The ACE Report is a periodic publication distributed to policyholders and other interested parties as a service by ACE. Its purpose is to address insurance concerns worldwide, as well as present timely information on current developments in liability issues surrounding directors and officers. The Editor of the ACE Report is Dan A. Bailey, a lawyer at Bailey Cavalieri LLC. in Columbus, Ohio, USA and a respected voice in the complex area of directors and officers liability.

Although prepared by professionals, this publication should not be utilized as a substitute for legal counseling in specific situations. Readers should not act upon the information contained herein without professional guidance.

Corporations, directors, officers and D&O insurers are already well aware of these potentially catastrophic federal securities law exposures. However, far less attention has been given to an apparently parallel expansion during the last year of liability exposures under state law causes of action. Largely as a result of the numerous corporate debacles over the last two to three years, state courts (which are primarily responsible for overseeing state corporate governance laws) are now demonstrating unprecedented antagonism towards defendant directors and officers in a variety of contexts, thereby creating judicial precedent for heightened D&O liability exposure for violations of state and common law fiduciary duties.

This increased focus on state law claims against directors and officers is attributable to several factors. First, many state court judges, particularly in Delaware, appear to believe that in order to restore public confidence in the corporate governance process, directors and officers need to be subjected to greater culpability and accountability. As a result, these judges are now more willing than in the past to criticize director and officer conduct.

Second, as a result of the Private Securities Litigation Reform Act of 1995, fewer plaintiff lawyers are being selected as lead counsel in the more lucrative federal securities class action litigation. In order to justify a claim for some level of attorney fees, the plaintiff lawyers who are excluded from the securities class action litigation are more frequently filing tandem state court lawsuits against directors and officers.

Third, in order to leverage a higher settlement for themselves, many institutional investors are filing state court claims against directors and officers rather than participate as a member of a large class in the federal securities class action litigation.

Fourth, many of the cases now being presented to state court judges involve bad facts for the defendants. Consistent with the adage that bad facts make bad law, these cases provide a good record for courts to apply a more critical legal analysis and to find D&O wrongdoing.

Although the severity of state court D&O claims settlements has not materially increased yet, it seems reasonable to believe that such a result will be a natural consequence of these factors. Since state court judges and plaintiff lawyers now apparently want to give these state law claims more vitality, it is likely that significant additional settlement payments will be required in the future to resolve these cases. Because in most states settlements in state court shareholder derivative suits are not indemnifiable, this development will result in more loss payments by D&O insurers under Side-A of the D&O insurance policy. The fear by insurers of that development is one of the main reasons why the pricing for Side-A Only policies continues to be relatively high.

The following discussion summarizes some of the judicial developments during the last year which evidence this increasing importance of state law claims against directors and officers. In light of the prominent role Delaware law plays in the area of corporate governance, exemplary recent rulings under Delaware law and pronouncements by the Delaware judiciary, who appear to be at the forefront of this movement, are particularly noted.

A. Business Judgment Rule

The Business Judgment Rule is one of the most important defenses for directors and officers in claims for mismanagement or breach of their duty of care. In essence, this defense prohibits courts from second-guessing the quality of the defendants’ business decisions, and allows the court to examine only the procedures followed by the defendants in reaching those decisions.

Today, board decisions relating to executive compensation receive some of the greatest attention and scrutiny. It is therefore not surprising that the Business Judgment Rule has received the greatest challenge over the last year in cases dealing with executive compensation decisions. The following two cases under Delaware law appear to materially erode this important defense in several respects.

In In re The Walt Disney Company Derivative Litigation, 825 A.2d 275 (Del. Ch. 2003), the Delaware Chancery Court held that the Business Judgment Rule does not protect directors of The Walt Disney Company with respect to allegations that the directors failed to evaluate, negotiate or approve a lucrative employment agreement with Michael Ovitz, who was a close personal friend of the company’s chair, Michael Eisner. The plaintiffs alleged the following facts:

The Court concluded that the directors simply delegated to Eisner the decision to hire his good friend, Ovitz, as president, and the terms of that employment relationship. Less than one year later, Ovitz resigned as president (following criticism of his performance) and received more than $140 million in severance payments pursuant to the employment agreement. According to the Court, these allegations, if true, indicate that the directors did not exercise any business judgment or make any good faith attempt to fulfill their fiduciary duties. The defendant directors consciously and intentionally disregarded their responsibilities, adopting a "we don’t care about the risks" attitude concerning a material corporate decision. As a result, the Business Judgment Rule did not protect the directors’ conduct. The Court stated:

Although one can read the Disney decision as a logical extension of prior case law which criticizes inadequate procedures by directors and officers, this decision demonstrates the very thin line between a court second-guessing the quality of the board’s procedures (which courts may do under the Business Judgment Rule) and a court second-guessing the quality of the board’s decision itself (which courts historically cannot do under the Business Judgment Rule). By finding the procedures by the Disney board in approving Ovitz’ employment terms to be "egregious process failures," the court in essence ruled that the directors can be liable for approving unreasonable employment terms. Arguably, such a result eviscerates much of the protection afforded to directors and officers by the Business Judgment Rule.

In Pereira v. Cogan, 2003 WL 21039976 (S.D.N.Y.) a New York court interpreting Delaware law found the former directors and officers of a bankrupt privately-held corporation liable for breaching their fiduciary duties in connection with compensation paid to the company’s CEO. Following a bench trial, the Court found the director defendants liable for the company’s payment of excessive compensation and illegal dividends to the CEO because the two-person compensation committee that purported to ratify the payments lacked true independence from the CEO, did not seek or obtain outside consultation from an executive compensation expert, and did not review any comparable data regarding the salaries and performance of other executives with similar responsibilities. As a result, the Court determined that the board should not have relied upon a report from the compensation committee that was so obviously insufficient and incomplete. Because the Court ruled that the directors completely failed to exercise any diligence in performing their duties regarding compensation, dividends and loans to the CEO, the directors were not entitled to the protections of the Business Judgment Rule, and were personally liable to the company for about $14 million in illegal dividends and excessive compensation which had been paid to the CEO. According to the Court, directors cannot rely on the Business Judgment Rule to escape liability if they either knew about improper or questionable transactions yet unreasonably failed to take action, or if they did not know about such transactions but should have taken steps by which they would have been informed of the transactions. Like the Disney decision, the Court cited the lack of proper board procedures to find the directors liable for approving a level of CEO compensation which the Court in hindsight believed to be excessive.

Perhaps most troubling, the Court found not only the directors, but also certain non-director officers, jointly and severally liable for the improper payments to the CEO. In adopting a potentially dangerous "prevention" test for determining officer liability, the Court held that an individual who has discretionary authority in a relevant functional area and the ability to cause or prevent the challenged action can be held liable for damages resulting from such action. Here, the Court concluded that the general counsel and CFO could have prevented the company from extending illegal loans and making certain illegal payments to the CEO by notifying the directors of the improper transactions. Because those officers failed to prevent the wrongful conduct, they were found to have breached their fiduciary duties and were held liable, with the directors, for the challenged transactions.

Both the Disney and Cogan decisions demonstrate the need for directors and officers to remain fully engaged and involved in the affairs of the company. If defendant directors and officers cannot demonstrate their diligent management and oversight, there now appears to be a greater willingness by at least some courts to second-guess their business decisions and to hold those individuals personally liable for any resulting harm to the company.

B. Liability Limitation Statute

In response to the corporate governance crisis in the mid-1980s, virtually all states adopted statutes which limited the liability of directors and, in some instances, officers under state law. The Delaware provision (Section 102(b)(7), Delaware General Corporation Law) served as a model for most other states and allows corporations in their certificate of incorporation to limit or eliminate the personal liability of directors for damages in claims by the company and its shareholders. Notably, though, the statute does not limit or eliminate liability for conduct not taken in good faith or for breach of the directors’ duty of loyalty. These state liability limitation statutes, like the Business Judgment Rule, have played an important role in minimizing director liability exposures in state law claims during the past 15 years.

However, some recent court decisions have evidenced an erosion in the level of protection afforded by these statutes, similar to the erosion described above with respect to the Business Judgment Rule. For example, in both the Disney and Cogan cases, the defendant directors argued that they should not be liable not only based upon the Business Judgment Rule, but also based upon their company’s respective Section 102(b)(7) exculpatory clause for directors in their certificates of incorporation. However, both courts found that defense inapplicable because the defendant directors’ alleged wrongdoing constituted conscious and intentional disregard of their responsibilities and thus constituted a breach of the directors’ duty of loyalty, as well as conduct undertaken not in good faith. Both types of wrongdoing are expressly excluded from the statutory exculpation in Delaware and most other states.

The Seventh Circuit Court of Appeals recently reached a similar conclusion in In re Abbott Laboratories Shareholders Der. Lit., 325 F.3d 759 (7^th Cir. 2003), finding the exculpation protection under an Illinois statute virtually identical to the Delaware statute not available to directors. In a somewhat tortured analysis, the Court first assumed the directors knew of various operational problems at the company since the company’s corporate governance procedures should have identified those problems for the directors. The Court then further assumed the directors decided no action was required to address those problems since no action was in fact taken. Based on these assumptions, the Court ruled that the directors consciously disregarded their duties, which constitutes conduct "not in good faith." Therefore, the Court found the statutory exculpation provision does not apply to shield the directors from liability.

Because the "duty of loyalty" and the conduct "not in good faith" exceptions to the state liability limitation statutes can be rather subjectively applied by courts, it appears clear from these recent cases that courts can easily sidestep this statutory defense by directors in most cases if the court is otherwise inclined to hold the directors personally liable.

C. Independent Directors

A centerpiece to the many corporate governance reforms mandated by Congress and regulators is the heightened expectations for the role of independent directors. Congress has mandated that public audit committees be made up exclusively of independent directors. Several national securities exchanges support the requirement that a majority of directors on public boards be independent and that certain corporate actions, such as the nomination of directors, be approved by independent directors or a committee entirely made up of independent directors. Certain types of special committees of the board, such as committees charged with negotiating a transaction with one or more officers or approving a business combination or evaluating potential litigation against directors and officers, must be composed solely of independent directors to be effective. If independent directors, following a reasonable investigation, make informed and disinterested decisions regarding certain matters, the independent directors and the other officers and directors of the company will typically be insulated from liability relating to those matters.

A critical question when those decisions are subsequently challenged is whether the independent directors who approved the decisions were in fact "independent." In the past, courts have looked primarily at whether those directors had a direct economic interest in the matter to determine whether they were independent. However, in In re Oracle Corp. Derivative Litigation, 824 A.2d 917 (Del. Ch. 2003), the Delaware Chancery Court raised the bar significantly regarding who can qualify as an independent director. In that case, two outside directors on the Oracle Corp. board of directors were selected by the board to serve on a special litigation committee ("SLC") formed to investigate whether the company should bring an insider trading lawsuit against certain other directors. The Court found that the two SLC outside directors, who were prominent Stanford professors with no economic ties to the company or any of the other directors, did not qualify under Delaware law as independent directors for purposes of the investigation, and therefore the Court refused to dismiss shareholder derivative lawsuits which were brought on behalf of the company against those other directors for insider trading since the company failed to conduct an independent analysis as to whether the prosecution of those derivative suits was in the best interest of the company.

Although neither of the two outside directors who served on the special litigation committee were directors at the time of the alleged insider trading, and although the special litigation committee hired a prominent independent law firm, interviewed 70 witnesses and reviewed numerous records before producing a 1,110 page report that concluded that the company should not pursue the insider trading claims against the other directors, the Court concluded that the SLC investigation and analysis were not truly independent and therefore refused to follow the recommendations of the committee.

Although the two committee members had no significant financial ties to the defendant directors and received no direct compensation from the company other than in their capacity as outside directors, the Court concluded that the common ties among the committee members (who were Stanford professors), the defendant directors and Stanford were so substantial that they created reasonable doubt about the independence of the committee members. For example, the Court noted:

Although the Court recognized that the livelihood of the two committee members would not be threatened if the SLC decided the company should pursue the insider trading lawsuit against the other directors, the Court found these connections sufficient to call into question the SLC’s independence. In doing so, the Court rejected the committee’s attempt to define independence as simply the absence of domination or control. Instead, the Court found that factors other than just economic relationships should be considered:

This test requires a court to consider a wide variety of factors, including social and personal connections between people, that might make one person feel beholden to the interested party. Such a test goes beyond the independence requirements for audit committees recently adopted by the SEC and the proposed national securities exchanges’ independent director requirements. The focus of those requirements is economic and familial independence, not social independence. The Oracle Court’s consideration of social and personal relationships may greatly reduce the number of truly independent directors on most boards, thereby significantly limiting the legal protections available from independent director approval. To be an effective board, directors are encouraged to behave in a collegial fashion and develop social relationships in order to enhance a constructive working environment. Such relationships apparently now must be analyzed to determine if some of the directors are independent from other directors. Such a result will, at best, create a chilling effect on the creation of social relationships among board members and, at worst, result in the disqualification of virtually all directors as independent directors for purposes of state law issues.

In summary, based upon these and other similar recent rulings, it is becoming increasingly more apparent that courts, like most others, now view director and officer performance with greater skepticism and will likely react to alleged wrongdoing by directors and officers with greater antagonism than before. Unfortunately, this type of significant change in mindset by particularly the Delaware judiciary is not likely to be temporary or short-lived, but will probably continue for many years to come. Although the overall quality of corporate governance has unquestionably improved in this post-Enron era, the legacy of heightened expectations and responsibilities for directors and officers under state law appears destined to result in higher and higher D&O losses in state law claims.