GROWING GAPS IN INDEMNIFICATION PROTECTION
Indemnification of loss and interim advancement of defense costs by a company are generally viewed as critical elements of an overall program for financial protection of directors and officers. Although a few gaps in indemnification protection have existed for years, thus creating the need for D&O insurance (see the April 1995 edition of The ACE Report), two recent court decisions demonstrate those gaps are larger than many previously thought.
A. Advancement of Defense Costs
Directors and officers usually assume that, even in the absence of insurance, their costs in defending a claim against them will be advanced by their company at least until the claim is resolved, at which time the company can determine whether indemnification of those defense costs is appropriate. Virtually every state's indemnification statute permits a company to make such interim advancements of defense costs, subject to a written undertaking by the defendant D&O to repay to the company the amount advanced if it is ultimately determined under the facts of the case that the company may not indemnify the defendant D&O for those defense costs.
However, a recent Delaware Chancery Court opinion casts considerable doubt as to whether the company may advance defense in many cases, absent a by-law provision requiring that advancement. In Havens v. Attar, 1997 WL 55957 (Del. Ch. Ct., Jan. 30, 1997), two shareholders of Highland Cellular, Inc. ("HCI") sued HCI's president and two directors for various alleged wrongdoing. When HCI began to advance defense costs incurred by the defendant D&Os, the shareholder plaintiffs sought an injunction from the Court prohibiting HCI from advancing defense costs for the defendant D&Os.
The Court ruled that absent a by-law provision specifically requiring defense costs advancement, a board's decision to advance defense costs is subject to the business judgment of the board. The Court further ruled, though, that the plaintiff shareholders adequately alleged that the HCI board breached their duty of care in approving the defense cost advancement, and therefore the court enjoined those advancements.
The Court found that the board failed to consider the potential magnitude of defense costs to be incurred by the defendant D&Os or the ability of the defendant D&Os to repay to HCI the advanced amounts if indemnification is ultimately unavailable. In essence, the court reasoned that if the defense costs to be advanced are likely to exceed the defendant D&Os' ability to reimburse the company, the board is improperly wasting corporate assets by approving the advancements.
Equally troubling, the Court in dicta suggested that if a majority of the board is seeking advancement, the business judgment rule may not apply because the directors have a personal interest in the advancement decision. If the advancement decision is not protected by the business judgment rule, the directors would be required to prove the "entire fairness" of their advancement decision - a standard of review few business decisions can withstand.
This court opinion emphasizes the importance of a well-drafted and comprehensive by-law indemnification provision which not only mandates indemnification of D&Os to the full extent permitted by law, but also mandates advancement of defense costs during the pendency of the claim. Without such a by-law provision, D&Os run a substantial risk in light of the Havens decision that no advancement from the company will be available where the likely defense costs exceed the D&Os' ability to repay.
B. Public Policy Limitation
The SEC and numerous courts have recognized for many years that it is against public policy to indemnify for actual violations of the federal securities laws, although indemnification for settlements and defense costs in securities claims has been allowed if an actual statutory violation is not established by a court. Because very few federal securities claims proceed to judgment, this public policy limitation rarely arises to prohibit indemnification.
However, a recent federal court decision suggests that the public policy limitation on indemnification may be far broader than previously understood. In First American Corp. v. Al-Nahyan, 948 F. Supp. 1107 (D.D.C. 1996), the court ruled that defendant directors and officers may not obtain indemnification for alleged violations of RICO. The court precluded indemnification even though no actual violation of RICO was established. Rather, the unsubstantiated allegations in the complaint were sufficient to invoke the public policy prohibition against indemnification.
The court's rationale does not appear to be limited to alleged RICO violations, and could logically apply to any alleged intentional wrongdoing. Such an analysis goes well beyond prior indemnification authority and could potentially apply to a large number of D&O claims which routinely allege, among other things, various forms of fraud or other intentional misconduct. As such, this case further demonstrates the importance of a quality D&O insurance program which will respond whenever indemnification is unavailable.
SERVING THE PUBLIC JUST GOT SAFER....OR DID IT?
One of the more troubling and most ignored exposures for directors and officers is service on the board of a non-profit organization. Most corporate D&Os serve on numerous non-profit boards, yet pay little attention to the sometimes surprising liability exposure associated with such service.
Within recent years, litigation against non-profit directors and officers has increased steadily for many of the same reasons which have caused the explosion in D&O litigation in the for-profit sector. Although non-profit D&Os usually do not face catastrophic exposure from securities class action lawsuits, in other respects their risk of personal liability is greater than for-profit D&Os. Frequently, persons serving on a non-profit Board adopt a rather casual approach to their responsibilities and fail to apply the same diligence and care which they bring to their for-profit job. In addition, the non-profit organization typically has limited resources to assist its directors in their decision-making and oversight roles.
Congress recently passed the Volunteer Protection Act of 1997 in an attempt to lessen this risk of personal liability for directors and other volunteers of non-profit organizations and governmental entities. In passing this legislation, Congress expressly found that the willingness of volunteers to offer their services to these organizations has been deterred by the potential for personal liability, and as a result many of these organizations have been adversely affected both by the withdrawal of volunteers from their boards and by the incurrence of higher costs to purchase necessary insurance.
Under the new federal law, no volunteer (including directors) of a non-profit organization or governmental entity may be liable under any federal or state law for conduct within the scope of the volunteer's responsibilities on behalf of the organization. A "volunteer" is defined as an individual performing services without receipt of compensation (other than reasonable expense reimbursement), or any other thing of value in lieu of compensation in excess of $500 per year. In order to avoid inadvertent loss of the protections of this new statute, non-profit boards should now carefully avoid even the appearance of conveying something of value to the Board in an amount in excess of $500 per year. For example, weekend retreats which are partially social or which include family members and which are funded by the non-profit organization may be applied towards the $500 per year limitation.
A "non-profit organization" is defined as any organization exempt from federal income tax pursuant to Section 501(c)(3) of the Internal Revenue Code of 1986 (i.e. charitable, educational, religious and other social benefit organizations). Social clubs, chambers of commerce, trade associations, labor organizations and other non-profit organizations exempt pursuant to different subsections of the tax laws are not benefited by this new legislation.
Like most liability limitation statutes, this new legislation contains numerous exceptions which will undoubtedly become the focus of plaintiffs in the coming years. Some of the more important exceptions, and thus some of the more important areas in which non-profit volunteers remain exposed to personal liability, include the following:
1. Gross Negligence. The legislation does not eliminate a volunteer's liability for harm caused by willful or criminal misconduct, gross negligence, reckless misconduct, or a conscious, flagrant indifference to the rights or safety of the individual harmed by the volunteer. Although seemingly justifiable, this exception is troubling in two respects. First, the exception applies not only to rather egregious wrongdoing, but also to "gross negligence". In many states, including Delaware, courts for several decades have held that directors and officers of for-profit corporations cannot be personally liable for breach of their fiduciary duties unless they are found to have acted with gross negligence. As evidenced by the explosion in claims against for-profit D&Os, this "gross negligence" standard has not been a material deterrent to plaintiffs in establishing D&O liability. Second, questions of fact will arise in determining whether an individual's conduct falls within this exception and thus the existence of this exception will likely preclude a court dismissing a lawsuit against the volunteer before trial.
2. Motor Vehicles. The statute does not eliminate liability for harm caused by the volunteer operating a motor vehicle, vessel or aircraft for which the operator is required to be licensed or to maintain insurance. Thus, organizations should continue to maintain general liability insurance coverage for its volunteers.
3. Claims by Non-Profit Organization. The statute does not eliminate liability in any claim brought by the non-profit organization or governmental entity for whom the volunteer serves. Although not entirely clear, it appears that this exception does not apply (i.e. the liability limitation exists) for derivative lawsuits brought on behalf of the organization by a member or other constituent.
4. State Law Limitations. Over the last 10 years, many states have passed their own liability limitation statutes for volunteers of non-profit organizations. This new federal law is intended to pre-empt any inconsistent, less protective state law unless the state expressly "opts-out" of the protections afforded by the new federal law.
However, certain types of exceptions to volunteer liability protection in state laws, if otherwise applicable, extend to this new federal legislation. For example, the federal liability limitation will not apply to the extent applicable state law requires the non-profit organization to adhere to certain risk management procedures (such as mandatory training of volunteers), or to the extent state law makes the liability limitation inapplicable to claims by a governmental officer, or to the extent state law makes the liability limitation inapplicable if the organization fails to provide a financially secure source of recovery for individuals who suffer harm as a result of the volunteer's actions.
5. Civil Rights Violations. The statute's liability limitation does not apply if the volunteer is found to have violated a federal or state civil rights law or a sexual offense as defined by applicable state law. This exception may significantly reduce the benefits of this new legislation in the context of employment claims against volunteer directors or officers. Employment claims alleging illegal discrimination or sexual harassment may fall within this exception. Since employment claims constitute the single largest exposure for non-profit D&Os, this is one of the more important and potentially troubling exceptions.
Even if one of the foregoing exceptions applies and therefore a volunteer is held personally liable, the new statute still contains an important protective provision. A volunteer may be liable only for that portion of the plaintiff's non-economic loss (i.e. physical injury, mental anguish, injury to reputation and other non-pecuniary loss) equal to the percentage of responsibility of that volunteer for such loss. By eliminating joint and several liability with respect to non-economic loss, this proportionate liability provision will be particularly helpful for wealthy volunteers who historically have become deep-pocket targets of plaintiffs.
In summary, the new statute provides potentially helpful liability protection for non-profit volunteers. However, in light of the numerous and apparently broad exceptions in the statute and the lack of any court interpretation of the new law, only marginal comfort should be taken at this time. The enactment of this new statute, though, creates a good opportunity for large for-profit corporations to remind their directors and officers that the same legal duties applicable to them in the for-profit world equally apply to their behavior as non-profit directors and officers, and therefore they should carefully consider in what volunteer positions they choose to serve and should diligently discharge their responsibilities in any such position. At the same time, for-profit corporations can remind their directors and officers that if their non-profit service is at the request of the for-profit corporation, indemnification from and insurance purchased by the for-profit corporation may be available to financially protect them in their capacity as non-profit directors, provided the terms of any outside position program maintained by the for-profit corporation have been followed.