United States: Increased Liability for Directors and Officers

There has been very extensive publicity and concern about increased liability for officers and directors of public companies under the Sarbanes-Oxley Act. Far less publicity has been given to a number of recent cases which also expand the liability of corporate officers and directors, including those of privately held companies, under state corporation laws. In certain situations, issues raised by these cases can create an even higher level of exposure for officers and directors than that created under the Sarbanes-Oxley Act. This issue of Business Briefs discusses these cases and also covers some recent developments in directors and officers liability insurance (D&O insurance) coverage.

The Cogan case discussed below imposed liability on directors and officers of a privately held company. It is particularly troubling, since liability was imposed in situations where the directors didn’t know of the acts of the CEO which were determined by the court to be improper, and where losses were suffered, not by the corporation’s shareholders, but by its creditors.

As a result of this decision, anyone who serves as a director or officer of a privately held company which they don’t control should consider whether they wish to continue to serve in such a position. The same issues raised by the Cogan case can apply in the case of a public company, but the financial and other benefits of serving as a director of a public company are typically far greater than those associated with being a director of a privately held company. It is also generally more likely that a public company and/or its D&O insurer will be able to cover the company’s indemnification obligations.

Anyone who continues to serve as a director or officer of a privately held company may have to spend a significant amount of time and effort in monitoring the company’s transactions in order to try and reduce the potential liability. Monitoring should include such things as:

(1) requiring circulation to all directors of

(2) meeting periodically with the company’s chief financial officer and outside accountants to discuss the company’s financial condition, transactions with affiliates and any other transactions outside of the company’s ordinary course of business.

Directors and officers should also try to ensure that the company’s bylaws contain broad indemnification provisions, and that the company maintains directors and officers liability insurance in reasonable amounts, since if company is insolvent, it will not have the funds necessary to indemnify the officers and directors for losses, no matter how strong the indemnification provisions of the bylaws are.

Liability of Directors and Officers for Breaches of Duty of Care

In the 1980s, the issue of director liability became a major business concern with the holding in the Smith v. Van Gorkom case that directors could be personally liable if they were grossly negligent in approving a merger. In response, the legislatures of Delaware, New York, New Jersey and Pennsylvania, and many other states adopted legislation permitting limitation of personal monetary liability of directors for breach of the duty of care. In 1986, Section 102(b)(7) was added to the Delaware corporation law permitting Delaware corporations to put in their certificates of incorporation a provision limiting personal monetary liability of directors in derivative or stockholder suits seeking damages for directors’ breaches of their duty of care. However, the statute provides that a company may not limit or eliminate a director’s liability for, among other things, (a) breaches of the duty of loyalty to the corporation or its stockholders, or (b) acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law.

Recent decisions call into question the extent to which directors may rely upon such exculpatory language in the charters of the companies on whose boards they serve. The Delaware Chancery Court on May 28, 2003, In re The Walt Disney Co. Derivative Litigation, 825 A.2d 275 (Del. Ch. 2003), denied a motion to dismiss an amended complaint that alleged the Board in effect abdicated its responsibility by failing to investigate basic information about an employment agreement with Ovitz, including the severance costs, and allowing Disney’s CEO Michael Eisner to act in its stead. Chancellor Chandler, noting that courts rarely impose liability on directors for breach of a duty of care, said that the alleged facts went beyond merely negligent or grossly negligent acts, but instead suggest that the directors "consciously and intentionally disregarded their responsibilities, adopting a ‘we don’t care about the risks’ attitude concerning a material corporate decision." Chancellor Chandler stated that the alleged facts suggest that Disney’s directors "failed to exercise any business judgment and failed to make any good faith attempt to fulfill their fiduciary duties to Disney and its stockholders."

The Chancellor held that "Where a director consciously ignores his or her duties to the corporation, thereby causing economic injury to its stockholders, the director’s actions are either ‘not in good faith’ or ‘involve intentional misconduct,’" and the allegations accordingly supported claims that fell outside the liability waiver provision in Disney’s certificate of incorporation.

The Disney decision must be compared with the earlier decision of Vice Chancellor (now Justice) Jacobs in Emerald Partners v. Berlin which states that "The conscious indifference argument has no evidentiary or legal basis." If in fact it is the law that a lack of "good faith" can be established by an abdication of duty, then the law in Delaware would seem to create the anomaly that a violation of the duty of care through a grossly negligent decision does not result in personal liability to directors while neglect amounting to an abdication of responsibility does.

Even more troubling than the Disney decision is Pereira v. Cogan, 294 B.R. 449 (S.D.N.Y. 2003). While not a decision of a Delaware court, this case involved a Delaware corporation and was written by Hon. Robert W. Sweet, a well respected federal judge. After trial on the merits, the court found that the directors of Trace International had breached the duty of care and the duty of loyalty. Trace was a privately held Delaware corporation that had sought protection under Chapter 7 of the Bankruptcy Code. Cogan, the CEO and Chairman, also owned a majority of the outstanding shares. The Trustee in bankruptcy brought an action against the directors and officers of Trace on behalf of creditors, alleging breach of fiduciary duties. The court found that under the facts of the case, fiduciary duties were owed to creditors as well as to stockholders because the company had been in the "vicinity of insolvency" at the time of the relevant acts. The defendants fell into three groups: Cogan, the other directors and certain officers. Cogan’s liability was clear — he had engaged in numerous "interested" transactions without taking any steps to address the conflicts, including unilateral increases in his compensation, taking unapproved loans from Trace, placing his wife on the payroll and his daughter in a "no show" job. The liability of the non-Cogan directors and officers was less clear and did not involve at any time the conflict of interest that has always been required to find a duty of loyalty violation.

In finding liability of the directors, the court explored a number of factual situations: elements of Cogan’s compensation that had not been approved by the board; dividends that had been paid without board approval; loans to Cogan and others; a "repurchase" of shares; a birthday party for Cogan at the Museum of Modern Art; and placing Cogan’s wife on the payroll and his daughter in a "no-show’ job.

Illustrative of the court’s analysis was its review of the repurchase of Trace shares from Dow Chemical. Because of its financial difficulty, the direct redemption of the shares was not a feasible alternative to Trace. In lieu of such a redemption, an arrangement was worked out by Cogan and Smith, Trace’s general counsel, whereby Trace would loan money to Cogan, who in turn would repurchase the shares without the adverse financial consequences to Trace of a share redemption. The court found that this was a sham transaction and in fact a redemption that was illegal because Trace did not have sufficient surplus to effect the redemption. As a basis for finding liability of the directors in connection with this redemption, the court stated that "directors will not be excused from liability if they either (1) knew about the challenged expenditure yet unreasonably failed to take action; or (2) if they did not know, should have taken steps by which they would have been informed of the challenged expenditure." In other words, assuming the directors knew nothing of the conduct in question, they have a legal obligation to investigate.

While such a finding of breach of the director’s duty of care is itself questionable, even more startling, the court also found a violation of the duty of loyalty, and thereby found that the § 102(b)(7) exculpatory language of Trace’s certificate of incorporation did not protect the directors from personal liability. The stated basis for this finding was that the controlling stockholder, Cogan, and officer and general counsel, Smith, had concocted the redemption plan "in secret." A duty of loyalty violation basically requires a conflict of interest because the duty of loyalty requires that the director put the interests of the corporation above his or her own. It is difficult to understand how a redemption of shares from a disinterested third party can be a transaction by which Cogan and Smith favored their personal interests over those of the corporation. The consequences to the directors and officers in this case were not trivial: damages ranging from $21 million to $44 million were assessed against the various defendants.

It is clear that the corporate scandals evidenced by Enron, WorldCom, Tyco, Global Crossing, etc. have called into question the standards applicable to corporate fiduciaries. One area of heightened scrutiny as evidenced by the Disney and Cogan decisions is the applicability of exculpation for breaches of duty of care. Whether the courts are legitimately searching for a cure to the excesses of Enron et al, or whether the courts are striving to fight off federal preemption of corporate governance as manifest in the Sarbanes-Oxley Act of 2002, the fact is that directors are at greater risk today than they have been in the past. The Disney court appears to have redefined the abdication or conscious indifference allegations as breaches of good faith, while the Cogan court has simply redefined a "duty of care" obligation as a "duty of loyalty" in order to by-pass exculpation. In either case, the signs are clear — DIRECTORS BEWARE!

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.