D&O Report

The ACE Report is a periodic publication distributed to policyholders and other interested parties as a service by ACE. Its purpose is to address insurance concerns worldwide, as well as present timely information on current developments in liability issues surrounding directors and officers. The Editor of The ACE Report is Dan A. Bailey, a lawyer at Arter & Hadden in Columbus, Ohio, USA and a respected voice in the complex area of directors and officers liability.

Although prepared by professionals, this publication should not be utilized as a substitute for legal counseling in specific situations. Readers should not act upon the information contained herein without professional guidance.

BANK D&O LEGISLATION
The Financial Institution Reform, Recovery and Enforcement Act of 1989 ("FIRREA") directed the FDIC, the Department of Treasury and the Department of Justice to conduct a comprehensive study of D&O liability, insurance and bond issues. The report from that Study was issued September 13, 1991. The conclusions of the Study, as summarized in the report, are as follows:

a. Some federal and state laws hold D&Os liable for simple negligence. FIRREA § 212 preempts state laws to the extent they preclude damage claims by FDIC based on grossly negligent, or worse, conduct. In FDIC v. Canfield, 763 F. Supp. 533 (D. Utah 1991), the court held that § 212 preempted a "simple negligence" state law and required proof of gross negligence. No corrective legislation is needed unless other courts follow Canfield. [Note: Because at least two cases have followed Canfield, the FDIC now believes corrective legislation is needed and has proposed such legislation.]

b. Legislative action is needed to make clear that automatic termination provisions in bond and D&O policies which automatically terminate or limit coverage when an institution is closed or placed in conservatorship violate public policy. Section 1821 (e)(12)(A) and (B), which retains current law for the treatment of D&O insurance and institution bonds, should be repealed.

c. Legislation is recommended to declare the "regulatory exclusion" against public policy.

d. Legislation is recommended to make clear that Congress deems application of the "insured v. insured" exclusion to FDIC actions against former officers and directors to be against public policy.

e. D&O insurance is generally desirable, allows risk reduction to depository institutions, and provides some protection to directors and officers. It is not in the best interests of the depository institution fund or the taxpayers for insolvent, or essentially insolvent, institutions to buy D&O insurance since the premiums presumably would be sufficient to both cover anticipated losses and provide a profit for the D&O carrier. There is no clear evidence to show that the existence of D&O insurance with a regulatory exclusion will attract better officers and directors, although there are strong public policy reasons to prohibit such an exclusion.

Substantial and fairly-priced bond coverage is generally desirable. Troubled institutions should not buy "high cost, low coverage" bonds, since the FDIC is capable of self-insuring the risk.

f. D&O insurance and bond coverage are generally available to financially sound depository institutions, although smaller institutions may have difficulty in finding a carrier. D&O insurance and bond coverage for troubled institutions carries high premiums for coverage restricted in dollar amount and scope. It is unclear what the effect would be on the availability of D&O insurance if insurers are forced to choose between coverage for suits by the FDIC and no coverage at all.

g. The Study has no clear answer to the question of what effect recommended legislation would have on the ability of depository institutions to attract qualified D&Os. It seems unlikely the recommended legislation would have a material impact on how D&O policies are currently underwritten and priced for strong institutions, although it may change the availability of D&O policies for insolvent and troubled institutions.

Legislation was proposed in Congress to implement the conclusions of the Study, but was defeated. The most significant aspect of that proposed legislation would have been the avoidance of the regulatory exclusion in D&O policies, which as reported in the October, 1991 issue of The ACE Report has been consistently upheld in the courts during the last year. Interestingly, both the D&O insurance industry and the American Bankers Association actively lobbied against the proposed legislation. Similar legislative proposals are expected in 1992.

SUBLIMINAL MESSAGE
Few people have questioned the creativity and boldness of professional D&O plaintiff lawyers. However, their method of alleging D&O wrongdoing rose to new levels in a recently filed complaint against various directors and officers of a financially distressed corporation. The caption of that complaint reads as follows:

DIRECTOR DUTIES TO LIMITED PARTNERS
In a recent Delaware Chancery Court decision styled In re USACafes L.P. Litigation, 1991 WL 101373, the court ruled for the first time that directors of a corporate general partner owe a fiduciary duty to limited partners. The case arose in connection with the sale of substantially all of the assets of a limited partnership. The limited partners alleged that the sale price was too low and that the directors of the corporate general partner received substantial personal benefits from the sale. The court denied the defendant directors' motion for summary judgment in which the directors argued that only the corporate general partner, and not its directors, owed fiduciary duties to the limited partners.

The court relied upon analogous decisions which have held that directors of a corporate trustee owe fiduciary duties directly to the trust beneficiaries. However, the decision fails to note that those trust cases recognize liability of directors of a corporate trustee primarily for breaches of the duty of loyalty, not for breaches of the duty of care. Here the court refused to dismiss either the duty of loyalty or duty of care claims, although the decision leaves unresolved the extent of any duty of care to limited partners:

At a minimum, the decision constitutes yet another example of director exposure to third parties. Perhaps the most significant effect of the case will be the extent to which the decision leads to claims against directors and officers in analogous situations. Certainly, the decision appears likely to apply in a general partnership or joint venture setting. Arguably, the decision may support a claim by minority shareholders of a subsidiary corporation against the directors of the parent corporation. Similarly, the case may support an argument that directors of an insurance company owe a direct fiduciary duty to policyholders to the extent director wrongdoing impairs the insurance company's ability to satisfy the policy terms.

This case may cause D&O insurers to increase their underwriting scrutiny of corporations that serve as general partners. Insurers may be less inclined to cover such risk under the corporate general partner's standard D&O insurance policy, but may prefer to specifically underwrite the limited partnership exposure through a separate limited partnership insurance policy, which insures both the corporate general partner and the directors of that corporate general partner.

CANADIAN EMPLOYMENT LAW ENACTED
The highly publicized and debated amendments to the Ontario Employment Standards Act received Royal Assent on October 16, 1991, ending a legislative process that uniquely sensitized the Ontario business community to D&O liability and insurance issues. Bill 70, introduced on April 11, 1991, proposes to significantly expand director and officer liability for unpaid wages and employee benefits. Although the legislation as finally enacted does not change existing director liability for unpaid wages, the furor over proposed expansions of that liability caused many Ontario directors to understand for the first time their personal liability exposure in this area and the importance of D&O insurance which covers that exposure.

Directors (not officers) of for-profit Ontario corporations have been and remain personally liable for unpaid wages, (including overtime pay but excluding termination or severance pay) and vacation pay that becomes payable while the director is in office. This liability is imposed without fault and exists if the corporate employer does not pay employees their wages as a result of bankruptcy, insolvency or other circumstances. Directors are liable for a maximum of six months of wages and twelve months accrued vocation pay, plus interest.

The originally proposed legislation would have extended this strict liability to directors of non-profit corporations, to officers and to liquidators and receivers and would have permitted recovery for wages accrued up to one year after the director left office. Because of strong business opposition, those proposals were deleted and the above-described prior law imposing wage liability only on for-profit directors was retained.

Prior to the proposed legislation, few Ontario directors apparently understood their pesonal liability exposure in this area. Because many more directors now understand that exposure, interest in Canadian D&O insurance has grown significantly.

Directors and their advisors should carefully review their Canadian D&O policy form to determine whether coverage for this wage exposure is included. D&O policies cover only claims for "Wrongful Acts". Wage liability is imposed without any act, error or omission by a director. The definition of "Wrongful Act" in the policy form should be examined to determine if it includes not only acts, errors or omissions but also "any matter claimed against Directors or Officers by reason of their being Directors or Officers". Absent such a catch-all provision in the definition, coverage may not extend to this type of strict liability.

LIABILITY TO UTILITY RATEPAYERS
Directors of a public utility face difficult challenges today. They are forced to contend with spiraling costs, increasingly restrictive and critical regulators, and aggressive consumer advocacy groups while maintaining stable profitability for shareholders. A recent Oklahoma state court ruling, if upheld on appeal or adopted in other jurisdictions, will significantly exasperate that situation.

Nine Oklahoma Gas & Electric directors were sued in a $533 million case action lawsuit on behalf of the utility's ratepayers. The complaint alleged that the utility's directors owe fiduciary duties to the ratepayers and that the defendants breached that duty by failing to cancel an unnecessary and unreasonably expensive contract to purchase electricity from a coal-fire co-generation plan.

The defendants sought to dismiss the claims, arguing that they do not owe a duty of prudent management directly to the ratepayers. Rather, the state Public Utility Commission was charged with regulating the utility for the benefit of the ratepayers. The court rejected that argument and ruled that the complaint states a cause of action upon which relief can be granted.

The decision is quite troubling. If directors of a utility owe fiduciary duties both to shareholders and ratepayers, those directors are placed in an inherent conflict. For example, what matters should the directors seek to pass along to the ratepayers by inclusion within the rate base and what matters should be retained as unreimbursed costs to be borne by shareholders? If the directors truly serve two masters with significantly different interests, both the frequency and severity of claims against the utility directors by one or both of those two masters will likely increase significantly.