Your Risks as a Board Member

Just before Christmas last year I received a frantic phone call from my Aunt Caroline, who told me that she had been named a defendant in a lawsuit. Aunt Caroline is 86 years old and until 1991 served as one of three members of the board of our family business, a $40 million mail-order distributor of supplies for biological education in Burlington, North Carolina. The corporation’s attorney had called my aunt to notify her that she was being sued, along with the other two board members, by a dissident shareholder.

Unfortunately, she had become caught in a crossfire between my older brother, Edward, the president of the company and owner of 68 percent of the stock, and my younger brother, Bill, who is not active in the business but owns 13 percent. After a long history of profitable years, the company founded by our father suffered a modest loss in 1992. Bill’s suit sought damages, charging that Edward had mismanaged the company while benefiting from an overly generous compensation package. Since Bill was suing on behalf of the corporation—an action known as a shareholder’s derivative suit—the attorney for the corporation told my aunt that he could not represent her.

After my aunt calmed down, I told her she was a blameless victim of the argument between my brothers but would have to undergo the ordeal of defending her actions as a board member. As an attorney, I agreed to act on her behalf and lead her through the labyrinth of approaching interrogatories, depositions, hearings, and media coverage.

As an employee and officer of Carolina Biological Supply since 1944, Aunt Caroline has devoted her life to helping make the business a success. (At 86, she still comes to the office every day to assist with maintaining the catalog mailing list.) When she first agreed in 1979 to serve on the board, she considered it an honor. Like most family business directors, my aunt never sought or received any advice on the duties and liabilities of board membership.

However, ignorance of such duties is no defense, and by agreeing to serve, every director enters a special relationship with the corporation, other stakeholders, and the public that subjects them to the possibility of someday having to defend their actions in court. This applies to first-generation family businesses with only two or three stockholders and directors as well as to second- and third-generation companies with multiple shareholders and directors.

Fortunately, the duties and obligations of board members are not overly numerous or difficult to understand, and there are steps that can be taken to limit personal liability. Indeed, most states, as a matter of public policy, try to minimize personal liability, in order to enable businesses to attract and keep qualified directors.

Assessing the risks

In today’s litigious society, there is an ever-present danger of being sued as a board member. You can be sued by shareholders, competitors, suppliers, unions, customers and other private citizens, and even by your fellow directors. Companies that engage in merger, acquisition, and divestiture activity or experience an after-tax loss pose special risks for directors. And you can also be sued by the government, which sometimes targets directors along with officers of the corporation in cases involving workers’ rights and environmental hazards. In cases of pension violations and company activities resulting in pollution that threatens employee health or the community, directors are increasingly being held civilly and criminally responsible under federal statutes.

For directors of most companies, however, the risk is not of crisis proportions. In Creating Boards for Private Enterprises (Jossey Bass, 1991), John Ward of Loyola University in Chicago, a top advisor to family businesses, writes: “…for the small and medium-sized private company, the specter haunting the modern boardroom—the fear of director liability—is little more than that: a phantom that fades on close inspection.”

The risk of being sued

Source: The Wyatt Company, 1992 Directors and Officers Liability Survey.

This perception has been confirmed in an extensive, well-documented survey by the Wyatt Company, the international management consulting firm. In its Directors and Officers Liability Survey for 1992, Wyatt researchers found a strong correlation between the size of a company’s assets, the number of shareholders, and the risk that their directors will be sued. Directors from 1,342 companies responded to the Wyatt survey. The table above shows the percentage of board members who were sued at least once as a result of their roles as directors. Wyatt regards these percentages as a yardstick of the risk of being sued.

The table shows that the chance of being sued is cut in half as the size of the company decreases from one asset category to the next. According to Phillip N. Norton, who compiled the data, the risk continues to decline for companies with total assets of $50 million and below.

The second part of the table demonstrates that the risk of being sued for directors of companies with fewer than 500 shareholders is approximately one-third that of companies with more than 500 shareholders. Again, the risk assessments are based on the percentage of respondents in the Wyatt survey who actually had to defend a lawsuit as directors.

The Wyatt survey found that shareholders were responsible for 52 percent of the lawsuits against directors. Employees accounted for an additional 20 percent, and customers and clients for 16 percent; competitors brought 6 percent of the suits, government 3 percent, and other third parties 3 percent. Typical claims in these actions were: breach of duties to minority shareholders; conflicts of interest; breach of trust; approval of excessive compensation; imprudent investments; misuse of inside information; breach of employment contracts; and improper expenditures.

Some of these charges will sound familiar to shareholders of family businesses. The danger of a lawsuit to a family business director is particularly acute whenever one or more minority shareholders not active in the business are dissatisfied with the way the company is being managed, with the size of dividends, or with their inability to cash in their stock.

For board members of family businesses, conflict among shareholders should be a red flag. Dan Bailey, an attorney in Columbus, Ohio, who is knowledgeable about director duties and liabilities, says that shareholder suits between family business members are especially hard to defend. These cases, he says, usually generate emotional heat that reduces the chances of rational judgments and an early settlement.

This has certainly been true in my Aunt Caroline’s case. Had she realized the implications of the developing feud between Edward and Bill over how the company should be run, she might have foreseen that the conflict would end up in court. In such circumstances, the wise course for a director to take is to resign. Ultimately, she did, but only after it was too late to avoid being dragged into court.

Responsibilities of the board

What is the role of the board of directors? What legal functions are expected of the board and how do they result in liability?

The Revised Model Business Corporation Act (1985) developed by the American Bar Association and followed by a majority of states, broadly defines the role: “All corporate powers shall be exercised by or under the authority of, and the business and affairs of the corporation managed under the direction of, its board of directors.” The company’s articles of incorporation and bylaws can expand or limit board functions.

Recognizing that a formal operational board is more fiction than fact for most family businesses and businesses with fewer than 50 shareholders, the American Bar Association developed The Model Statutory Close Corporation Supplement (1985) whose provisions have been included in the corporation statutes of most states. The Supplement allows family businesses to tailor their board to their own specifications. They can dispense with or limit the authority of the board as desired, provided they specify in the corporate charter who will be responsible for performing the traditional board functions. Under the Supplement, family businesses no longer have to maintain the fiction of having an active, functioning board of directors. However, whoever is designated by the charter as having the responsibility for performing the required duties will be held liable on the same basis as a board member.

First line of defense

Most lawsuits are based on an alleged failure of the director to meet the standards of conduct required by state law. The first line of defense in any suit is to show that the director did discharge his or her duties as required by law.

Before serving as a board member you should ask your attorney to review your state’s statutes and advise you on what conduct is required. The standard set by most states is the one recommended by the American Bar Association in the Model Business Corporation Act, which requires that a director discharge his duties: in good faith; with the care an ordinarily prudent person in a like position would exercise under similar circumstances; and in a manner he reasonably believes to be in the best interests of the corporation.

In deciding whether or not a director has violated the required standards of conduct, the courts interpret the director’s actions in light of the business judgment rule. Under this rule, the director who has complied with the required standard cannot be held liable for injury or damage caused by his or her decision, no matter how unwise or mistaken it ultimately proves to be. To successfully challenge a director’s actions a plaintiff must prove the absence of one of the five elements essential to the standard of conduct, which are:

• Business decision. That the director’s actions were the result of a business decision.

   

• Disinterestedness. That the director was disinterested in the outcome of the decision and was not guilty of self-dealing. This raises the question of whether the director violated the duty of loyalty.

   

• Good faith. That the director exhibited honesty and integrity and a desire to benefit the corporation’s shareholders.

   

• Due care. That the director made a reasonable effort to obtain the information needed for informed decisions.

   

• No abuse of discretion. That the director’s decisions had a rational business purpose and were not so unreasonable as to fall outside of permissible bounds. An example of a possible abuse would be a director who voted to pay twice the true market price for a piece of property. Since courts presuppose discretion, the possibility of proving the abuse of this element is rather illusory.

The business judgment rule creates a presumption that in making a business decision, the director has informed himself about the issues and alternatives and has acted in good faith and the honest belief that the chosen course is in the company’s best interests. To overcome this presumption, a plaintiff must show that the director’s actions were illegal, motivated by self-interest, or made without adequate investigation or deliberation.

A landmark case on the business judgment rule is Smith v. Van Gorkom, which was decided by the Delaware Supreme Court in 1985. In this case, after a brief, two-hour meeting, the board of Trans Union Corporation approved the sale of the company for $55 per share to a takeover specialist. The board’s decision was based solely on verbal presentations by four individuals, one of whom was Van Gorkom, the CEO of Trans Union. The court found the board’s decision-making process, which took only two hours to set a price for the complete sale of a $700 million company, to be so inadequate that the board could not have made an informed business judgment. Therefore, the board’s decision was not protected by the business judgment rule and the court found the officers and directors liable for any resulting damages. In this case the directors were fortunate since the suit was settled for $23.5 million, which was reportedly paid for by insurance ($10 million) and voluntarily by the takeover specialist ($13.5 million).

The Van Gorkom decision was a wake-up call to directors, that they had better be prepared when voting on major corporate decisions if they wanted the protection of the business judgment rule. In response to the threat of expanded liability posed by Smith v. Van Gorkom, Delaware and most other states have enacted provisions authorizing corporations to eliminate or limit a director’s personal liability for shareholders’ derivative suits or for actions brought by a corporation against a director. In most states, these provisions are optional and require the corporation to amend its charter or bylaws in order to institute them.

In my Aunt Caroline’s case, the defendants filed a motion to dismiss on the grounds that Bill, the minority shareholder, had failed to overcome the presumption that the directors were acting “other than in good faith and in the exercise of their reasonable business judgment.” The judge agreed and granted the motion. The case is now being appealed.

Paying the legal bills

In most cases the financial risk to the director is not the danger of an adverse judgment. Very few courts find a director guilty of a breach of duty. The big expenses are associated with the costs of having to defend a suit. At one hearing in my aunt’s case, the courtroom resembled a state bar convention. There were eight attorneys besides me. Because of the possibility of conflicts of interest between the corporation and the defendants, and among the defendants themselves, each party had to have his or her own attorney. With hourly rates for experienced attorneys averaging $200, this added up to a total hourly expense of $1,600 that will be paid to lawyers.

Who will pay? When a director is named a defendant, he will look first to the corporation to pay all legal fees and liabilities. This payment of legal expenses by the corporation is referred to as indemnification. There are three categories of indemnification: mandatory, prohibited, and permissive.

• Mandatory indemnification: When a director is successful in defending a suit on its merits, the corporation must pay all legal expenses incurred. This obligation includes cases dismissed on technical grounds such as the running of the statute of limitations. However, a corporation can limit the right of the director to mandatory indemnification through provisions in the company’s articles of incorporation.

   

• Prohibited indemnification: Indemnification is prohibited by most states when the director is found guilty of serious personal misconduct such as having violated his fiduciary duty to the company or when the director knows, or should have known, that his activities were clearly in conflict with the best interests of the corporation. This prohibition is based on the reasoning that it is against public policy to permit indemnification under such circumstances.

   

• Permissive indemnification: Permissive indemnification allows the corporation to pay attorney’s fees, judgments, and settlement payments when the director is found to have acted in good faith and in a manner he or she reasonably believed to be in the best interests of the company. Statutory provisions for permissive indemnification vary by state and can be provided by a company’s articles of incorporation, bylaws, individual contracts with directors, or shareholder resolutions. If you are contemplating joining a board, you should have your attorney review the company’s charter and bylaws to make certain you are covered to the maximum extent allowable by your state’s law.

Since lawsuits can drag on for years, it is important to make certain your company’s charter or bylaws provide for the periodic payment of legal expenses by the corporation. The typical state statute permits such payments provided the director signs a promise to repay the expenses if he loses the case and is not entitled to indemnification.

In the lawsuit involving my Aunt Caroline, the company has paid the legal expenses so far but has required her to sign an agreement that she will, “repay the Company—-unless it shall ultimately be determined that—-(she) is entitled to be indemnified.” In such matters the language used in the articles of incorporation and bylaws determines whether the company will be required to indemnify the director, so check these provisions before you need them.

Even when the company is bound by its own bylaws to provide indemnification, the directors may ultimately be hit with all the costs of an expensive lawsuit. The corporation’s promise to pay for liability and legal costs is of little value if the company is insolvent and goes out of business before the suit is resolved.

Directors and officers insurance

According to the Wyatt survey, only 45 percent of the companies with assets below $50 million have D&O insurance. The number with such coverage increases to 65 percent for companies with assets of $50–$100 million. The two main reasons given for not carrying D&O insurance were “Management sees no need for it” (49 percent) and “The costs are too high” (48 percent).

The survey showed that the median premium for D&O insurance was $25,000 for companies with assets of less than $30 million and $52,303 for companies with assets of $30–$100 million. A number of factors influence the amount of premium, among them company size, number of shareholders, type of business, deductible limits and exclusions, and the financial health of the company. There is little uniformity in the price of D&O policies, and the insurance companies are often close-mouthed about how they calculate premiums. So it pays to shop around for a fair price.

Should your company have D&O insurance? Dan Bailey of Columbus, who is with the firm of Arter and Hadder, says there are four good reasons for purchasing D&O insurance:

• D&O insurance covers many gaps in state indemnification laws. For example, some states do not allow indemnification if a suit is settle, prior to trial and any payment is made to the plaintiff. Such expenses can be covered by insurance, however.

   

• Many states prohibit indemnification if a director is found by the court to have violated the standard of conduct, yet allow an insurance carrier to pay liability and defense costs. State statutes permit the insurance carrier to decide on what its policies will and will not cover.

   

• If a director violates federal securities laws, D&O insurance can cover the liability and defense costs. Insurance is particularly important in such cases because the Securities and Exchange Commission specifically says indemnification of these expenditures is against public policy. Owners of privately held businesses should remember that the sale of any company stock is controlled by the same securities laws that control the sale of stock in publicly held companies.

   

• D&O insurance protects a director if a corporation becomes insolvent and, as a result, is unable to pay for liability and defense costs. Many complex business cases take years to resolve. What guarantee does the director have that the company will still be in business when time comes to pay the legal bills?

A major consideration in choosing one one policy over another is the number and type of exclusions—acts for which the insurance company will not provide coverage—in the policy. Typical exclusions include suits by the corporation against a director or by one insured director against another; acts involving fraud, personal profit, or public offerings; environmental actions; discrimination claims; and leveraged buyouts. Coverage for these types of claims are routinely excluded and the purchaser will have to pay substantially more for the policy which omits these exclusions.

Carolina Biological Supply carries D&O insurance, but it did not cover Aunt Caroline’s defense costs because the policy specifically excludes suits by one director against another. Before serving on a board, you should have your attorney check the company’s D&O policy for exclusions, liability limits, deductibles, cancellation provisions, and allowance for periodic payments of litigation expenses.

In response to Smith v. Van Gorkom, most states enacted new statues authorizing corporations to eliminate or limit a director’s personal liability for monetary damages to the corporation or shareholders for an unknowing breach by the director of his fiduciary duty. This provision is quite effective in preventing shareholder derivative suits, the most common cause of legal action against directors.

The advisory council alternative

In an attempt to get around the liability threat, some companies prefer to establish an advisory board or council of advisors rather than a formal, legal board. John M. Nash, president of the National Association of Corporate Directors, suggests that business owners who have never had an active board might want to start by appointing an advisory board. In addition to concerns about liability, an advisory board is a good first step for owners who worry that an outside board might interfere with their decision-making. Once owners discover that a board does not threaten their control, that the members are there to question the basis for their decisions but not their authority to make them, the advisory council can be turned into a legal board with full voting responsibilities.

Whether the members of an advisory council will be insulated from liability depends on how the council is structured and how it performs. Dan Bailey believes that if the members perform the same functions as regular board members, for example if they provide management with business advice—such as which accountants to use or whom to make a corporate officer—they will be held accountable for the same standards as a normal board. Though many companies now have advisory boards, Fred A. Tillman, professor of legal studies at Georgia State University, says that he has been unable to find any major court tests on whether members of advisory councils can be held liable for corporation actions. He recommends that council members be careful not to function as board members.

For members of legal boards, however, there is no such ambiguity. Anyone who is now on the board of a family business, or is considering becoming a member, should be familiar with the duties expected of a director and the standard of conduct required by law. For directors who perform their mission of supervising management to the best of their ability, the risk of being sued is minimal. It should not deter them from serving a well-managed, successful company.

In determining the level of risk, you should pay particular attention to the quality of management; the number of shareholders; the family’s ability to cooperate and its reputation for fair dealing; the company’s plans for mergers and acquisition; and its environmental record. You should have your attorney review liability limits and provisions for indemnification in the company’s bylaws and articles of incorporation as well as its D&O coverage. In today’s corporate world, board membership can no longer be treated as membership in a Good Ole Boys’ Club, but as a serious undertaking that carries risks as well as rewards that should be accepted only by responsible business persons.

John S. Powell, a former president of Carolina Biological Supply, is now a certified Superior Court mediator for the state of North Carolina and a family business consultant. He is also director of the North Carolina Family Business Forum in Burlington.

Doing the right thing as a director

• Keep yourself informed about company affairs on a continuing basis and actively participate in board deliberations.

   

• Obtain in advance and carefully review specific proposals to be acted upon at board meetings. A director has a duty to be fully informed about such issues.

   

• Act with care and be deliberate in deciding how to vote on matters that come before the board. Do not make hasty decisions; you might be guilty of negligence if you decide a matter before you have had adequate time to study it.

   

• Avoid transactions that place your interests in conflict with the company’s.

   

• Use company and outside experts such as accountants, attorneys, and valuation specialists if they will help you make an informed decision.

   

• Maintain written records of your preparation and deliberations on important board issues. If you disagree with a board decision, make certain that your dissent and the reasons for it are entered into the minutes. A good set of board minutes will be vital to your defense in any lawsuit.

— J.S.P.