Canadian statutory derivative actions have a 35-year history. Recent developments may make derivative actions more attractive to plaintiffs than, for example, actions for oppression. The primary targets for derivative actions are directors and officers. This paper explores derivative actions and various steps that directors and officers can take to reduce the risks of such actions and to minimize the likelihood of personal exposure should such actions arise.

Directors and Officers as Targets

While derivative actions may be brought on behalf of the corporation or its subsidiary against strangers for wrongs done to the corporation/subsidiary, the majority of actions focus on alleged wrongs by directors and officers. These have included secret profit or commission by a director, breach of fiduciary duties, negligence, issuing shares at an improper value, ultra vires acts, conflicts of interest and misappropriation of corporate opportunities.

Even in cases involving strangers, the directors/officers are more than likely to be targeted for failing to pursue strangers on behalf of the corporation.

Pension funds are becoming more aggressive in initiating actions, including derivative actions against directors for perceived wrongs. Recently, the Ironworkers Ontario Pension Fund filed a shareholder derivative action against Research in Motion (“RIM”) for $105 million in damages. The defendants are four members of RIM’s Audit and Compensation Committee who allegedly backdated stock options improperly.

The recent Ontario Court of Appeal decision, Ford v. OMERS, may also significantly increase the use of derivative actions. The court in this case (a dissent, appraisal and oppression action) held that the oppression remedy, as pleaded, did not allow recovery of damages for an improper and oppressive transfer pricing arrangement with Ford Canada’s 94 percent parent, preceding the period during which the plaintiff security holders held their shares. The recovery might have been significantly increased had the plaintiffs chosen the derivative action route.

Risk Mitigation

Since the primary targets for derivative actions are directors and officers, how do they go about minimizing the risks that they face from such actions?

Due Diligence

The 2001 amendments to the Canada Business Corporations Act (“CBCA”) and the 2007 amendments to the Ontario Business Corporations Act (“OBCA”) enlarged the due diligence and good faith defence available to directors.

A robust compliance program which identifies issues and risks faced by the corporation and involves the appropriate professional person in advising the Board (auditor, lawyer, engineer, actuary, for example) can insulate or bulletproof the directors of the corporation by allowing them to avail themselves of the due diligence defence. The elements of an effective compliance program include an atmosphere of compliance from the top down; written procedures and policies; a compliance officer reporting to the board or to an appropriate board committee; an ongoing education program within the organization; and periodic evaluation of the policies and procedures.

While the due diligence defence is only expressly afforded to directors, one of the additional benefits of a rigorous compliance program is that, by identifying problems and issues early, it can improve the chances of having them resolved. Such resolution, of course, will also benefit the officers.

Indemnification

The next level of defence for directors and officers are the indemnification provisions provided for in the various corporate statutes. Again, the indemnification provisions of the CBCA were amended in 2001 to allow broader indemnification, including the ability to advance costs. The 2007 amendments to the OBCA are broadly similar.

Directors should at least ensure that their indemnification is as broad as the statute now permits. By-laws for CBCA corporations passed before 2001 and those currently in effect for OBCA corporations may be too restrictive and should be reviewed.

Recognizing that by-laws may be amended without the approval of a director/officer or even the involvement of a former director/officer, careful and prudent directors/officers obtain indemnity contracts from the corporation which they serve. A well-drafted contract will not only deal with circumstances where the corporation is allowed to indemnify, including the important obligation to advance costs, but will also obligate the corporation to seek court approval where it is a prerequisite to indemnification. This is crucial in the case of derivative actions.

Insurance

Indemnities are, of course, only as good as the financial solvency of the person (corporation) that stands behind them. Insurance provides a third party (the insurance company) to stand behind the indemnity. Indeed, in the case of derivative actions, where court approval is required for directors and officers to obtain indemnity, an insurance policy may become even more important.

To ensure that your Directors’ and Officers’ (“D&O”) Policy is sufficient to cover your exposure as a director and officer, a periodic review of your D&O Policy is important as risks, policy wordings and market availability vary over time.

Most policies insure the corporation as well as directors/officers and contain an insured against insured exclusion. Since a derivative action involves the corporation (an insured) suing its directors and officers, such an exclusion would preclude coverage for derivative actions. Most modern D&O policies contain exceptions for derivative actions as long as the insured directors and officers do not assist the person driving the derivative action in any manner.

Significant shareholders initiate derivative actions. Most D&O policies contain exclusions for actions by major shareholders, either direct or derivative. While the threshold varies from policy to policy, 5 percent or 10 percent is not unusual. Alternatives that you, or the corporation, might consider include obtaining indemnities from the major shareholder(s), having the D&O Policy amended to reduce or eliminate the effect of the exclusion, and looking into new products/policies (Side A, Difference In Condition, for instance) that provide protection only to directors and/or officers with narrower exclusions.

One of the most important features of D&O policies is the duty to defend. Experience shows that a well-organized and presented defence may be the best protection that a policy can provide to the directors/officers. These defences, especially for derivative actions, can become extremely expensive.

While the duty to defend is normally considered to be broader than the coverage, if it is clear from the pleadings that the policy does not cover the action, there will be no duty to defend. This is an additional reason why, in the case of derivative actions, it is so important that directors and officers have the maximum protection available to them under the circumstances. A well structured and negotiated D&O insurance program may be the ultimate and best protection.