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.

LAWYER-DIRECTORS: AN ENDANGERED SPECIES
Approximately 30% of the 250 largest industrial companies in the U.S. include on their boards of directors a lawyer, most of whom are partners in a law firm which represents the corporation. From the lawyer's standpoint, this practice helps strengthen the relationship between the client and the law firm, thus assuring continuation of lucrative fees. From the company's standpoint, this practice may enhance the credibility of the lawyer's advice and permits the lawyer to function better as an effective watchdog for potential legal problems.

When analyzed critically, however, service by lawyers on their clients' boards of directors creates a host of legal problems for both the lawyer and the corporation. As explained below, these problems far outweigh the self-serving and relatively minor benefits from such board service. The wisdom of this practice may be best summarized by the old maxim, "the lawyer who represents himself has fool for a client."

A. HEIGHTENED LIABILITY EXPOSURE
Lawyers who serve as directors of their corporate clients expose themselves to increased liability risks in the following areas, among others.

1. Duty of Care. Directors are generally held to a standard of care commensurate with their special background, qualifications, knowledge, skills and training. The combination of the lawyer-director's specialized legal expertise and his intimate familiarity with many of the corporation's affairs will likely impose a higher standard of care and diligence than that placed upon other directors on the board.
2. Duty of Loyalty. Lawyer-directors are frequently faced with situations in which, in their capacity as directors, they participate in discussions or decisions affecting legal fees which may be paid to them or their law firms. Many decisions by a board will result in the need for substantial outside legal counsel services and thus substantial fees. In such circumstances, the lawyer-director who participates in those decisions may later be accused of self-dealing and violation of his duty to act only in the best interests of the corporation and its constituents. Conversely, if the lawyer-director abstains from those types of discussions and decisions, the corporation is deprived of the benefit of that board seat. The mere appearance of a conflict of interest by the lawyer-director may serve as a magnet for claims by private litigants or extra scrutiny by regulators.
3. Reliance Defense. An important defense available to directors under many types of claims is the good faith reliance upon outside experts, including legal counsel. A lawyer-director may not invoke this defense if he or his law firm provides the expert advice to the board. Similarly, the remaining board members may also be foreclosed from invoking this defense, if the lawyer-director provides the expert advice arguably in his capacity as a director, not as outside legal counsel.
4. Inside Director. Under numerous statutory theories of liability, an "inside" director faces greater liability exposure than a disinterested "outside" director. Lawyer-directors are generally considered "inside" directors because they are perceived to be beholden to management in order to maintain their lucrative, fee-generating relationship with the company. The lawyer-director's heightened liability exposure as an insider is most pronounced in the context of federal securities law claims, where outside directors enjoy more formidable liability defenses than inside directors.
5. Vicarious Liability of Law Firm. In addition to subjecting themselves to increased liability risks, lawyer-directors also may subject their law firms to those same risks. Law firms can be held liable for the conduct of their attorneys as directors under several legal theories. The law firm may be considered a "controlling person" of the lawyer-director for purposes of the federal securities laws and thus be jointly and severally liable for actions of the lawyer-director. Similarly, the law firm may be vicariously liable under the common law doctrine of respondent superior if the lawyer-director is deemed to be serving as an agent for the law firm. Also, consistent with a few court decisions, a law firm may be vicariously liable if it can be shown that the law firm "deputized" one of its attorneys to represent the law firm's interests on the corporation's board. This potential liability may be increased of the law firm selects the lawyer or consents to the lawyer's service on the board.

B. LOSS OF ATTORNEY-CLIENT PRIVILEGE
In addition to the lawyer-director incurring heightened liability exposure, the corporation and its other directors and officers may jeopardize their ability to protect from discovery communications between them and their lawyer-director. The attorney-client privilege generally protects confidential communications between a lawyer and client relating to the provision of legal services. This critically important privilege may not protect communications with the lawyer if the lawyer's communication is found to be in his capacity as a director. It is frequently difficult to distinguish between communications relating to legal advice and communications with a lawyer-director relating to business advice, particularly in the context of a board meeting.

Even if the communication is otherwise subject to the privilege, the outside counsel's service as a director may increase the risk of waiver of an otherwise applicable attorney-client privilege. Other directors or officers may mistakenly believe that communications by the lawyer-director were by the lawyer in his director capacity and therefore disclose those communications to third parties.

If the attorney-client privilege is inapplicable or waived, serious consequences may occur in the context of litigation. In a proper case, the files of not only the lawyer-director, but also his law firm, may be available for discovery by plaintiffs to the same extent as files and records of the corporation itself.

C. INEFFECTIVE DIRECTOR
A lawyer-director typically is not considered a disinterested, independent director due to his professional and self-serving relationship with company management. As a result, a lawyer-director's role on the board is quite limited. He should not serve on the nominating, audit or compensation committees, which should e composed of directors independent from management's influence. For similar reasons, he should not serve on various special committees of the board formed to review merger or buyout proposals, to evaluate demands in the derivative litigation context, or to validate an interested director transaction. Such special committees should consist of only disinterested directors in order to qualify for the protection afforded by the business judgment rule. For the same reasons, a lawyer-director may not be an objective and effective monitor of management conduct, which is fast becoming one of the primary responsibilities of directors.

Because of the dual capacity served by lawyer-directors, their participation in board meetings may mislead other directors. Opinions expressed by the lawyer-director may be mistakenly interpreted to constitute legal advice when in fact it was intended simply as business advice. Conversely, a lawyer-director may dilute the importance of his legal advice to the board if his conduct as director appears to ignore the legal concerns raised. In each of these situations, an increased risk exists that the other directors will give inappropriate significance or improperly discount the advice and opinions of the lawyer-director.

D. DISQUALIFICATION OF LAW FIRM
The lawyer-director and his law firm may be disqualified from representing the corporation or the other directors and officers in litigation against the corporation or its D&Os. If the lawyer-director is a co-defendant in that litigation, at least a potential for a conflict of interest between that lawyer-director and the co-defendants may disqualify the lawyer and his law firm from representing any of those co-defendants. For example, either the lawyer-director or the other co-defendants may wish to assert as defense reliance upon the other. Even if no potential conflict of interest exists, it is doubtful the lawyer-director could exercise truly independent judgment for the benefit of the co-defendants when he is a co-defendant personally. Ironically, such a disqualification would prohibit the lawyer-director from earning substantial fees, which ultimately is one of the primary reasons most lawyer-directors choose to serve in that dual capacity for clients.

E. INSURANCE
The lawyer-director will have potential insurance coverage under both his professional errors and omissions/legal malpractice insurance policy and the company's directors and officers liability insurance policy. However, both types of policies afford coverage only for wrongful acts committed solely by the insured in his capacity as a lawyer or as a director and officer, as the case may be. Because of the difficulty in identifying in which capacity a particular wrongful act was committed and because many wrongful acts arguably are committed in both capacities, lawyer-directors have little certainty as to the existence and extent of insurance coverage for claims arising out of that dual capacity. At best the insurers for the two types of policies will be arguing about their respective liabilities; at worst, both insurers will deny coverage.

F. CONCLUSIONS
Recent activity by private litigants, the FDIC, the RTC and the SEC suggest that the problems identified above are not simply academic issues, but are arising with greater frequency. The risks to the lawyer-director, the other directors and officers and the corporation arising from a company's outside counsel serving as a director are sufficiently severe that companies should seriously consider adopting a general prohibition against such practice.

CREATIVE FORMS OF D&O INSURANCE
Because of increased D&O insurance capacity, knowledgeable insureds and brokers are now focusing more aggressively not only on pricing, but also on policy terms and conditions to enhance the value and quality of the D&O insurance program. The two most creative coverage concepts which have emerged from the current competitive marketplace are summarized and discussed below.

A. MULTI-YEAR POLICY
Multiple-year D&O policies were quite popular in the early 1980's. However, during the last ten years only CODA and ACE routinely offered a form of this type of D&O insurance product. Now, several other D&O insurers are indicating a willingness to underwrite this type of policy. Typically, the policy issued by these insurers is subject to a signal aggregate limit of liability of the entire policy period, subject to a reinstatement of the aggregate limit under certain circumstances. Few insurers other than CODA and ACE offer multiple-year policy with annual reinstatement of limits.

Some of the factors to consider when evaluating a multi-year single aggregate D&O policy include the following:

1. Costs. This type of policy is more cost efficient for insureds because any unused limit of liability is not simply discarded at the end of each policy year and the insureds are not required to purchase additional limits each year. However, the cost savings from this efficiency may not be as much as insureds would initially expect. D&O underwriters actuarially assume a full limit loss is relatively rare and thus two or more full limit losses within a two or three year period is remote. Therefore, the need for (and the cost associated with) an annual reinstatement of limits may not be great. This type of policy also provides to the insureds more cost predictability since the premium level for the entire policy period is defined at the beginning of the policy period, subject to any additional premium if the limit of liability is reinstated. The premium may be payable in full at inception or may be payable in installments over the policy period.
2. Policy Adjustments. Both the insureds and the insurer have limited, if any, ability to adjust the policy terms throughout the policy period. If the insureds believe future events will improve their marketability to D&O insurers, it may not be prudent to purchase a multi-year policy which would delay the insureds' ability to benefit from their enhanced marketability. Conversely, if future events will likely impair the insureds' marketability, a multi-year policy may be advantageous.
3. Limit Reinstatement. Reinstatement of the aggregate limit of liability is one of the more difficult issues to address in multi-year single aggregate policies. If a limit reinstatement is not allowed, the insureds have a larger risk of full limit erosion, although this risk can be addressed through purchase of additional excess coverage. If a limit reinstatement is allowed, the timing, conditions and premium for electing the reinstatement must be negotiated. Frequently, one limit reinstatement is allowed, provided the reinstatement election is made within a relatively small time period immediately following notice by the insured of a claim.
4. Excess Policies. D&O policies which are excess of a multi-year single aggregate primary policy are likely to be more expensive because there is a greater change of erosion of the underlying limits. If the excess policies do not have the same policy period and single aggregate provisions as the primary policy, the insureds may have a potential gap in coverage unless the excess policies specifically agree to drop down for multi-year erosion of the primary's limits.

B. MULTI-LINE POLICY
Companies which typically purchase both D&O and some type of E&O policy may now be able to combine those coverages into a single policy, thereby realizing greater insurance efficiencies and improving the quality of coverage. Some of the factors to consider when evaluating this type of insurance program include the following:

1. Limit of Liability. Like a multi-year single aggregate policy, this type of policy creates greater insurance efficiencies by eliminating the need for two separate limits of liability, thus presumably reducing the total cost of the insurance coverages. However, because more risks are covered by the combined policy, there is a greater likelihood that the limits liability of that combined policy will be eroded or depleted. Therefore, higher limits should be purchased in the combined program than are otherwise purchased in the separate D&O and E&O programs. As explained above, any excess insurance coverage in the combined program will likely be somewhat more expensive than comparable excess coverage in either the separate D&O and E&O programs because there is a greater likelihood that the underlying limit will be exhausted or depleted in the combined program.
2. D&O Protection. By combining E&O coverage for the corporation with D&O coverage, a fundamental purpose of D&O coverage is largely diluted since D&Os would no longer be assured that a defined limit of liability is earmarked solely for their personal protection. To address this important concern, the direct D&O coverage (i.e. Coverage A) of the D&O policy could have a separate limit of liability independent from the limit of liability applicable to the corporation's coverage for either corporate reimbursement or E&O liability claims.
3. Competing Policies. A combined policy avoids the duplicative coverage inherent when separate D&O and E&O policies are purchased, thus reducing the cost of coverage without reducing the scope of coverage. In addition, a combined policy would avoid allocation disputes between separate D&O and E&O policies with respect to which portion of a combined loss is covered by which policy (although a non-indemnifiable D&O loss could create an allocation issue if a separate limit existed for that coverage as suggested above).
4. Policy Drafting. A carefully drafted combined policy could afford greater consistency and policy wording than separate D&O and E&O policies, thereby minimizing the potential for inconsistent and unintended coverage results under the separate policies. Standard provisions in the separate policies may need to be amended for purposes of the combined policy. For example, the "insured v. insured" exclusion in the D&O policy should not be inadvertently broadened because the E&O coverage insures employees of the corporation. Similarly, exclusions which typically are included in only one of the two pollicies being combined should not be expanded to apply to coverage from the other policy.

These types of creative insurance products are not appropriate or even available for all companies. However, in today's insurance marketplace, knowledgeable insureds and brokers should at least explore the availability and wisdom of these or other creative variations of the traditional D&O policy. In many respects, one's ability to improve and existing insurance program today is limited only by one's imagination.