Published in Lexpert, November 2005.
Our October 2005 article described increased personal risks faced by directors and officers of public companies in the current corporate governance climate.
Due diligence. Exercising due diligence is the most important advice for directors and officers. It is very unlikely that a director or officer will be held liable if appropriate care was taken in coming to a decision. This means ensuring that there is timely, adequate and appropriate information on which to reach a conclusion. For significant decisions (i.e., a merger transaction or other company altering transaction), one board meeting to approve the transaction may not be sufficient; rather, a number of meetings as the transaction develops, with significant input from outside experts (including lawyers and financial advisors), will likely be required.
Appropriate reliance on experts can also be a defence to liability in and of itself, in addition to aiding in the establishment of the due diligence defence (though the recent Supreme Court of Canada decision in Peoplesappears to require the use of outside experts for this defence to be available). An on-going practice directors and officers should implement is to understand in detail the risks a corporation faces and to ensure that satisfactory preventative measures are in place. Some boards have a "Risks in the Business" item as a standard agenda item at all board meetings. While the focus (in terms of assessing whether boards have paid adequate attention) for the past few years has been on accounting and internal control issues, executive compensation and corporate disclosure policies are areas of significant current sensitivity.
Business Judgment Rule. The business judgment rule was recently reaffirmed in Peoples.In essence, directors and officers will not be liable for a breach of their duty of care owed to the corporation if they act prudently and on a reasonably informed basis. Perfection is not demanded; rather a court will examine whether an appropriate degree of prudence and diligence was brought to bear on a decision. Peoplesalso stated that the decision itself must be reasonable in light of the circumstances in which it was made. However, a court is likely to find this requirement met in a situation where the process was careful and rigorous.
Corporate Governance Practices. Both Peoples and the recent Delaware decision in Disney noted that the establishment of good corporate governance practices can protect directors from liability. Though these two cases do not appear to agree on the weight to be placed on a failure to implement corporate governance developments, the best way to proceed is to establish and follow a good set of corporate governance practices; there is only upside to this approach.
Establish a Record. In order to establish the due diligence defence, it is important to keep a proper record of deliberations made and actions taken. This includes maintaining a thoughtful collection of board and committee minutes. This does not mean a comprehensive transcript (which will inevitably be unreliable); rather, meeting minutes should indicate the major topics of discussion and the important factors considered in reaching decisions. Board materials, correspondence, presentations and similar evidence of the process involved in reaching a decision should also (generally) be maintained.
Disclosure Policies and Disclosure Committees. Effective on December 31, 2005, directors and officers of public companies will face statutory personal liability for misrepresentations in public disclosure and for failure to make timely disclosure of material events. CEOs and CFOs also currently face potential personal liability for their certifications of the accuracy of their company's public disclosure. The discussion above about due diligence is equally applicable to these liability risks (and in fact there is an affirmative statutory due diligence defence to disclosure liability in the legislation). In addition, companies should adopt a disclosure policy, to ensure that a process is in place so that material developments are brought to the attention of senior officers and directors in a timely fashion.
Companies should also consider the creation of a management disclosure committee specifically charged with ensuring that companies comply with their disclosure obligations. These steps will both reduce the likelihood of a disclosure violation occurring and, where a violation has occurred, increase the likelihood that a director or officer can rely on the due diligence defence.
Managing Conflicts. Another key area of risk is conflicts of interest. Where conflicts are at play, due diligence and business judgment may not be enough- a court or regulator is much more likely to examine the underlying fairness of the transaction to the company. Accordingly, directors and officers must be sure to carefully examine all details and underlying facts before agreeing to a transaction involving or benefiting insiders of the corporation. At a minimum, such transactions must be approved by a committee of independent board members (this is mandated in some cases). Even then, directors must be scrutinizing and challenging, and should consider obtaining advice from external advisors separate from those normally retained by the corporation.
Enron is an example of a situation where a conflict of interest (in this case with respect to off-balance sheet transactions involving a member of management) was brought to the attention of the board, but a number of details likely to affect approval of such transactions were not. These included details with respect to compensation of the management-related investors (including other employees of the corporation, some of whom received huge short-term returns for little or no risk), guarantees provided by the corporation and the identity of all the investors (some of whom included spouses or other close relationships with management). Conflict situations (including such "routine" ones as executive compensation) require a board to be at its toughest-the risks are untenable otherwise.
Insurance and Indemnification. Directors and officers must be careful to ensure that appropriate indemnification and insurance is in place (we will address director and officer insurance issues more fully in a future article). At a minimum, on the indemnification side, directors and officers should have separate indemnification agreements with the corporation to ensure that the maximum amount of indemnification is made available (the indemnification permitted by the corporate statutes is not always mandatory, and there are a significant number of issues that can arise in accessing indemnification that are not addressed in a typical indemnity agreement-including when indemnity payments will be made, burdens of proof, payment for attending discoveries or regulatory proceedings, etc.).
With respect to insurance, directors and officers must pay careful attention to severability provisions to ensure that misrepresentation or fraud (including, for instance, of the type that leads to a restatement of the financials provided to the insurer in the application process) by a member of management does not cause innocent directors and officers to lose their coverage. Independent directors may also want to consider obtaining separate independent director liability insurance to ensure that management (who are more likely to have significant insured costs, particularly up front) do not use up all the available coverage in defence costs or settlements. There is often a conflict between the interests of management (in reducing premiums) and those of directors (in obtaining suitable coverage for service that is not highly remunerated in the first place). There is a developing practice of increased director involvement, including independent representation of directors, in these matters.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.