exchange Act reports whether the independent auditor has informed the company of any material correcting adjustments in accordance with GAAP and the SEC rules.

Implement procedures to “flag” these types of transactions for review on an ongoing basis.

Ensure the directors and officers do not receive any impermissible extensions of credit from the company

The Act prohibits a public company from entering into certain credit arrangements with its directors and officers or otherwise renewing, extending or modifying the terms of any credit arrangement in place before July 3, 2002. It is recommended that companies do the following to ensure compliance:

∙Adopt and circulate to directors, officers and appropriate personnel clear policies and procedures that define and prohibit the proscribed extensions of credit.

∙Extend the credit ban to “arranging” or otherwise assisting the directors and officers in obtaining credit from unrelated third parties, family members and affiliates of directors and officers, as well as the providing of travel advances and use of company-supported credit cards “personal” uses.

∙Identify all outstanding loans or other extensions of credit made by the company or a company subsidiary to any officer or director. Establish procedures to prevent any modifications to existing credit agreements or further extensions of credit, even if future advances were contemplated by the original arrangement.

∙Do not forgive loans previously made to directors and officers without careful consideration whether such forgiveness will be viewed as a “modification” of an existing credit arrangement.

∙Review for compliance with the new rules any arrangements with directors or officers that have credit-like features, such as cashless exercise of stock options or procedures in stock option plans for loans to purchase option shares.

Review the company's document retention plan and revise if necessary

The Act prohibits document destruction in connection with a federal inquiry or investigation. Compliance with an appropriate pre-established document retention plan may be useful evidence to support an affirmative defense against a charge of improper document destruction. The following key points should be kept in mind when creating and maintaining a records retention policy:

∙Policies should be applied uniformly.

∙There must be legitimate reasons for the policy and a rationale for the way documents are slated for destruction.

∙Policies should take into account any administrative or regulatory record-keeping requirements.

∙Policies should not be adopted in bad faith or with the primary purpose to avoid preserving potential evidence.

∙When litigation is reasonably foreseeable, the policy should prohibit the destruction of potentially relevant documents even if the documents would otherwise be destroyed. Adequate safeguards should exist to assure documents are not inadvertently destroyed under those circumstances.

Some financial observers believe that, at least initially, the new rules may lead to more civil and criminal shareholder lawsuits and larger settlements involving public companies. In some cases, plaintiffs' attorneys may argue that the company failed to implement the new rules. In other cases, the attorneys may allege that the rules were improperly implemented, thereby resulting in the misstatement of company financial reports.

Coverage Issues

The insurance brokerage industry is divided regarding the effect of the new rules on D&O coverage for the activities of individual audit committee members. Some brokers are confident that most standard D&O policies already cover the added exposure, citing the fact that such policies usually contain severability clauses that state the wrongful acts of one insured cannot be imputed to another insured. Thus, if one audit committee member violates the new rules, coverage is still available for the other directors and committee members.

Other brokers, however, feel that policy severability is a moot issue because, under the new rules, all audit committee members must sign off on the company's financials. This may mean that any fraudulent misstatement in the financials will be attributed to all committee members even if some members were unaware of the erroneous information.

Policy Rescission Issues

Whether the new audit committee rules will result in more instances of policy rescission also is the subject of debate. “Rescission” means the voiding of the policy as of inception, with the result being that the policy is deemed to have never existed. Most D&O policies allow the insurer to rescind the policy or reject a claim if there is a material misrepresentation in the initial coverage application. If the audit committee recommends restatement of the company's financials, some brokers believe such restatement could make underwriters question the accuracy of financials that were provided with the initial coverage application. If underwriters are sufficiently uncomfortable with the restatement, they could attempt to rescind the policy.

Other brokers disagree, claiming that policy rescissions have declined in recent years and that the earnings restatement exposure is covered since there is no specific financial restatement exclusion in most standard D&O policies.

Because of the potential for bad-faith litigation, policy rescission is relatively rare and usually only a last resort for insurers. However, insureds concerned about the impact of the new rules on traditional D&O coverage for audit committees and the potential for policy rescission may wish to consider the purchase of supplemental coverage. At least one major broker is promoting an Audit Committee Liability Insurance policy that has been developed to specifically address the potentially heightened exposure of audit committee members. The policy provides non-cancelable coverage, applies if an existing D&O policy is cancelled or rescinded, and is intended to fill gaps in the underlying D&O policy.

The need for separate audit committee liability coverage is probably low for larger, Fortune 1,000 companies. Such companies typically have well-established governance procedures and are very familiar with the intricacies of D&O insurance coverage. But smaller companies may not have such sophisticated governance procedures in place and may be more vulnerable to coverage gaps or rescission because of their limited experience with D&O coverage.

Protection for Insureds

There are several measures that can be taken by public companies concerned about a gap in coverage or the possibility of D&O policy rescission. These measures, which may both help companies comply with the new rules and provide documentation needed to defend potential lawsuits, include, but are not limited to, the following:

∙Becoming informed about the new rules affecting audit committees and making sure that the committee is composed of the required number of financially literate independent directors.

∙Carefully documenting the process of selecting audit committee members.

∙Carefully drafting the audit committee's charter to accurately reflect the actual practices and responsibilities of the committee.

∙Closely monitoring the conduct of the audit committee and its members by the board of directors to ensure compliance with the new rules.

∙Reviewing existing D&O insurance to determine the scope of policy exclusions and the adequacy of the policy's severability provisions. It is important that the policy protects those board members who act in good faith. If the severability provisions are unclear or considered insufficiently broad, an attempt should be made to clarify the insurer's intent and to broaden the provisions by endorsement.

∙Considering purchase of additional coverage limits or coverage from a different insurer. An Audit Committee Liability policy or change of insurer may be required if the existing D&O policy's severability provisions are unfavorable and cannot be modified.

At a minimum, public companies should ask their broker or D&O insurer how the new rules affect existing coverage for innocent audit committee members if a lawsuit alleges fraudulent misstatement of earnings. Some brokers have suggested that such exposure may be now precluded, although the response may vary by insurer. If the broker or insurer confirms coverage, such confirmation should be obtained in writing.

By providing specific guidelines and procedures, the new rules should help ensure public companies take the necessary measures to prevent misstatement of financials and the resulting deception of investors. The actual effect of the new rules, however, remains to be seen.

Managing the Audit Committee Exposure

Previous audit committee rules were revised in 2000 and 2001 and the new rules have been adopted by the National Association of Securities Dealers and the Accounting Standards Boards. These new rules specify the responsibilities of audit committee members, prescribe qualification guidelines for those serving on audit panels, delineate audit committee functions, and require that corporate auditor reports be accompanied by written statements of approval by audit committee members.

Under the rules, audit committees must be made up of at least three (rather than the previous two) independent directors who are “financially literate.” The term “financially literate” means being able to read and understand financial statements. In addition, companies listed on the AMEX or NASDAQ must have at least one audit committee member with employment experience in finance or accounting, a professional certification in accounting, or comparable experience or background. The committee must provide details of all discussions held with outside auditors and must warrant that the company's financial statements have been discussed with management.

The new rules also require companies to have a written charter for their audit committee. (The NYSE continues to allow public companies with less than $25 million in revenue and market capitalization to have only two audit committee members, one of whom must be independent.) The charter must set forth the committee's structure and responsibilities as well as the procedure for submitting its reports to the board and, if necessary, replacing outside auditors.

Additionally, the Sarbanes-Oxley Act of 2002 created specific new requirements regarding the composition, responsibilities, and procedures of audit committees. Under the Act, audit committees must

∙be directly responsible for the engagement and oversight of the corporation's auditors, including resolution of disagreements between management and auditors regarding financial reporting;

∙establish procedures for receiving and dealing with complaints and confidential, anonymous submissions by employees regarding accounting, internal controls, or auditing matters;

∙approve, in advance, all non-audit services (except certain specified “de minimis” services) provided by the corporation's independent auditors; and

∙receive reports directly from the corporation's auditors on issues related to the audit, such as alternative treatments of financial information under generally accepted accounting principles that were discussed with management and the treatment preferred by the auditors.

The Sarbanes-Oxley Act thus places a substantial burden on audit committee members to oversee the corporation's auditors, resolve conflicts between auditors and management, and deal with complaints or concerns about the corporation's accounting practices.

Managing the Outside Directorship Liability Exposure

When a corporation's directors and officers also serve as directors for outside entities, these shared relationships may create a significant exposure for the corporation. Outside directors often are targeted as “deep pockets” when there are insufficient corporate or individual assets to satisfy a judgment against the entity's “inside” directors and officers. It is therefore important to identify the outside entities to which the corporation's directors and officers belong.

Because outside directors owe the same fiduciary duties to the corporation and its shareholders as do inside directors, outside directors should be instructed not to attempt to substitute their judgment for the judgment of the entity's inside directors, nor should they constantly oppose the decisions of the entity's managers. However, to best protect their own individual liability, outside directors should be committed to act in the best interests of the corporation and its shareholders.

Outside-directorship positions often are with entities that have common business interests or other dealings with the corporation that has requested the outside-director service. These situations can be particularly problematic because of potential dual-loyalty conflict issues, such as those related to intercorporate transactions, maintaining confidences, and misuse of corporate opportunity. In addition, potential antitrust issues can result, particularly if the outside directorship is with an actual or potential competitor of the requesting corporation.

Outside directorship positions should be specifically evaluated and approved by a designated committee or person based on well-defined criteria so that the director or officer will qualify for corporate indemnification. The corporation's D&O insurance policies also should be reviewed to determine the extent of available coverage for outside-directorship liability. Some insurers do not provide any type of outside-directorship coverage; others provide this type of coverage only on an excess basis with specific qualifications or restrictions. When the coverage is provided by the D&O policy, it may apply either as double excess (i.e., the coverage applies excess of the outside entity's indemnification, and insurance), or as triple excess (i.e., the coverage applies excess of the outside entity's indemnification, insurance, and excess to the requesting corporation's indemnification).

Further, outside-directorship-liability coverage may apply subject to a limit of liability either included in, separate from, or as a sublimit of the policy's full limit of liability. In order to avoid potential defense and loss payment allocation issues, the language of the other-insurance clauses in both policies should be examined closely and modified where necessary to clarify that the outside entity's policy pays first.

From an insurance standpoint, outside directors and officers are both insured persons under most standard D&O policy forms. Although both directors and officers have the same benefits to the policy, officers are more exposed to large litigation losses compared to outside directors. For example, officers frequently retain separate defense counsel from the outside directors and may be sued in proceedings separate from the outside directors. An officer may also settle his case prior to resolution of an outside director's claims. An effect of these differences is a heightened potential that “officer” claims will deplete some or all of the available insurance limits, leaving an outside director with little or no remaining insurance.

In addition, circumstances may arise that may jeopardize a director's indemnification from the company after retirement from the board. First, the company's financial condition could significantly weaken after a director's retirement. Because a director may be sued several years after retirement and because it may take several years to resolve such lawsuit, indemnification protection may be dependent on the company's financial condition well into the future. Second, between now and then, the company's board and management may change and become antagonistic toward a director, in which case they may withhold indemnification. Third, the company may be legally prohibited from indemnifying some types of losses, such as settlements in shareholder derivative suits.

D&O insurance policies typically insure former as well as current directors and officers, but such policies cover only claims first made during the policy. For example, a lawsuit filed against a director three years from now will be covered under the policy in effect at the time of the claim, not the policy that was in force at the time an alleged wrongful act occurred. As a result, the quality and amount of insurance protection for a lawsuit filed after retirement will be dependent on the company's financial ability and desire in future years to maintain the same level of insurance protection, as well as the availability and cost of that protection in the future insurance market. There are new insurance products to address these and other outside-director concerns. Because it is the corporate officers who typically control the insurance-procurement process, outside directors may want to consider the assistance of an independent advisor to evaluate and identify available enhancements for the benefit the outside directors.

Managing the Employee Benefits Exposure

A particularly sensitive area of potential liability exists when directors or officers also serve as plan fiduciaries for corporate employee benefit plans. Such individuals may be subject to inherent conflicts of interest when balancing the sometimes competing interests of the corporation and plan participants. For example, decisions relating to the timing and method of the corporation's funding of the plans and the investment of plan assets in the corporation's securities present clear conflicts which must be addressed from the standpoint of both the corporation and the plan.

Whenever a potential conflict exists, it should be fully disclosed to legal counsel and, where appropriate, to some or all board members. Where necessary, an appropriate response should be developed, including disqualification of the person involved with the conflict from voting and discussion, disclosure to shareholders or other remedial action. Whenever doubt about a potential conflict exists, advice from legal counsel should be obtained.

Managing the Executive Compensation Exposure

There is a widespread perception that too many corporate executives are being paid too much money without regard to their performance. Many people believe that by adopting compensation practices which either ignore performance or focus only on short-term performance, executives have been incentivized to make important company decisions based upon short-term benefits or self-interest rather than upon the long-term goals of the company and the best interests of society.

As a result of the immense focus now being given to executive compensation, there is unprecedented pressure on corporate directors from all industry sectors to reign in excessive compensation practices. However, while there is wide agreement that reform is badly needed, there is no consensus as to what form the reform should take. Some of the reforms that are now, or that likely will be, adopted are briefly discussed in the following paragraphs.

Director and Shareholder Responses

Shareholder efforts in reforming executive compensation practices have primarily focused on disclosure of compensation packages and policies. However, the overall size of compensation packages continues to grow despite the greater disclosure. At best, the disclosures have resulted in some curtailment of executive perks, such as corporate jet privileges and club memberships.

Some of the more substantive reforms that are either being voluntarily adopted by some boards or being proposed by shareholders include the following:

Claw-Back. A claw-back policy typically requires executive officers to repay to the company all performance-based compensation in the event the company restates its financial statements due to misconduct on the part of the executive officer. Unlike a similar provision in the Sarbanes-Oxley Act (SOX), this provision applies to all high-ranking executives, not just to the CEO and CFO.

Say-On-Pay. Another popular shareholder proposal is the so-called “say-on-pay” resolution, which allows for a nonbinding or advisory shareholder vote on a company's executive compensation policies. Supporters of this type of resolution contend that directors will be forced to either comply with the shareholder advisory vote or convince shareholders that the current executive compensation policies of the company are appropriate. Opponents contend that the shareholder vote is meaningless and frequently uninformed.

Bonus Banking. This reform concept requires a portion of the executive's annual bonus to be withheld for at least three years and then recalculated based on updated corporate results. A related reform requires executives to hold a majority of their company stock and stock options until two years after retirement or termination. The goal of these types of reforms is to minimize the executive's focus on short-term returns and to encourage a longer term perspective with respect to both incentivizing behavior and measuring performance.

Integration with Risk Management. A somewhat more subtle compensation reform is to integrate the company's enterprise risk management (ERM) process with executive compensation policies. Examples of potentially dangerous features of an executive compensation from an ERM perspective program include (1) very low salary and high annual incentive pay; (2) too simplistic an evaluation system that favors quantitative achievement without regard to quality of earnings, risks undertaken, and other subjective considerations; (3) financial goals that are so far above past performance as to require unacceptable risk-taking; (4) very high threshold levels of performance are required to qualify for incentive compensation; and (5) huge stock option grants. To the extent the executive compensation program is viewed as potentially encouraging inappropriate risk behavior, those features should obviously be revised.

Regulation

In 2006, the SEC adopted new, more comprehensive disclosure rules relating to executive compensation practices by public companies. Under these new rules, public companies must disclose not only the amount and type of compensation paid to its CEO, CFO, and the three other most highly compensated officers, but must also must disclose the criteria used in reaching executive compensation decisions and the degree of the relationship between the company's executive compensation practices and corporate performance.

In February 2009, Congress imposed severe executive compensation limitations in connection with the federal government bailout program. Pursuant to the Troubled Asset Relief Program (TARP), companies that receive bailout funds are subject to sliding-scale limitations on the size of bonuses paid to executives and must submit a say-on-pay nonbinding resolution to shareholders annually regarding the company's compensation policies. The legislation also prohibits golden parachute severance arrangements.

As a result, the unprecedented pressure and public outcry relating to executive compensation appears to be giving rise to a new era of external oversight and regulation of executive compensation practices.

Litigation

Although some recent court decisions suggest a greater willingness by courts to second guess compensation decisions in some contexts, generally courts continue to largely defer to the discretion of directors regarding compensation issues. However, some recent court decisions demonstrate that this judicial deference to directors is not limitless, particularly if the process used by the directors in approving the compensation was flawed.

In cases where courts are willing to consider whether the amount being paid to the executive is reasonably proportionate to the value of services rendered, courts usually consider one or more of the following criteria to judge the value of the services rendered: (1) the executive's ability and experience; (2) the level of compensation paid to others in similar circumstances; (3) the corporation's performance; (4) whether the compensation was shocking; or (5) whether the executive performed unusual or extraordinary services. More typically, though, courts do not perform this level of analysis and instead uphold the directors' compensation decisions if the director's decision-making processes are adequate and there is no fraud or duress. For example, directors should create a record that demonstrates a thoughtful and informed decision, including support from a compensation consultant or other market data.

The widespread condemnation of huge executive compensation packages for senior officers of some of the worst performing companies has and will continue to forever change executive compensation practices, rules, and claims. Directors of all types of companies should recognize this significant change and should be more cautious, thorough, and measured in executive compensation decisions. Carefully scrutinizing executive compensation arrangements and fully disclosing the company's compensation policies, the size and terms of the executive compensation packages, and the linkage of those compensation decisions with individual and company performance are now important loss prevention practices.

Emerging D&O Exposures

Despite the inherently unpredictable nature of D&O claims, organizations must continually seek to identify and mitigate future exposures. An important part of that process is an analysis of historic trends and current systemic developments that are likely to have some influence on future D&O claim activity. The following trends and developments could lead to future severe D&O claims.

Stock Market Rebound

With the stock price for many companies now at or near historic lows, it is difficult for plaintiffs to successfully allege that directors and officers officially inflate those low prices due to misrepresentations. In addition, the stock price for most companies has or probably will soon bottom out, which means the likelihood of a future severe stock drop following a corrective disclosure is not great for most companies. As stock prices rebound, though, companies that have a stock price rebound may become attractive targets for shareholder plaintiffs if those companies later announce surprising adverse information that causes a reactive stock drop. Many more companies (and their directors and officers) could be susceptible to allegations of stock price manipulation.

Misrepresenting Poor Financial Performance

In a depressed economic climate, companies may try to minimize the financial challenges by misrepresenting the company's true financial performance and condition. This fraudulent activity is not limited to the most senior officers within a company. Lower-level employees also may feel tremendous pressure to meet budget and to adequately contribute to the company's financial success. As has been repeatedly demonstrated in various large corporate scandals over the years, it only takes a few people to create a major disaster for the entire company (including innocent directors and officers).

Companies can undertake various initiatives to minimize this risk by monitoring their commitment to fraud prevention and detection. For example, companies can do the following:

∙Implement comprehensive fraud awareness training for employees that emphasizes the importance of truthful disclosures and educates them on ways to identify whether fellow employees are reporting information completely and accurately.

∙Review current policies and procedures to identify the adequacy of the company's initiatives to prevent and detect fraudulent practices.

∙Have senior management, as well as the board, assess and strengthen the internal audit and compliance programs through further training, additional personnel, and updated practices.

∙Update and publicize whistleblower procedures.

Although most large companies already have these types of programs in some form, the current increased potential for fraudulent activity suggests companies should reexamine and improve the effectiveness of those programs.

Financial Distress

Most companies have adopted dramatic initiatives to reduce costs, have closed unproductive facilities, or have revised the company's strategic and operational plans. Following such action, shareholders, and in some instances creditors, can allege management failed to act in a timely manner or with sufficient vigor or misrepresented to investors the severity of the company's financial situation or future prospects. There also may be allegations of various types of statutory violations related to the company's response to its financial challenges.

For companies that file bankruptcy, these exposures become particularly acute. History has shown that D&O claims frequency rises when the company enters into an insolvency proceeding since the company's affairs are more visible and various constituents (particularly creditors) can more easily organize and prosecute claims.

There also is a host of new and unresolved issues relating to the federal government's unprecedented intervention in financially distressed companies. As a major stakeholder in these companies, will the government become a plaintiff in D&O claims against former or current D&Os? Will other shareholders have viable claims against D&Os for allowing the government to control major business decisions for the company? Will the mere existence of that government support encourage or aggravate the prosecution of D&O claims by others? It is far too early to determine the effect of government bailouts on D&O claims, but it is certainly reasonable to believe there will be an adverse impact on defendants.

Industry Changes

Some industries are facing large transformations or acute volatility, which increases the risk of D&O claims for companies in or affected by those industries. For example, it appears the healthcare industry may be undergoing fundamental changes in the competitive marketplace and to historical revenue and expense structures. The directors and officers of the companies adversely affected by the transformation may be susceptible to a variety of claims, including disclosure claims alleging the D&Os failed to properly warn shareholders of the likely consequences of the industry changes and mismanagement claims alleging the D&Os failed to properly anticipate, plan for, and react to the industry changes.

Another example is the energy industry and companies heavily reliant on the energy industry. The price of oil probably will continue to be highly volatile, thus subjecting many companies to large swings in financial performance as their revenues and expenses vary widely with the oil price fluctuations. Many energy companies are making unprecedented investments in largely untested and speculative businesses and technologies. Inevitably, some of those endeavors will fail or disappoint investors. The larger the failure or disappointment, the better the chance for shareholder litigation that criticizes various decisions and disclosures relating to the failed or disappointing venture.

The good news for careful directors and officers is that many of those troubling exposures can be mitigated if not eliminated through prudent and common sense governance practices. But when a D&O claim eventually is filed, it is critical that the defendants have maximum indemnification and insurance protection. Like other aspects of D&O best practices, that maximum protection will exist when needed only if the company proactively and periodically evaluates and where appropriate enhances its protections, using independent, and highly qualified outside advisors.

Managing Cyber Risk Exposures and Questions for Directors

For many companies, cyber risks represent one of the most volatile and potentially damaging exposures to the company. However, because these risks are so new, evolving, and complex, many boards have given little if any attention to these risks. Although each company faces unique cyber risks and therefore each company's response to these risks should be unique, the following summarizes ten important questions that directors could ask in order to better understand these risks and whether the company is adequately responding to these risks.

1. Is the responsibility and accountability for the creation, implementation, enforcement, and updating of an integrated and company-wide cyber risk management program clearly defined at the executive level?

2. Does the management team that addresses cyber risks include senior representatives from executive management, IT, legal, risk management, public relations, and compliance/audit?

3. Is the overall cyber risk management program periodically reviewed by the board?

4. Does a board committee have designated oversight responsibility for the cyber risk management program?

5. What are the company's greatest cyber risks and how are those risks being anticipated, managed, and mitigated?

6. Is each component of the cyber risk management program documented, frequently tested, and periodically audited by independent experts, and what are the results of that testing and audit?

7. Are protocols for reacting to a cyber risk crisis when it occurs well defined and broadly understood?

8. Are all employees required to participate in regular education and training programs relating to cyber risks?

9. What is the company's budget and staffing for cyber risk management and how does that compare with peer companies?

10. What, if any, insurance coverage does the company maintain for cyber risks and is that coverage adequate in scope and amount?

Jumpstart Our Business Startups Act (JOBS Act)

The Jumpstart Our Business Startups Act (JOBS Act) was enacted on April 5, 2012, and will fully take effect when implemented by SEC rulemaking, which the statute directs the SEC to adopt within ninety days. However, due to various backlogs at the SEC, there may be significant delays beyond the ninety-day rulemaking deadline.

Some of the key elements of this important bill include the following:

∙Cutting and suspending $245 billion worth of payroll taxes for qualifying employers

∙Significant spending for a Pathways Back to Work Program for expanding employment opportunities for low-income youth and adults and extending unemployment benefits for up to 6 million long-term beneficiaries

∙Significant spending for new and pre-existing infrastructure projects, modernizing at schools and community colleges, rehabilitating and refurbishing hundreds of thousands of foreclosed homes and businesses, and additional funding to protect the jobs of teachers, police officers, and firefighters

∙Loosening regulations on small businesses that wish to raise capital while retaining investor protections

Of greatest interest to D&O insurers, agents, and brokers and emerging businesses is the change in regulations relating to how an “emerging growth company” raises investment capital. Under the bill, an emerging growth company is defined as an issuer with total annual gross revenues of less than $1 billion during its most recently completed fiscal year.

The JOBS Act is intended to make funding more accessible for emerging growth companies by allowing non-accredited investors to participate in various funding initiatives. It is believed by the sponsors of the bill and others that this will increase the number of new startup companies receiving investment capital and ultimately result in increased number of jobs, thereby lowering the current unemployment rate.

The major elements of the bill governing emerging growth companies include the following:

∙Allowing small businesses to utilize crowd funding (also sometimes called crowd financing or crowd-sourced capital, is an initiative typically making use of online media to solicit pledges of small amounts of money, purchases, or investments from individuals who typically are nonprofessional financiers). The Internet already has been a tool for fundraising from many thousands of donors. Subject to rulemaking by the U.S. Securities and Exchange Commission (SEC), startups and small businesses will be allowed to raise up to $1 million annually from many small-dollar investors through Web-based platforms, democratizing access to capital. Because the Senate acted on a bipartisan amendment, the bill includes key investor protections including a requirement that all crowd funding must occur through platforms that are registered with a self-regulatory organization and regulated by the SEC. In addition, investors' annual combined investments in crowd-funded securities will be limited based on an income and net worth test.

∙Expanding “mini public offerings.” Prior to this legislation, the existing “Regulation A” exemption from certain SEC requirements for small businesses seeking to raise less than $5 million in a public offering was seldom used. The JOBS Act will raise this threshold to $50 million, streamlining the process for smaller companies to raise capital consistent with investor protections.

∙Creating an “IPO on-ramp.” The JOBS Act is intended to make it easier for emerging, high-growth firms to go public by providing an incubator period for a new class of emerging growth companies. During this period, qualifying companies will have time to reach compliance with certain public company disclosure and auditing requirements after their initial public offering (IPO). Any firm that goes public already has up to two years after its IPO to comply with certain Sarbanes-Oxley auditing requirements. The JOBS Act extends that period to a maximum of five years, or less if during the on-ramp period a company achieves $1 billion in gross revenue, $700 million in public float, or issues more than $1 billion in non-convertible debt in the previous three years.

The exact impact on the D&O insurance market and what D&O insurance coverage implications may surface are speculative at this time; however, some of the potential issues may include:

∙An increase demand by the public company market for D&O insurance products. As emerging businesses transition from private or closely held organization structures to publicly traded corporations, many may view the previously discretionary purchase of D&O insurance now as a necessary protection and to better attract independent directors who likely would require such coverage as a condition of service.

∙Higher premiums for companies utilizing the provisions of the new Act to raise capital. Because the JOBS Act removes some of the requirements and reporting necessary to get to the public offering stage, some insurers may be more cautious in offering D&O insurance terms to such firms or the premiums may be higher due to an increased perception of risk compared to companies raising funds outside the Act whose controls are more stringent and mature.

∙New exclusions under private company policy forms that specifically preclude coverage for such things as crowd funding may emerge due to the unsettled nature of the JOBS Act and the potential for further rulemaking as respects the act's current crowd funding provisions.

∙Increased importance as to how securities law exclusions in private company D&O policies are worded and interpreted. The determination whether claims such as those based on crowd funding misrepresentation would be excluded under such policies may not always be clear.

This broad new legislation may require significant time before the D&O legal and insurance communities can assess its full impact. As such, future supplements of FC&S D&O will report on and look more closely at emerging developments from the JOBS Act, including specific D&O insurance coverage issues and strategies to be aware of.

Employment Practices Liability Loss Prevention

Although the frequency of employment-related claims has increased dramatically in recent years, one encouraging aspect is that both frequency and severity of loss can be controlled through various prevention techniques, including but not limited to:

∙Developing and implementing concise, written employment policies and procedures

∙Sexual harassment, employee-awareness, and diversity management training

∙Specific policy and procedure to avoid wrongful discharge suits

∙Settlement agreements and claim releases

∙Alternative dispute resolution: arbitration and mediation

The goal of each of these techniques is to prevent employees from bringing a formal claim of wrongdoing or lawsuit against the employer in the first place. But even when a claim of wrongdoing is not prevented by such measures, the existence of sound employment policies and procedures can be important evidence of the employer's commitment to its workforce. Such evidence may help absolve the employer of any wrongdoing or help to mitigate damages or punitive awards when a claim is found to be meritorious.

Written Procedures

In today's increasingly regulated business environment, it is more important than ever that employers have clear, well-considered, comprehensive written strategies for the prevention of employment practices liability claims. It is equally important to document the implementation of such procedures through training and education programs.

Interviewing, Pre-Employment Screening, and Testing

A sound strategy to avoid employment-related claims should begin even before an employer hires an employee. Federal labor laws and the labor laws of many states place strict limitations on the pre-employment inquiries that a prospective employer may make of a job applicant. Within these parameters, however, there is much that an employer can do to protect itself against possible employment practices claims.

Interview Dos and Don'ts

Anyone who conducts an employment interview should use a written interview guide. Such a guide should contain a detailed script for conducting the interview, including all of the questions that are needed to enable the interviewer to obtain a complete and accurate overview of the applicant's skills and experience. An interview guide assures that applicants are handled in such a way as to make comparisons between applicants both valid and reliable. Remember, however, that an interview guide is just that, a guide. Effective interviewing obviously requires flexibility. Interview questions need not be asked in the order shown in the guide, and some may even be omitted as an interview progresses. Digression from the interview guide, both in order to retain spontaneity and to pursue particular inquiries about a given applicant, are always appropriate.

A structured interview should cover the following basic areas:

∙Background information about the applicant

∙Questions about job-related behavior (for example, the applicant is asked to describe what decisions and/or actions he or she has made in situations similar to those that will be encountered on the sought-after job)

∙Follow-up questions (such as questions concerning information that may be missing from the application form)

∙Questions about the applicant's education history

∙Questions relating to specialized training and skills

∙Questions about intangible factors such as the applicant's goals and attitudes

∙A description of the job being interviewed

∙A description of the next step in the interview/hiring process

The Employment Application

An employer's application form should notify applicants that any material misrepresentation or omission will be grounds for refusal to hire them. It also should be made clear to applicants that even if they are hired, any later discovered misrepresentations or omissions on their application may result in discharge.

The application should require complete disclosure of the applicant's educational and work history. A request for references should also be included on the application. Overstated or falsified job applications are an endemic problem for employers. Before an offer of employment is made, the employer should independently confirm the information provided by the applicant. It is particularly important that the employer question the applicant about any time gaps in his or her educational or work history. References should be called and background information sought before an offer of employment is extended. An employer that fails to carefully review an employment application and check references might subsequently be the target of a claim if it becomes necessary to terminate the employment relationship at a later date.

The employment application also should include a clear, concise statement that employment is “at-will.” At-will means that the employment relationship may be terminated at any time, by either the employer or the employee, without notice and for any reason that is not otherwise illegal. Many courts have held that an at-will statement contained in the application protects an employer against claims of wrongful termination or termination without good cause in breach of an implied contract of employment. An at-will statement does not, however, prevent an employee from claiming discriminatory discharge in violation of Title VII, the ADEA, the ADA, or some other federal or state anti-discrimination statute.

Reference and Background Checks

Recent surveys suggest that anywhere between 25 and 35 percent of job applicants lie, misrepresent, and/or omit material information from their employment applications. These misrepresentations and omissions may relate to an applicant's educational qualifications, work experience, or other relevant matters. Therefore, it is important that an employer check an applicant's references in order to confirm at least basic information about the dates of employment and positions held, attendance, and performance at various schools.

Of course, personal references usually will present a favorable picture of the applicant, but they should be checked anyway. Many applicants will list as references the most important people that they know. These people often are particularly frank and objective.

When attempting to elicit meaningful information from a personal reference, it may be helpful to ask about some weakness in the applicant that the employer has already independently discovered. Normally, this will result in either a confirmation or a detailed denial.

If a reference does raise concerns about an applicant who has been tentatively chosen for employment, the employer should not automatically disqualify the applicant. If the unfavorable information is inconsistent with the information gathered from other reference checks, it may suggest a biased or mistaken reference. At minimum, another interview should be scheduled with the applicant so that the negative information can be explored.

Drug and Alcohol Testing

An employer may elect to have applicants undergo drug and alcohol testing (if the applicant is applying for a job as a driver that is covered by regulations of the Department of Transportation, a pre-employment drug screen is required). This type of testing often is an effective technique for screening out potential employees who may prove problematic if hired. Drug and alcohol tests may be done in conjunction with a pre-employment physical or they may be required by employers that do not make use of such physical examinations. In either case, the drug and alcohol test should be administered only by a medical facility using state-of-the-art equipment, such as a gas chromatographer. If the applicant does not pass the drug and alcohol test, a sufficient sample should be maintained so that a second, confirming test can be performed.

Some states, however, restrict or prohibit such testing altogether, and under the federal Americans with Disabilities Act, such testing can be conducted only after a conditional offer of employment has been extended. The test then must be uniformly given to all persons who are hired for a particular position. An employer that implements a drug and alcohol testing program in violation of law, or that implements a poorly designed program, runs the risk of a claim of unlawful discrimination by an applicant who is denied employment because he or she refused to take the test or did not pass it. In some states an employer's demand that an applicant take such a test may be a violation of statutorily protected privacy rights, giving rise to yet another possible claim against the employer.

Job Offers

In order to avoid misunderstanding and potential claims, all job offers to applicants should be clear and unambiguous. Job offers should address (1) compensation and benefits, (2) relocation requirements and benefits, if any, (3) working hours, (4) travel requirements, (5) starting date, (6) deadline for accepting the offer, and (7) any special job requirements. Job offers normally are based on certain conditions, such as passing a physical examination and/or drug and alcohol test, receipt and verification of references and academic degrees, and proof of citizenship or legal ability to work in this country. While most job offers are made orally, some employers may choose to confirm them in writing, particularly for senior employees.

Job Descriptions

An employer should develop written job descriptions for every position in the organization's work force. Job descriptions should set forth the educational, experiential, and physical requirements of each position. The essential functions of each job should be clearly defined. In addition, job descriptions should delineate each employee's supervisory and reporting roles.

Employee Handbooks

After an applicant has been hired, the employee needs to be made aware of what the employer expects of the employee and what the employee can expect from the employer as a part of the employment relationship. This information often is best provided by clearly stating the employer's policies, rules and procedures in an employee handbook or manual.

The possible topics to include in an employee handbook can be extensive, ranging from non-discrimination and hours of operation to sick leave and at-will employment. While the actual content of a handbook will depend upon the nature and size of the employer's operation, a listing of some of the policies that an employer might consider for inclusion is illustrated in Exhibit 3 of this section. An employee handbook also is an indispensable resource for orienting and training new employees. A handbook can serve as a readily available guide for personnel administration and can be used to instruct supervisors and managers who themselves may be unclear about the employer's policies, or who may otherwise commit unintentional violations of law.

For an employer, particularly one with a small or medium-sized workforce, effectively managing employees is an increasingly complicated and timeâ€'consuming task. Employers often find themselves without consistent or cohesive policies on a multitude of subjects, including proper hiring procedures, discipline rules, and termination techniques. Subsequently, the employer is forced to resort to managing its employees on an ad hoc basis. This situation arises for employers that are not large enough to employ an experienced personnel administrator.

Problems associated with the lack of formal and comprehensive policies and procedures on matters such as leaves of absence, absenteeism, and sick leave often lie dormant for long periods of time. Unfortunately, when such problems do surface, they often come in the form of a charge of discrimination, the denial of pregnancy or family-care leave, an administrative investigation, or a lawsuit alleging wrongful termination in breach of an implied contract of employment.

Frequently, the employer does not recognize the need for an employee handbook until it is too late. With carefully drafted and legally reviewed provisions in an employee handbook that clearly discuss issues such as non-discrimination, leaves of absence, and equal employment, the likelihood of disputes and litigation are greatly reduced. At minimum, a wellâ€'written employee handbook can significantly reduce the time, energy, and money that employers may be required to expend in the defense of judicial and administrative claims by their employees. For example, the EEOC will give great deference to properly written and implemented equal-employment and non-harassment policies.

Also, many federal and state labor laws, including FMLA and various state anti-discrimination statutes, now require that employees receive written notification of their statutory rights relating to employment. An employee handbook can help employers comply with these legislative mandates, while at the same time providing employees with a balanced and understandable explanation of their

rights and benefits.

Sexual Harassment and Employee Awareness Training

Most employers will benefit by changing the way they think about sexual harassment and the way that their employees interact with one another. What used to be considered safe, consensual conduct often can be misconstrued and should be avoided entirely.

The Scope of Sexual Harassment Claims

Items as innocuous as birthday cards, Christmas gifts, or even supportive hugs can be taken out of context and used against employers. In such an environment, employers should counsel their employees to avoid sexual jokes or comments altogether. Countless cases involve employees who laughed at a joke and seemingly participated in the fun, only to later contend they simply felt too embarrassed to complain. The fact that an employee merely laughed at a joke, comment, or gesture does not insulate the employer from liability or bar the employee from later bringing a claim.

One of the most common complaints of sexual harassment involves the consensual relationship between employees. Often, a spurned lover later claims that he or she was pressured into granting sexual favors for the sake of keeping the job or advancing in the business. Other employees claim that when they have attempted to break off the relationship, the coworker refused to listen and continued to pressure the employee at work. Either scenario makes for the need to sort through the stories by way of messy, expensive, and often embarrassing depositions and written discovery in litigation. An employer's claim that the relationship was consensual will not make a lawsuit go away. It usually is left to a jury to decide whether the relationship was truly consensual. Some juries have decided that where a relationship involves a supervisor and a subordinate, an implied threat is inherent in the relationship.

Non-Fraternization Policies

Because of the increased exposure arising from sexual relationships among employees, many businesses are implementing non-fraternization policies by prohibiting sexual relationships between coworkers, especially in employee/supervisor relations. However, before implementing such a policy, employers should consult with expert counsel in their state, as some states prohibit employment policies that affect employees' activities outside the workplace.

Harassment Policies and Communication

The key to controlling sexual harassment in the workplace is communication. Employers must adopt strong and clear policies prohibiting such conduct and make their employees aware of these policies. At a minimum, a sexual harassment policy should describe and give examples of the various types of conduct that might be deemed as harassment. The policy also should make clear that the employer will not permit or condone sexual harassment in the workplace and that any such harassment will result in severe discipline, up to and including termination.

Diversity Management

As the frequency and severity of harassment and discrimination claims continue to rise in the U.S., more companies and public agencies are attempting to reduce their exposure to such risks by investing in workplace diversity and awareness programs. However, without careful planning and a critical evaluation of the effectiveness of such programs, the risk of claims may not be reduced. Poorly executed programs may even increase the potential for claims.

Because media scrutiny increasingly focuses on high-profile sexual harassment and discrimination cases, such as publicized cases involving Texaco or Mitsubishi, some corporations are actively pursuing diversity management programs, betting that such initiatives can improve worker morale, improve productivity and ultimately reduce their exposure to potential lawsuits and claims. Other companies are implementing diversity programs simply for their perceived public relations value.

However, critics of diversity management warn that companies may need to temper their enthusiasm and take a critical look at diversity initiatives that promise to manage or mitigate the risks of sexual harassment and racial discrimination.

Preventing Wrongful Discharge Suits

Specify the Rules

As noted previously, an employer should take care not to promise employees more than it can or is willing to deliver. For example, an employer should not talk about “permanent” or “lifetime employment” when it does not really mean that it will keep the employee forever, regardless of circumstances. Close attention should be paid to employee handbooks, employment applications, and other employment documentation that may suggest that an employee's employment is permanent or that discharge will occur only for “good cause.” Employers should avoid disciplinary policies that provide for termination only when an employee violates a specifically identified rule. Such a policy might be interpreted to mean that an employee cannot be terminated for any other reason, even something as serious as theft. Similarly, an employer should avoid creating a progressive discipline process that restricts the employer's ability to terminate an employee without taking every step in the process. It should be noted, however, that some employers, such as governmental bodies receiving federal funds, are required to afford certain classes of employees' due process rights prior to a demotion or termination. These employers, therefore, have limitations on their actions to terminate employees without following specified procedures.

An employer should consider expressly defining its employee-discharge policy as “at-will.” This can be accomplished by including a clear at-will employment statement as part of the employment application completed by prospective employees, or by having newly hired and existing employees sign an at-will employment agreement. However, since such a disclaimer may have a negative impact on employee morale, some employers prefer to adopt detailed rules advising employees of what conduct will result in discharge. On the other hand, such a list of rules may inadvertently omit some appropriate grounds for discharge. Each approach has its advantages and disadvantages, but in either case, the employer must take care that employees clearly understand the rules.

Many employers require a newly hired employee to serve a probationary period. Such a requirement is thought to give the employee a trial period during which the employer is free to discharge the employee for little or no reason. But many courts have found an implication that discharge may be made only for good cause when the employee successfully completes the probationary period. Also keep in mind that an employee discharged during a probationary period still can make a claim for unlawful discrimination. Employers should consider avoiding any reference to a probationary period. Use of the term trial period may help, but to avoid any misunderstanding of the intent of a trial period, the employer may choose to discontinue the practice of a formal probationary period and instead informally observe a new employee's performance and document deficiencies as needed. A waiting period still may be required for benefit eligibility, but without the negative implication that arises from a formal probationary period.

Be Candid with Employees

An employer should give employees regular, periodic written evaluations of their work performance. Unfortunately, many employers that evaluate employees seek to avoid the sometimes difficult task of informing an employee of less-than-adequate performance. The resulting inflated evaluation can be used against the employer at a later date. For example, an employee discharged because he or she did not get along with coworkers might point out that such a problem was never mentioned in any performance evaluations, and in fact he or she was always rated above average in their peer interactions. Where this occurs, a jury might be persuaded that the reason given by the employer for the discharge was actually a subterfuge and that the discharge was based on unlawful discrimination. Therefore, it is important that evaluations accurately and candidly reflect the employee's performance as compared with the employer's standards and expectations.

If an employee's performance is so poor that he or she is in danger of discharge, the evaluation should specify the areas of needed improvement, give a specific time frame within which the employee is to improve, and put the employee on notice as to the consequences of non-improvement.

Employees should be provided with a copy of their performance evaluations. They also should be given an opportunity to make comments. The employee should be asked to sign the evaluation form. If the employee chooses not to exercise this right, the employer should have that fact witnessed and documented. The employer should keep the signed evaluation, along with other employment documents, such as employment applications, warning notices, and termination reports, in readily identifiable and confidential employee personnel files. The most comprehensive employment documentation in the world is meaningless unless the employer can find it when needed.

Employee Discipline

Except in cases such as theft, intoxication at work, or gross misconduct, progressive discipline should precede discharge. In other words, an employee ought to be given one or more warnings or some other type of discipline, such as a suspension, demotion, or transfer prior to discharge.

In the case of employee evaluation, a disciplinary notice should be honest and direct. The employee should be informed as to the reason for the warning or discipline, accorded a specific period within which to meet the employer's standards of performance, and advised as to the consequences of non-performance. The employee, after having an opportunity to comment upon and sign the warning notice, should be given a copy, with the original being retained in the employee's personnel file.

Consider the Options

Discharge is not the only possible solution to the problem of an employee who performs unsatisfactorily or violates employer rules and policies. If the employee has a long record of good service but has recently been promoted to a job that is beyond his or her ability, an employer might consider demotion, possibly by return to a job in which the employee adequately performed. If the employee's problem arises from a personality conflict with peers, counseling might be considered.

Other alternatives might consist of a referral to an employee-assistance program, a disciplinary suspension without pay, or the granting of outplacement assistance or other benefits in exchange for a written release of claims against the employer.

Discharge

In those situations where it becomes necessary for an employer to discharge an employee, the reasons for the discharge should be documented in writing. Care must be taken when stating the reasons for discharge. In any subsequent administrative or judicial proceedings, an employer may not be able to rely upon grounds other than those originally presented to the employee to support the discharge, even if there were other reasons. Additionally, care should be taken to avoid any implication that discharge was based on an illegal reason. For example, if an employer discharges a woman because of her inability to fulfill the aspects of a job that requires travel, the employer may be exposed to a claim of sex discrimination if she is unable to travel because of childcare.

The discharge interview is not an appropriate time for the employer to try to avoid hurting an employee's feelings by being less than absolutely candid. This is not to say that the final meeting between the employer and the employee should degenerate into a name-calling session. On the contrary, the discharge interview should be handled as tactfully as possible, since in some states the manner and method of an employee's discharge may actually be the basis for a lawsuit. Therefore, the employer should have two representatives at the discharge meeting: one who conducts the meeting and one to witness the event. Both employer representatives should prepare a file memo immediately after the meeting, detailing what happened and what was said. These memos should be put into the employee's personnel file in case of any subsequent administrative or judicial claim. The discharge meeting should be conducted behind closed doors to avoid involving the entire company. While other employees ought to be informed of the discharge, it is usually best that they not be given detailed explanations. To avoid claims of defamation, such matters should be left between the employer and the employee. The discharged employee should be allowed to collect his or her personal belongings and leave the employer's premises without being humiliated.

Post-Termination References

Often, an employer will be approached by a discharged employee or their prospective employer for a reference. The employer may feel some obligation to give a positive reference to help the employee get a new position. Such a reference, however, may undermine the reason given for discharge and may be used against the employer in case of subsequent litigation. On the other hand, a negative reference, even if truthful, may provide fuel for a discharged and already disgruntled ex-employee to bring a claim against the former employer for defamation, blacklisting, or discrimination. To avoid this possibility, an employer should give a “neutral” job reference that includes only length of service, final position held, and rate-of-pay at termination.

Settlement Agreements and Release of Claims

If an employer is in the process of discharging an employee and believes that the employee may respond with some sort of administrative or judicial claim, the employer may consider the use of a settlement agreement and release of claims. Under such an agreement, the employee may receive severance pay, outplacement assistance, or an extension of benefits that he or she would not otherwise legally be entitled to. In return, the employee waives all claims relating to his or her discharge or any other aspect of the employment. Thus, the employer is protected from post-employment litigation.

However, there are some restrictions on the use of such settlement agreements. For example, an employee cannot give up an age-discrimination claim under the federal Age Discrimination in Employment Act unless he has been given twenty-one days to consider the waiver. Even then, the employee has a seven-day period to cancel the settlement agreement. Similarly, some states restrict the types of claims (such as workers' compensation and unemployment) that employees can waive. Employers also should be aware that employees sometimes claim that they were in a position of duress at the time of signing a release or waiver, and therefore such release or waiver is ineffective. The employer should take care to avoid placing undue pressure on an employee to sign a release or waiver agreement.

Arbitration and Mediation

In an effort to control the cost of litigation, employers increasingly are turning to arbitration agreements and mediation to resolve employment-related disputes. While arbitration and mediation generally are effective loss-control tools, some employers favor these alternative dispute-resolution procedures while others do not. Depending on how the arbitration or mediation agreements are structured, there may be a debate whether such agreements are just and fair for both the employer and the employee.

An increasing number of employers are requiring as a condition of employment that applicants and employees give up their right to pursue employment discrimination claims in court and agree to resolve disputes through binding arbitration. These agreements may be presented in the form of an employment contract or be included in an employee handbook or elsewhere. Some employers have even included such agreements in employment applications.

The use of such agreements is not limited to particular industries but can be found in various sectors of the workforce, including, for example, the securities industry, retail, restaurant and hotel chains, health care, broadcasting, and security services. Some individuals subject to mandatory arbitration agreements have challenged the enforceability of these agreements by bringing employment discrimination actions in the courts. The EEOC, while mindful of case law enforcing specific mandatory arbitration agreements (in particular, the Supreme Court's decision in Gilmer v. Interstate/Johnson Lane Corp., 500 U.S. 33 (1991)), nonetheless believes that such agreements are inconsistent with the civil rights laws.

Other Considerations

While many employment-related disputes will continue to be resolved through formal litigation, arbitration and mediation appear to be the dispute-resolution models most likely to predominate in the future. If approached with a focus on fairness, an arbitrated or mediated resolution of employment problems often results in a less acrimonious and more productive workplace for all concerned. However, employers should give careful consideration to the benefits and possible pitfalls of arbitration and mediation before deciding if these procedures are right for the company. Employers also should consult with qualified counsel experienced in employment-related matters prior to developing and implementing any employment agreement that requires arbitration or mediation of employment disputes.