This is the third post in this series of posts on corporate compliance issues for governing boards. We will wrap up our discussion on fiduciary duties, this time concentrating on the protections afforded to board members. Future posts in this series will expand on federal sentencing guidelines and best practices.  

Protections Afforded to Board Members with Respect to Fiduciary Duties

In order to encourage independent persons to serve as board members, state law offers a number of legal protections to persons serving as board members.

  1. The Business Judgment Rule

In evaluating a board member’s compliance with his or her fiduciary duties, courts generally follow the business judgment rule. Under the business judgment rule, courts do not inquire into the wisdom of actions taken by board members in the absence of self-interest, fraud, bad faith or abuse of discretion. The business judgment rule specifically applies to any situation board members make a decision which, in retrospect, was or is argued to be a bad one. If the board members are thereafter sued because of that decision, a court applying the business judgment rule will not second-guess the merits of the decision as long as the court finds all of the following to be true:

  • The board members made a business decision (the rule does not apply to acts of board members which do not constitute business decisions);
  • The board members were disinterested (that is, they are not “on both sides of the transaction” and will not derive any personal benefit from the decision);
  • The board members exercised “due care” (as noted above, this means acting like an ordinarily prudent person would act);
  • The board members acted in good faith; and
  • The board members did not abuse their discretion.

If one or more of these factors is not satisfied, the court will interpose its own judgment to determine whether or not the transaction in question was in the best interests of the organization.

It is important for board members to note that having a personal or economic interest in the matter decided rebuts the business judgment rule for those board members having a personal or economic interest, unless those interested board members can show that the material facts of their interest were disclosed or otherwise known to other board members and at least a majority of the non-interested board members.

The business judgment rule will also be rebutted for non-interested board members who approve the matter unless they can show that, despite the personal or economic interest of the interested board members, the non-interested board members believed the matter to be in or not opposed to the best interests of the organization or that the transaction was fair to the organization from a substantive point of view.

When the business judgment rule is rebutted, courts generally require board members to prove fairness not only from a financial viewpoint, but also from a procedural or “fair dealing” viewpoint.

Officers generally are also protected by a similar business judgment rule. However, the business judgment rule does not protect officers in derivative matters or matters when officers’ actions are in violation of their authority.

Nevertheless, although the business judgment rule protects board members from mistakes in judgment, the rule does not protect board members who misleadingly hide or fail to disclose such mistakes.  Shareholders are entitled to judge board members’ mistakes in determining whether to vote for or against the election of such board members. Manipulating financial statements not to reflect such mistakes or intentionally hiding mistakes from shareholders or the investing public may result in liability to board members under federal and state securities, federal and state tax laws, state corporation law, as well as under theories of common law fraud.

  1. Right of Reliance on Others Board members are permitted to rely reasonably upon information presented by officers, employees, board committees and independent professional advisors in making their decisions.

Click here to view table.  

Under Ohio law, a board member, officer, employee or other agent of an organization who is successful on the merits or otherwise in defense of any action, suit, or proceeding in which he or she is named by reason of being a board member, officer, employee or other agent is entitled to be indemnified against expenses, including attorney fees actually and reasonably incurred by him in connection with the action, suit or proceeding.

  1. Contractual Indemnification

Ohio law permits corporations and certain other organizations to indemnify or agree to indemnify board members, officers, employees and agents in advance of a decision on the merits and even if he is she is not successful on the merits, provided that the person:

  • Acted in good faith;
  • In a manner the person reasonably believed to be in or not opposed to the best interests of the organization; and
  • With respect to any criminal action or proceeding, had no reasonable cause to believe the person's conduct was unlawful.

The organization may pay or reimburse the indemnified person for all expenses (including attorney fees), judgments, fines and amounts paid in settlement actually and reasonably incurred by the person in connection with such action, suit or proceeding.

In order for there to be protection, there must be a determination that indemnification is proper by:

  • A majority of board members who are not parties to such action, suit or proceeding; or
  • A committee of such disinterested board members; or
  • If there are no such board members, or if the board members so direct, by independent legal counsel; or
  • The shareholders; or
  • A court of competent jurisdiction.

As discussed above, indemnification is mandated by statute if the indemnified person is successful on the merits or otherwise in defense of any such action, suit or proceeding.

In a derivative or other action by or in the right of the organization, only expenses are indemnified unless the indemnified person is successful in defense of the claim. No indemnification of even expenses is available if the board member is adjudged to be liable to the organization unless the presiding court determines the board member is entitled to indemnification.

Many state courts have held that indemnification is not available for intentional misconduct and federal courts have held that indemnification is not available for securities law violations for reasons of public policy.

  1. D&O Insurance

One value of Directors and Officers liability insurance (D&O) is that Ohio and most other states’ laws permit broader coverage under D&O insurance than under statutory indemnification. Another value of D&O insurance is that it is available even if the organization is insolvent and even after a change in control.

D&O insurance is typically a claims-made policy that pays losses – or reimburses the organization for its payment of losses – incurred by a covered person for claims of wrongful acts made during the policy period. The policies often insure against breaches of duty, neglect, errors, misstatements, misleading statements, omissions or acts, whether in a personal action or a derivative action. The policies sometimes include intentional wrongdoing, usually in the absence of dishonest or criminal conduct.

These policies often contain a securities law exclusion excluding coverage claims for wrongful acts in the purchase of sale or the organization’s securities. For this reason, board members of publicly-traded organizations will generally need to have a securities law endorsement expanding coverage to include claims of such wrongful acts.

These policies also exclude coverage claims that are not reported to the insurer in a timely fashion as well as claims alleging:

  • Death, bodily injury, sickness, disease or tangible property damage or destruction;
  • Environmental discharge or damage;
  • Libel or slander;
  • Disgorgement of profits under section 16(b) of the Exchange Act;
  • Employee benefit plan liability;
  • Illegal remuneration (unless approved by shareholders);
  • Suits by other insureds; and
  • Dishonest or criminal acts.

Steps to Enhance Board Members’ Protections

Coupling the basic tenet that board members “direct” management and must therefore delegate with the conditions to a board member’s right of reliance on others offers a framework for determining a board member’s duties. Because a board directs rather than manages and because management manages under that direction, a board must determine reliability and competence of management for each matter that the board delegates to them.

The best way to determine reliability and competence is to ask questions.  Accordingly, the purpose of the questions must be to test management’s reliability and competence.

The same questions should be asked separately of different persons, trying to include –where appropriate – someone independent of management. Possible persons independent of management include the person serving the internal auditor function, representatives of the external auditor, outside legal counsel, and outside experts with experience in the matters under consideration.

The consistency of the different answers should be compared. The answers among different constituencies will unlikely be the same. For example, management is more likely to view certain business issues more positively than the external auditor or chief legal officer.  On the other hand, the external auditor and chief legal officer are more likely to view risks of liability as more material than management. And often a chief financial officer views a matter from a different perspective than the chief executive or chief operating officer. Accordingly, answers will differ, but there should be consistency.

The skill is to learn when to stop asking questions. Nothing is more bothersome to management than irrelevant, unnecessary questions. As a general rule, board members should stop asking questions and accept the answers when those answers are consistent. On the other hand, board members should delve deeper when the answers to the questions are inconsistent.

Board members and management should expect there will be some tension between them during this process. Management needs to understand that board members must ask questions to determine whether management is reliable and competent for the matters delegated to them. The board should understand that management will fear “being micro-managed” or “not being trusted.”  For this reason, the chair or lead board member of the board should from time to time remind management that board members are required to ask such questions to fulfill their duties and that management should not necessarily view this as an adversarial process.

An additional way to relieve this tension is for the board to have regular separate executive sessions with different members of management so that it becomes part of the routine operation of the board.  A board should consider meeting regularly with the CEO, CFO, chief legal officer, internal auditor and representatives of the external auditor.