A Practical Look At Director Liability Exposure

Recent high-profile controversies with governance implications raise the interest level on director liability risks. The traditional perspective is that fiduciary service does not expose directors to significant personal exposure, and there are no significant indications of a contrary trend. However, issues of liability exposure should be considered in the context of a broader scope of potential risks. Here are what I feel are the top 7 and what to do about them.

1. Stakeholder challenges. The most obvious source of liability exposure arises from shareholder derivative actions, and similar stakeholder breach-of-duty claims. Yet, an extremely high burden of proof is required under Delaware law to overcome business judgment rule protection and sustain such allegations. This is especially important as to the board’s legal and compliance oversight, and business risk evaluation processes. Yet, claims involving more outrageous fact patterns (e.g., those involving cyberbreaches and workforce culture) generate less favorable outcomes, particularly in jurisdictions outside of Delaware.

2. Director resignation. Recent circumstances arising from the entertainment industry are a reminder that fiduciary exposure also may arise in situations where directors resign from the board, for whatever reason. Depending upon the circumstances, the act of resignation itself may constitute a breach of fiduciary duty, even though the resigning director may not have caused the problem. The fiduciary concern would be whether by resigning, and leaving the resolution to others, the director has exacerbated the problem.

3. SEC enforcement. Public company directors have not historically faced significant exposure to SEC enforcement action, and this is unlikely to change under the current policies of the new administration. Nevertheless, there have been several recent high-profile SEC enforcement actions instituted against audit committee chairs, which are a reminder that the SEC will take action against individuals (especially “gatekeepers”). This is particularly so where an individual was a direct participant in alleged corporate misconduct, or was willfully blind to evidence of such misconduct.

“Regardless of the impact of future revisions to the ‘Yates Memorandum’, it is clear that the Department will not depart from its fundamental commitment to individual accountability as a compliance deterrent.”

4. Creditors’ rights. The scope of a director’s individual liability exposure also includes creditors’ rights actions arising from corporate financial distress. A prominent 2015 decision of the U.S. Court of Appeals upheld a jury verdict of approximately $2.3 million in compensatory damages against the officers and directors of a nonprofit home for the aged, for breach of fiduciary duty and deepening insolvency arising from their financial (mis)management of the organization.

5. Industry debarment. Depending upon the specific industry sector, board members may be subject to removal/debarment, fine or similar sanction should a director’s actions or nonactions violate appropriate regulatory expectations of governance or significantly contribute to alleged corporate misconduct. A leading example of this risk is the authority of the Office of Inspector General, Department of Health and Human Services, to impose the penalty of exclusion from the Medicare and Medicaid programs.

6. “Yates” and its progeny. The Department of Justice has long maintained a policy of holding individuals accountable for corporate misconduct, when it can be determined that they significantly contributed to the decision to set the company on a course of such misconduct. This policy was most recently enhanced in a September, 2015 policy memorandum issued by then Deputy Attorney General Sally Q. Yates. Regardless of the impact of future revisions to the “Yates Memorandum”, it is clear that the Department will not depart from its fundamental commitment to individual accountability as a compliance deterrent.

7. Reputational harm. Perhaps the most subtle element of director liability exposure is the risk of harm to personal reputation. Recent academic studies have confirmed that many individuals pursue board service as a means of enhancing their personal reputation, level of industry credibility and professional credentials. Yet derivative litigation, government investigations and media coverage of corporate controversies typically speak (in the public record) to the conduct of the board. This reputational risk arises regardless of whether the corporation is ultimately vindicated in the process.

What to do
Effective director recruitment and retention efforts include an organized response to anxieties concerning individual liability exposure. An obvious step is to assure availability of comprehensive insurance and indemnification coverage for board members. More substantive responses relate to (1) assuring that decision-making processes satisfy business judgment rule requirements; (2) oversight processes are substantive and based on effective information reporting systems; and (3) that directors are trained to recognize and respond to “yellow” and “red” flags of risk.

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Michael W. Peregrine
Michael W. Peregrine, a partner at McDermott Will & Emery LLP, advises corporations, officers and directors on matters relating to corporate governance, fiduciary duties, and officer-director liability. His views do not necessarily represent the views of McDermott Will & Emery or its clients.