Risky Business

Published in Lexpert, October 2005.

This article examines the increased personal risks faced by directors and officers of public companies. Our next article discusses how to manage these risks.

The recent corporate scandals, and subsequent corporate governance reforms, have resulted in substantial increased personal risk to directors and officers of public companies.

In January 2005, ten former outside directors of Worldcom agreed to pay $18 million to settle shareholder suits, $18 million that could not be recovered by any indemnification or insurance available to the directors, and estimated to be in the neighborhood of 20% of the aggregate net worth of these directors (excluding principal residences, retirement accounts and judgment proof joint-assets). Around the same time, ten former directors of Enron (8 of whom were outside directors) settled shareholder claims for $13 million of their own money (representing their pre-tax profits from their Enron stock sales). The requirement that directors pay personally has been driven by class action-leading institutional shareholders as a way of "disciplining" directors perceived not to have done a good enough job.

Closer to home, there is litigation requiring Nortel executives to return bonuses paid on the basis of financial information that was restated: the pressure extends to more junior executives, including in-house counsel, who are asked to return bonuses paid on the basis of the original financials. Similar claims have been threatened against other Canadian companies.

Regulators have also increased the responsibilities of directors and the risks directors face. This is most obvious in the case of audit committees, where there are now detailed rules regarding member responsibilities and qualifications. Audit committee members must be financially literate and must disclose their background in this regard. This has created a concern that audit committee members will be held to a higher standard than other directors in determining liability, particularly in cases involving financial matters. The same rationale could also apply to other directors recruited because of specialized qualifications, including to satisfy corporate governance "best practices", which often require specialized expertise in order to sit on specific board committees.

The notion that a director’s experience will be a factor in determining liability was evident when the Ontario Securities Commission considered the background and expertise of the various directors of YBM Magnex in determining individual culpability. Sanctions sought by securities regulators can include fines, reimbursement of (substantial) investigator and prosecutor costs and prohibition on service as a public company officer or director (for up to a lifetime term).

The recent Peoples decision in the Supreme Court of Canada stated that directors will be held to an objective standard in determining compliance with the statutory duty of care they owe to the corporation. However, the Supreme Court indicated that such a standard was more onerous than the subjective standard previously applied at common law. The Supreme Court also noted that prevailing socio-economic conditions can be taken into consideration, stating in this regard that "the emergence of stricter standards puts pressure on corporations to improve the quality of board decisions". The Supreme Court also stated that the "factual aspects of the circumstances surrounding the actions of a director or officer" are important in determining compliance with the duty of care. This case provides little realistic comfort that a director’s specialized skillset will not be a factor in determining liability. The recent Disney case out of Delaware did hold that a failure to comply with corporate governance "best practices" is not a factor in determining whether directors have met their fiduciary duties. However, this appears inconsistent with the language in Peoples.

Starting on December 31, 2005, under recently proclaimed legislation in Ontario, directors and officers of Canadian public companies will have statutory civil liability for misrepresentations in public disclosure documents and for failure to make timely disclosure of material changes. This will provide purchasers in the secondary market (where the vast majority of stock trading takes place) with statutory rights against directors and officers for disclosure violations, a right previously provided only to primary purchasers. While there are provisions in the legislation intended to stop so called "strike suits", and a due diligence defence (which will be discussed in more detail in our next article), if the experience in the U.S. (which has had similar liability for years) is at all informative, we can expect a significant amount of litigation and exposure on this basis.

CEOs and CFOs of public companies are required to personally certify the accuracy of the disclosure documents filed by the companies they manage. The certification requirements may be extended in the future to include matters relating to disclosure controls and internal financial controls (as is already the case for some U.S. companies, and to a certain extent for cross-border Canadian companies). Under current Canadian law, there is a reasonable possibility that CEOs and CFOs could face personal liability for misrepresentations in any of these certifications (that is, they may not be able to argue that the certifications were provided on behalf of the corporation and thus only the corporation should have liability for them), on the basis of misrepresentation, breach of a statutory duty or otherwise. In any event, once civil liability for public disclosure is implemented at the beginning of 2006, there is no question that all directors and officers of a company face potential liability for inaccurate or misleading certifications filed by the CEO and CFO.

There are increased risks that directors and officers’ insurance, and indemnification from the company, will not be available when needed most. Insurance policy risks include provisions relating to limit sharing (innocent directors and officers sharing available coverage - including for defence costs - with those involved in wrongdoing, limiting the amount available to them), lack of severability and rescission by insurers of policies due to misrepresentations in the application for insurance (which most directors and officers are not involved in reviewing) and inadequate (or no) coverage of regulatory defence costs (an increasing liability in fact).

In addition, it was recently held in Disney that "an intentional dereliction of duty, a conscious disregard for one’s responsibilities" by a director can constitute a breach of the fiduciary obligation to act in good faith with respect to the corporation. The implication of that type of finding would be to preclude directors from being able to receive indemnification in connection with any related liability (as indemnification from the corporation is sometimes not permitted where the "good faith" obligation is breached).

Even where a director or officer is not subject to personal liability, association with a corporate scandal can leave a director or officer tainted for life. With a public that is increasingly scrutinizing and critical of the conduct of board members and officers, and with a media that has a longer memory (aided by technology), the reputational risk, and the consequences of being even tangentially involved in a corporate scandal, have increased significantly.

Other new risks touched on in previous articles include those faced by compensation committee members in connection with excessive management compensation, failures by board members to follow corporate governance mandates they have approved, and up the ladder reporting requirements for in-house counsel. The new risks may seem daunting. But stay tuned: in our next article, we will tell you how to manage these risks.

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.