D&O Insurance: Do Private Companies Need it? (Part I)

The short answer is “probably yes”.   There is an emerging trend in the courts and legislative bodies, as yet in its infancy, to find directors and officers of a corporation personally liable for actions taken on behalf of the corporation.   Perhaps this a reaction to the proliferation of “ten minute” corporations and LLCs established through the Internet, coupled with the notion that an individual should not be able to avoid responsibility for his or her actions so easily.  In any case, as the trend gains momentum, plaintiffs’ lawyers will bring more cases seeking to hold officers and directors personally liable for the acts of the corporation.  If nothing else, this will impose legal costs for defense that, even if borne by the corporation, can have a significant financial impact on the owners of a small corporation (who are often also the directors and officers).

The trend is not hard to see.   Consider:

1. In a recent case the North Carolina Court of Appeals held that a homeowner has a negligence claim against the president of a home construction company in his personal capacity, even though he was acting in the name of a corporation he owned. White v. Collins Building, Inc. et al., No. COA10-216, C.A.N.C., filed January 4, 2011.   The Plaintiffs Andrew and Barbara White (“Plaintiffs”) purchased a beach home from developer, AEA & L, LLC, which in turn had contracted with Defendant Collins Building, Inc. (“Corporation”) to construct the residence. Defendant Edwin E. Collins, Jr. (“Collins”) was the president and sole shareholder of the Corporation.   Plaintiffs brought a series of claims against the Corporation, Collins personally, AEA & L, LLC and various subcontractors, but dismissed all claims except the negligence claim against Collins.  Collins moved to dismiss the negligence claim against him on the ground that he could not be held individually responsible for the acts of the Corporation. The trial court agreed and allowed Collins’ motion to dismiss, but the Court of Appeals reversed the decision and found in favor of the Plaintiffs.  The Court acknowledged that a properly formed and maintained business entity like a corporation or a limited liability company provides a shield of protection from personal liability for an individual member or officer, but the protection is not absolute. There are two ways to hold an individual corporate officer responsible for the actions of the corporate entity; either by piercing the corporate veil or by establishing direct negligence on the part of the individual member or officer. The court said in its decision, “It is well settled that an individual member of a limited liability company or an officer of a corporation may be individually liable for his or her own torts, including negligence.”   What is remarkable about the case is that the decision is directly contrary to the centuries old concept of a “corporate veil”.

http://www.vannattorneys.com/contractors-beware-your-corporate-shield-is-cracked/

2.   In another case in a different state, the Supreme Court of Wisconsin held that a corporate officer may be held liable for non-intentional torts committed in the scope of his or her employment, depending on public policy considerations.   Casper v. American International South Ins. Co., et al. 2011 WI 81 (July 19, 2011).    In 2003, the Casper family minivan was stopped at an intersection when Mark Wearing’s truck struck it from behind going 40 miles per hour. Five passengers in the Casper minivan were injured.  Mark Wearing, co-employed at two of the defendant companies, was under the influence of several prescription drugs when the accident occurred. The court unanimously declined to hold that corporate officers can never be held personally liable for negligent acts committed in the scope of employment, and noted that the business judgment rule, which allows some latitude for wrong decisions, only protects corporate officers and directors for negligent acts that impact shareholders, not third parties.  In this case, a majority of the court (6-2) ruled that public policy considerations precluded liability.  However, the door is now open.

http://www.wicourts.gov/sc/opinion/DisplayDocument.pdf?content=pdf&seqNo=68178

3.  In another recent case the Federal District Court for the Western District of Washington denied a motion for summary judgment and ruled that a corporate officer can be held personally liable for copyright infringement by a corporation.  Blue Nile Inc. v. Ideal Diamond Solutions Inc. d/b/a IDA, et al. (No. C10-380Z, Aug. 5. 2011).  Blue Nile, an online diamond retailer, brought a copyright infringement suit against Ideal Diamond Solutions, claiming that IDS used Blue Nile’s copyrighted images on IDS’ website.  Blue Nile also sought to hold IDS’ founder, Larry Chasin, personally liable.  On cross-motions for summary judgment, the court found Chasin personally liable on the grounds that copyright infringement is a strict liability tort there is no corporate veil protection against copyright infringement for corporate officers.  The court rejected Chasin’s defense that he did not know that the images used on the IDS website infringed on Blue Nile’s copyrights because, the court reasoned, any infringer is strictly liable regardless of whether the infringement is intentional or innocent.  Moreover, the court rejected Chasin’s defense that he did not personally create the infringing website because he had the right and ability to supervise the infringing activity and had a direct financial interest in the infringing activity.

http://www.seattlecopyrightwatch.com/Blue%20Nile%20v.%20Ideal%20Diamond_Amended%20Order.pdf

4.     There is a well established legal doctrine known as the “responsible corporate officer” (RCO) doctrine that permits the government, in certain circumstances, to pursue officers and directors of a corporation for certain types of misconduct by the corporation.  The RCO doctrine imposes strict liability.   It is not a defense for the RCO to say that he or she did not know of or participate in the wrongful acts of the corporation.  The doctrine is based on two United States Supreme Court decisions.  United States v. Dotterweich, 320 U.S. 277 (1943), and United States v. Park, 421 U.S. 658 (1975) Historically, the RCO doctrine has been applied in cases involving state and federal laws intended to protect the “public welfare”, such as food and drug laws, environmental laws, and even securities laws. Most recently, the government has sought to apply the doctrine to the health care industry, including medical device companies, pharmaceutical companies and hospitals and health systems. The trend is clear.  The government is trying to expand the scope of the RCO doctrine, and the possible applications are as varied as the concept of “public welfare” is broad.

5.   Some Federal statutes allow for a finding of direct liability of directors and officers, such as the Foreign Corrupt Practices Act, 15 U.S. Code § 78m.   A willful violation of the FCPA by an officer, director, employee or agent can result in a fine of up to $100,000 and imprisonment for up to fine years.  Violations by such persons that are not willful can result in a fine of up to $10,000.  The corporation cannot pay these fines on behalf of these individuals.   The FCPA is just one example of this growing legislative trend.  Another example is the FBAR reporting by individuals, such as corporate officers, who have signature authority over the corporation’s foreign bank accounts (see May 6, 2011 post on this blog).  If the individual fails to file the FBAR, there is personally liability even if the individual had no beneficial interest in the corporation’s foreign bank account.

6.  In event of the insolvency of a corporation, directors and officers can be personally liable for certain unpaid corporate tax liabilities, including penalties and interest. The most common types of taxes for which personal liability arises are so-called “trust fund taxes,” such as state sales taxes, income tax and social security withholding and similar obligations, which are deemed held in trust for the government.  The tax collector will argue that the funds were willfully diverted to pay other creditors.

7.  In addition, when the government launches an investigation of alleged violations of law by a corporation, it will often focus its attention on one or more officers who may be found to have personnel liability, in addition to the broader liability of the corporation. This usually results in separate counsel for the corporate officers in question, which can result in significant additional legal fees.

This list is merely illustrative and by no means exhaustive.

While the threat of personal liability is very real for directors and officers, the important question is:  Who pays the fines and the legal defense costs?   Most corporations indemnify its directors and officers against the risk of personal liability, subject to a few exceptions for conduct that is clearly improper, such as self-dealing at the expense of the corporation.

However, there are two situations where the indemnity may not provide much comfort.  The first situation is during the insolvency of the corporation.  What good is an indemnification from an insolvent indemnitor?  Moreover, insolvency is the time when the risk of lawsuits against directors and officers is the highest because the plaintiffs do not have much chance of recovering losses from the corporation.

The second situation is when the government launches an investigation into possible wrongdoing by a corporation and then focuses on one or two officers or directors.  The rest of the directors and management may feel that the corporation itself is blameless and, if any laws were violated, it was wholly the fault of the individuals under suspicion. A consensus may emerge among the “clean” officer and directors to throw the suspects “under the bus” in order to make the corporation look more cooperative in the eyes of the government investigators.  This could raise questions about the legal fees of the officers and directors suspected of wrongdoing.  At the outset of the investigation, the corporation will probably hire independent counsel for the directors and officers under suspicion or, alternatively, agree to pay counsel hired directly by those individuals.  Then, if the corporation decides to shift all blame to the directors and officers being investigated, it may look for a way to stop paying those expensive legal fees.  If the fees are cut-off, the affected officers and directors will have to sue to enforce the indemnity but such a suit can itself be an expensive proposition and, meanwhile, the government’s investigation continues and the counsel for those directors and officers is not being paid.    The answer to these two situations is D&O insurance.  Not only does it provide protection in the case of insolvency of the corporation, but it also can eliminate troubling questions about the limits of a corporation’s indemnification.  Of course, D&O insurance is not a perfect solution.  Like all insurance it has limits on the coverage and exceptions. For example, any conduct that, under state law, could not be covered by a broad indemnification, such as fraud, is usually excluded from D&O coverage.

D&O coverage, which is limited to coverage for the wrongful acts and alleged wrongful acts of directors and officers, is usually part of a broader insurance program that includes a Comprehensive General Liability Policy (“CGL”), which is designed to protect a company from personal injury claims (this often includes coverage for claims of advertising injury, defamation, invasion of privacy, copyright infringement and other intellectual property injuries); and/or Employment Practices Liability Insurance (“EPLI”), which is a specialized insurance policy protecting companies against employment related lawsuits.

The Corporation Secretary

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