Board protection Featured

12:06pm EDT February 28, 2006
Spurred by the stunning collapses of Enron, Tyco and WorldCom, the Sarbanes-Oxley Act was signed into law in 2002. Among other reforms, this act expanded the responsibilities as well as the potential liabilities of corporate officers and directors.

As a result, says Bruce Friedman, a partner in Alschuler Grossman Stein & Kahan LLP’s Insurance & Reinsurance Practice Group, the environment in which officers and directors operate has changed considerably.

“There is a much more agressive enforcement environment where people are concerned that not only might they be exposed to liability as a director or officer in terms of damages, but they might also be exposed to the SEC regulators,” he says.

Smart Business spoke with Friedman about the types of lawsuits that a company’s officers and directors can be exposed to, how to protect against them and the importance of keeping abreast on current legislation.

What kinds of lawsuits are officers and directors exposed to?
In publicly traded companies, directors and officers can be exposed to lawsuits arising out of the trading of securities. Generally, these are cases that fall under Section 10 of the Securities and Exchange Act. In essence they are fraud and misrepresentation claims where someone sues the company and its directors and officers, claiming that they have misrepresented the financial condition of the company. A claim that commonly goes alongside this is insider training, where a director or officer is accused of trading on material nonpublic information.

There are also potential claims for breach of fiduciary duty that are usually brought in the form of derivative actions. In privately owned companies, you don’t have the public securities exposure that you have when you’re on the board of a publicly traded company, but you still have potential claims by minority shareholders. And in both publicly and privately held companies, there is a possibility of employee-related claims such as discrimination and harassment.

If not prepared, what costs can be associated with defending lawsuits?
Lawsuits in the securities area can cost millions of dollars to defend. That’s also true of significant breach of fiduciary duty claims and derivative actions. Even in the employment area, you’re looking at hundreds of thousands of dollars, if not a million dollars, to defend a serious claim of harassment or discrimination.

How has the Sarbanes-Oxley Act expanded potential liabilities for company leaders?
Sarbanes-Oxley put the directors and officers on the line with respect to representations concerning the company’s financial statements. Sarbanes-Oxley now requires that the top leadership of a company actually sign the financial statements, stating that to the best of their knowledge this is the true and correct picture of the company’s financial condition. So it really exposes the executives to a class-action suit if there is anything wrong. They can be prosecuted by the Securities and Exchange Commission as well.

Has it become tougher for public companies to keep quality members of their board in place due to this act?
I think it is harder to attract board members these days in light of Sarbanes-Oxley and the role of the independent director — the one who’s not employed by the company, (and) is sometimes referred to as the outside director. The independent director plays a very important role now because they have more of a watchdog role with respect to the insiders and that adds to their responsibility and to their exposure.

What advice would you give to a CEO or business leader about keeping current on legislation that might affect officers and directors?
The best advice for a large business entity would be to have the general counsel charged with the responsibility to keep the officers and directors apprised of any changes in the law that would expose them to any new claims. And also they should do some risk-management counseling in the securities, Sarbanes-Oxley and employment areas so that people know where the boundaries are. In a smaller company, that obligation is something that should be assigned to outside counsel.

How important is it to have proper protection in place when trying to attract officers and directors?
Most people will not serve on a publicly traded company’s board or take an officer position unless there is adequate directors’ and officers’ and employment practices liability insurance. One of the first things that people ask after they find out about the company is, ‘Do you have insurance, and how much?’

Bruce Friedman is a partner in Alschuler Grossman Stein & Kahan LLP’s Insurance & Reinsurance Practice Group. Reach him at bfriedman@agsk.com.