Time to Review D&O Liability Protections in Distressed Private Companies

May.13.2020

The COVID-19 pandemic is testing the oversight and management skills of directors and officers (“D&Os”) of all businesses, especially lean private companies. Leadership teams are facing difficult decisions involving layoffs and furloughs, skipping rent payments on leases and interest payments on outstanding indebtedness, emergency financings and distressed M&A transactions, each of which pose serious potential personal liability to D&Os. In midst of this crisis, companies should review measures they have in place to reduce the risk of personal liability to D&Os to ensure that D&Os are not distracted by the risk of personal liability to stockholders for their good faith business decisions which later might be second guessed if their company should suffer significant losses or fail. Key measures to review are:

Exculpation

Nearly all of today’s Delaware corporations include in their charters a provision eliminating directors’ personal liability for monetary damages for losses suffered by the company except as related to a breach of their duty of loyalty (for example, due to conflicts of interest) or actions not taken in good faith. Importantly, with this provision, directors are protected from personal liability for actions taken in good faith, which are protected by the business judgment rule even if their actions ultimately cause substantial losses to the company. Essentially, this provision is intended to encourage directors to exercise their best business judgment, especially in a time of crisis like the current pandemic.

Officers, however, are not covered by exculpation clauses. To the extent that they are deemed to owe fiduciary duties to stockholders (as is the case under Delaware law), officers can be held personally liable to stockholders for breach of fiduciary duty. Directors who are also officers face the same exposure for decisions that they make in their capacities as officers.

Indemnification & Advancement of Expenses

Routinely, as allowed by Delaware law, Delaware incorporated companies include in their bylaws (and also may include in their charter) a provision mandating indemnification of D&Os for losses and expenses incurred in connection with claims arising out of their service to the company. Such indemnification is generally limited to situations in which D&Os acted in good faith in a manner they believed to be in the best interests of the company. In addition, indemnification is mandatory if the D&O is successful in defending a claim. Indemnification is not available if a D&O is found liable in a derivative lawsuit brought by a stockholder.

Bylaw provisions also typically provide that D&Os may receive advancement of expenses before an action is finally determined or settled. This right is crucially important given the high cost and lengthy duration of litigation. Without an advancement right, a D&O may be required to shoulder such costs for years and attempt to be indemnified only after the dispute is completed, which may be long after the company is creditworthy enough to repay such amounts.

On top of bylaw protections, many Delaware corporations provide for D&Os to enter into separate indemnification agreements with the company to ensure these protections are several and thus cannot be amended without such D&O’s consent.

In this time of crisis, companies should review their charters, bylaws and indemnification agreements with D&Os to ensure that these are state of the art and consistent with recent case law concerning the rights of and limitations on indemnification and advancement of expenses for D&Os. Examples of specific provisions to review and update include:

  • Scope of Indemnifiable Matters: D&Os (current and former) should be indemnified to the fullest extent permitted by the relevant state law. Exclusions should be as narrow as legally permissible. Expenses incurred by D&Os defending their rights to indemnification or advancement of expenses should be included.
  • Standard of Conduct: D&Os should be presumed to have satisfied the applicable standard of conduct unless the company can establish otherwise.
  • Contribution: Consider adding D&O protection for certain conduct that isn’t indemnifiable for public policy reasons, such as violations of specific federal securities laws. In such situations where the company and the D&O are jointly liable, the company contributes 100% of the liability. Even if not jointly liable, the company contributes based on the relative benefit it received from the D&O’s conduct that gave rise to the claim or based on the relative fault of the company.
  • Advancement of Expenses: Provide detail regarding technical requirements and process, including the specific steps the D&O must take to receive advancement (e.g., provide template written notice), burdens of proof, standards of proof, timing and whether the D&O may be required to provide collateral.
  • Partial Success: Explicitly entitle D&Os to partial indemnification in situations where the D&O is partially successful in defending a claim.
  • Settlement of Claims: Consider giving D&Os the right to consent to any settlement agreed by the company unless the D&O is fully indemnified for any liability arising from the settlement.
  • Other Indemnitors: Address the company’s obligations to D&Os who may have overlapping coverage from a third party. For example, explicitly acknowledge the company’s obligation to make payments and provide insurance regardless of any other rights the D&O may have.
  • D&O Insurance: Explicitly obligate the company to provide coverage.
  • Trust: Consider whether the company should establish and fund a trust to serve as a source for covering the company’s indemnification and advancement obligations.

D&O Insurance

The liability-reducing tools discussed above are only effective if the company has sufficient financial resources to fulfill its obligations to a D&O. The importance of D&O insurance cannot be overstated, especially in the private company context where businesses are frequently thinly capitalized.

D&O insurance coverage typically (1) protects directors and officers from personal losses resulting from conduct arising out of their duties to the company (“Side A Coverage”), (2) reimburses the company for indemnifying directors and officers for claims made against them (“Side B Coverage”) and (3) reimburses the company for certain claims made directly against it (“Side C Coverage”). Side A Coverage is the most D&O-friendly and is meant to protect D&Os to the extent they are not covered under exculpation and indemnification provisions, or due to a company’s insolvency. D&Os should choose a policy carefully and be aware of its limitations. Most notably, Side A Coverage, Side B Coverage and Side C Coverage are often combined into one policy and share the same policy limits, meaning that a company could exhaust the policy’s coverage under Side C Coverage and leave little left for direct coverage of D&Os. To the extent feasible, D&Os should obtain a policy that distinguishes Side A Coverage limits from Side B and C limits, or should consider individually obtaining Side A Coverage for added protection. The cost of D&O policies varies widely depending on factors such as company size, industry, revenue, debt and legal history, but generally ranges from $3,000 to $10,000 per year for each $1,000,000 in coverage. No coverage can be provided for breaches of the duty of loyalty or bad faith actions, although coverage under a D&O policy is often broader than the protections of indemnification alone.

Given the benefits of D&O insurance policies, companies should make sure they have as much D&O insurance coverage as they can reasonably afford in order to backstop any gaps in coverage–whether due to potential lack of financial resources or otherwise.

In connection with a merger or similar transaction, it is recommended that the selling company obtain a D&O “tail” policy which extends pre-closing policy coverage for claims made up to 6 years after closing. D&Os of the selling company should (a) involve an insurance broker early in the deal process to answer questions about price and coverage of a “tail” policy and (b) to the extent feasible, include covenants in the acquisition agreement requiring the buyer to honor such obligations after closing.

Key Take-Away

In this time of crisis, D&Os need to have the peace of mind that they can discharge their roles as fiduciaries and take actions that they believe are in the best interests of the company and stockholders without fear that their good faith business decisions will expose them to personal liability. Timely review and improvement of the liability-limiting measures described above is critical to achieving this objective.