November 11, 2008
Economic Crisis and Board Liability
Posted by Michelle Harner

In an August 2007 press release, Marsh warned “the financial services sector, including insurance companies, hedge funds, banks and ratings agencies, that they may be exposed to greater directors’ and officers’ liability (D&O) and errors and omissions (E&O) liability claims in the wake of the current subprime mortgage crisis.”  Despite speculation about a domino effect, the cost of D&O liability insurance for other sectors, which dropped significantly in early 2007, has continued to decline.  A recent article suggests that this pricing trend may continue because the litigation/liability impact of the subprime mortgage crisis generally has been localized and somewhat contained.  As more companies begin to feel the pinch of the credit crunch and investors tally up their losses, however, litigation against directors and officers of companies outside of the financial sector is likely to increase.


Nevertheless, increased litigation does not necessarily mean increased board liability.  In fact, to the extent that a board’s conduct is simply negligent or even grossly negligent, the board likely will be protected under an exculpation clause in the company’s charter.  Moreover, even if a board’s conduct is allegedly outside the scope of exculpation, the litigation likely will settle before the plaintiff’s case proves too much and places the alleged damages outside of the company’s indemnification or D&O liability insurance policies.  As suggested by the findings of a recent empirical study of securities class actions conducted by Tom Baker and Sean Griffith, the amount and structure of D&O policies influence and encourage settlements before trials on the merits in many cases.  This settlement strategy of course makes sense in light of “final adjudication” and “in fact” triggers included in most bad actor and similar exclusions in D&O policies.


Settlement before adjudication on the merits perhaps helps corporate officers, who are not protected by exculpation clauses and may not be protected by the business judgment rule, sleep at night.  Likewise, it may render meaningless the increasing case law discussion of whether a board’s alleged disregard of its duties constitutes gross negligence or bad faith, at least from a board liability perspective.


The Delaware Court of Chancery in Ryan v. Lyondell Chemical and the Delaware Bankruptcy Court in Bridgeport Holdings Inc. Liquidating Trust v. Boyer, 388 B.R. 548, recently indicated that a board’s lack of significant engagement in a sale process could constitute bad faith.  (Both decisions were decided at the pre-trial motion stage; see Gordon Smith’s September post on Ryan for a thoughtful discussion of what such a decision really means for boards.)  Shortly after those decisions, the Delaware Court of Chancery again addressed the issue of bad faith and determined that allowing an interested officer to manage a division sale or approving a naked no-vote termination fee was at best an act of gross negligence and not bad faith.  (See McPadden v. Sidhu and In re Lear Corp. Shareholder Litigation, respectively.)  In each case, the court’s focus on the gross negligence versus bad faith distinction hearkens back to the Delaware Supreme Court’s statement in Stone v. Ritter that “[w]here directors fail to act in the face of a known duty to act, thereby demonstrating a conscious disregard for their responsibilities, they breach their duty of loyalty by failing to discharge that fiduciary obligation in good faith.”


I raise this recent quartet of cases because the issue of gross negligence versus bad faith could play an important role in litigation arising out of the current economic crisis.  Although, as suggested above, the distinction may not ultimately subject the board to personal liability, it could impact the future cost of D&O liability insurance.  A corporate defendant’s ability to dismiss litigation against its board because of an existing exculpation clause eliminates any related claim under the company’s D&O policy and arguably helps contain premium costs.  Moreover, if cases continue to settle prior to adjudication on the merits, which I suspect they will, dismissal of the litigation at the motion to dismiss or summary judgment stage may be the only means to avoid payments under D&O policies.


If a board authorized investments in mortgage-backed securities, collateralized debt obligations, collateralized loan obligations or similar investment vehicles without understanding the structure of, or risk inherent in, those vehicles, has the board committed a conscious disregard of its known duties?  Likewise, does such a violation exist if a board of an insolvent company knowingly authorized a high-risk investment strategy without considering creditors’ interests?  It will be interesting to see how courts resolve those and similar issues and how the insurance industry responds.

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