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.

D&O TAKEOVER EXPOSURE – EUROPEAN STYLE
Unlike the U.S., merger and acquisition activity in Continental Europe is now thriving. Fueled by a healthier economy than the U.S. and a strong desire by investors to enter the European market before 1992, European takeover activity in the early 1990's could equal or surpass the U.S. merger mania of the late 1980's. For example, according to an estimate by the Banca Commerciale Italiana, nearly 11,000 Italian companies could be targets of management led buyouts in the next few years. In France, more than $5 billion in capital is reportedly accessible to dealmakers which, when leveraged, yields between $10 and $15 billion in available funds to finance the buyouts in France.

This environment has fueled the same controversy as existed in the U.S. throughout the 1980's – by what standards should directors be judged when acting in the change-in-control context? Historically, the European legal system has heavily favored the target board over the bidder, deferring in virtually all instances to the good faith decision of the board. However, following the U.S. lead, a growing concern about protecting shareholder rights and interests is emerging, thereby criticizing director conduct which does not maximize shareholder value in the short term.

The recently released revised draft regulation by the European Community Commission that defines how member nations agree to regulate takeovers reflects this growing concern for shareholder rights by drastically diluting directors' discretion in the takeover context, thus significantly increasing director liability exposure. The amended regulation enumerates "guiding principles" that purport to set forth a policy of evenhandedness between bidders and the board, thus opening markets in the European community that have previously been closed to takeovers. Among other things, the guiding principles state:

1. All holders of securities of a target company who are in the same position are to be treated equally.
2. Target shareholders are to be permitted sufficient time and information to enable them to reach a properly informed decision on the bid.
3. The board of a target company is to act in the interests of all shareholders and may not frustrate the bid.
4. Neither the target company nor the bidders may take an action that might create a false market in the securities of the target company, the bidder company or any other company concerned by the bid.

Principle no. 3, above, is the most troubling from a director's perspective. By focusing only on the interests of shareholders, and not the long-term interests of the corporation and other constituents, the proposed guiding principle would create a legal environment for directors similar to that which existed in the U.S. during the late 1980's and which resulted in enormous liability for U.S. directors. The proposal would be a significant change in corporate law of many EC countries, including Germany and the Netherlands, which have required directors to consider shareholder's interests only as one of several competing factors.

The proposed guiding principle requiring the disclosure of all material information and prohibiting the creation of a false market tends to duplicate Section 10 (b) and Rule 10b-5 of the U.S. Securities Exchange Act of 1934, which has served as the primary weapon in the U.S. arsenal of laws creating director liability. All communications by the target company's board would be closely scrutinized with the benefit of 20/20 hindsight to determine if any material omissions, half-truths or false statements existed.

In addition to duplicating many U.S. legal standards, the European Community is also being inundated with the same U.S. lawyers and investment bankers who created, structured and in many respects fueled the U.S. takeover climate of the 1980's. As the U.S. market has contracted, these advisors are now actively soliciting and obtaining lucrative engagements in Europe. It is reasonable to expect these advisors to impact the dynamics of takeovers in Europe similar to the way they impacted takeovers in the U.S., thereby also fueling director liability exposure.

Approval of the draft EC Commission takeover regulations has been delayed pending full debate of the diverging opinions concerning the proper role of directors in the change-in-control context. Approval of these regulations, in some form, appears likely in the spring of 1991. The form of the finally adopted guiding principles will likely determine, to a large extent, director liability exposure in the coming years for European directors as they respond to the European version of "merger mania".

RECENT D&O PROTECTIVE LEGISLATION – HAS IT WORKED?
Beginning in March, 1986 with the amendment of various Indiana statutes defining or affecting director liability and financial protection, more than 40 states attempted to ameliorate the perceived D&O crisis of the mid-1980's by adopting various forms of remedial legislation. On the 5^th anniversary of the commencement of this historic effort, it is appropriate to re-examine the value of those new statutes and whether they have, in fact, afforded directors and officers any significant protections.

Perhaps the most significant observation is the dearth of virtually any judicial opinions in any state interpreting these new statutes or applying the new statutes to specific situations. One could naively conclude that all of the statutes are so well drafted that their validity, meaning and application are indisputable. A more likely explanation is that claimants can so easily circumvent the purported protections within the statutes that they need not attack the validity or interpretation of those statutes. Rather, they merely allege wrongdoing which falls outside of the scope of the statutes, thus completely circumventing the liability protections in the legislation.

Although each of the states adopted different approaches when enacting their legislation, a brief examination of the Delaware statute demonstrates how easy most claimants can circumvent the protections of the statute. Assuming a Delaware corporation amends its certificate of incorporation to eliminate director liability to the fullest extent permitted by the Delaware statute, the directors of that corporation are still liable for the following claims, among others:

1. Liability for any breach of the director's duty of loyalty to the corporation or its shareholders. A director's duty of care, which is protected by the statute, is not clearly distinguishable from the duty of loyalty. In many instances, a claimant seeking recovery for certain director wrongdoing can allege the wrongdoing constituted a breach of either the duty of care or the duty of loyalty.
2. Liability for acts or omissions not in good faith. Because such a claim creates issues of fact, this exception to the statute assures claimants their claim will not be dismissed prior to the trial before a jury or other fact finder.
3. Liability to anyone other than the corporation and its stockholders. Recent surveys have concluded that approximately 50% of reported D&O claims are made by persons other than the corporation and the shareholders.
4. Liability for violation of any federal statute, including the federal securities laws, RICO, the anti-trust laws, anti-discrimination laws, ERISA, pollution laws, etc.
5. Liability of a director in his capacity as an officer of the corporation.

In order to assume that the directors will be afforded whatever protection might be available from these statutes, the corporation should carefully draft any amendment to its certificate of incorporation that may be required to implement the liability protections of the statute. If such a provision is drafted too broadly by purporting to eliminate liability beyond the scope of the statute, the entire provision, not just the portion of the provision that exceeds the scope of the statute, may be ineffective. A recent Delaware Chancery Court opinion confirmed this potential result by refusing to dismiss a claim seeking to invalidate an entire liability limitation provision in a Delaware corporation's certificate of incorporation because the Court found that scenarios could plausibly be constructed where the provision would eliminate a claim for breach of the directors' duty of loyalty, a result proscribed by the Delaware statute.

Many state statutes not only sought to limit director liability, but also expanded the financial protection available to directors and officers in the event they incur personal liability. For example, many states expanded the permissible scope of indemnification by a corporation and some states authorized alternative forms of financial protection such as the use of trust funds, self-insurance and captive insurance companies. Unlike the liability limitation provisions, these financial protection provisions have provided meaningful additional protection to directors and officers if fully utilized.

A surprising number of corporations have not recently examined their indemnification provisions to assure that they afford maximum, state-of-the-art protection for the directors and officers. In those states that permit other forms of financial protection, corporations should also consider the benefits from and ramifications of such alternatives. Although none of those alternatives are complete substitutes for traditional D&O insurance, they can provide important supplemental protection.

THE EMERGENCE OF D&O LIABILITY EXPOSURE UNDER A NEW "BABY RICO" STATUTE
Throughout the 1980's, the Racketeer Influenced and Corrupt Organizations Act ("RICO") served as a thorn in the side of corporations and their D&Os by permitting plaintiffs in "garden variety" commercial suits to recover treble damages and plaintiffs' attorney fees. Amending RICO to limit its scope and effect has been a legislative priority for many business organizations in recent years. It appears likely some type of remedial amendment will be enacted eventually. However, corporations and their D&O's are now being attacked by a new statute which promises to be as effective a weapon in the 1990's as RICO was in the 1980's.

In 1986, Congress amended the False Claims Act to permit private citizens to bring "qui tam" lawsuits on behalf o the U.S. government against anyone defrauding the U.S. government. These lawsuits are similar to shareholder derivative suits in that the citizen seeks recovery for the government from persons who injured the government. Like RICO, the statute permits the recovery of treble damages and reasonable attorney fees and costs if the claim is successfully prosecuted.

As an incentive for private citizens to bring these suits, the statute guarantees payment to the citizen of at least 15% of any judgment or settlement recovered by the government in cases in which the Department of Justice ultimately participates and up to 30% in cases where the Department of Justice does not participate. The combination of treble damage recovery and a guaranteed bounty to the winning plaintiff creates an extremely attractive financial incentive for citizens to pursue these claims.

The 1986 amendments to the statute were intended to apply primarily to fraudulent practices in the defense and procurement areas. However, like RICO, the statute is worded quite broadly and potentially impacts any company doing business with or otherwise having a relationship with the U.S. government. For example, companies (and their D&O's) who obtain government loans or loan guarantees, who participate in federal grant programs or farm subsidies, who obtain federal entitlements, who receive medicaid or medicare claim payments or who otherwise perform contract or subcontract work on government projects are potential targets. The basis for a claim under this statute is not limited to the conduct giving rise to the relationship between the company and the government. The example, virtually all government contracts have various "boilerplate" provisions requiring the contracting company to fully comply with all environmental laws, employment laws, etc. If a company violates such laws, it thereby violates the government contract and thus potentially becomes exposed to a qui tam lawsuit.

The 1986 amendments also overruled prior judicial interpretations of the False Claims Act by specifying that a person "knowingly" makes a false claim, and thus violates the statute, when the person acts in "reckless disregard" of the truth. No proof of actual knowledge or specific intent to defraud is required. A similar "recklessness" standard is applied to Section 10(b) and Rule 10b-5 claims under the Securities Exchange Act of 1934. Based upon experiences under the securities laws, this "recklessness" standard will not likely become a significant impediment to claims under the False Claims Act.

Qui tam lawsuits were relatively rare during the first few years following the 1986 amendments. However, within the last year, the number of suits has increased significantly. As these suits gain greater publicity and as plaintiffs successfully recover large awards (settlements since 1986 reportedly approximate $70 million), the frequency and severity of this new exposure is likely to increase substantially.

HOW MUCH D&O INSURANCE IS ADEQUATE?
ACE has compiled a listing of the limits purchased by different categories of industry, as of September 30, 1990. The average, in millions of dollars, is as follows: