CBM: TK Kerstetter, President & CEO, Corporate Board Member
Anderson: Steve Anderson, Executive Managing Director, Executive Liability, Beecher Carlson
CBM: You spend a great deal of time talking to and advising directors. If you could have their attention for just 15 minutes, what advice would you offer to improve their effectiveness as a board?
Anderson: I know it sounds simple, but I would advise them to expect the best, but prepare for the worst. A surprising number of boards do very little crisis management planning around events that would threaten the reputation and viability of the company. For all the discussion around the increasing role of directors in enterprise risk management, there is little emphasis upon how the board would actually mobilize and respond immediately upon receiving news of a possibly catastrophic event for the company. That news usually provokes very strong and swift reactions from multiple stakeholders, including shareholders, customers, regulators, suppliers and lenders. Boards need to be completely prepared for the first few hours and days of a crisis or risk turning a bad situation into a disastrous one. Directors are sometimes surprised to discover the extent to which uncertainty around who and what exactly caused the harm to the company creates tremendous tension in what were previously congenial and supportive relationships between the board and senior executive officers and even between directors. By conducting crisis management simulations, boards may be able to avoid missteps in the early stages of an actual crisis.
The other advice I would offer is to pay special attention to business units that generate the highest financial returns to the company. As we have learned particularly in the financial services sector, relatively small parts of large organizations can generate out-sized profits in good times, but also bring the firm to financial ruin. Offer support to the most profitable and rapidly growing business units, but also measure the downside risk as well. Do not allow star performers and divisions to operate in an environment where they are solely responsible for their own risk controls. Keep them in the fold in terms of compliance reviews and independent reviews of their business. Do not become intoxicated with outrageous profits without regularly assessing whether those businesses are taking excessive risk to sustain or increase their growth. The attention will very often not be welcomed by star performers, but it is nevertheless necessary as a matter of sound corporate governance.
CBM: Corporate Board Member’s research shows that directors are more concerned about their personal risk of serving on a board than they have been in the last 5 years. Is this a legitimate concern or just normal anxiety on increased media hype?
Anderson: In the face of a once-in-a-generation size meltdown of the financial markets, directors have every reason to be more concerned. Increased media scrutiny; extensive new regulations; and heightened public expectations among investors are almost certain consequences of the fall-out occasioned by a failure of risk controls within the financial and credit markets. As we witnessed with Sarbanes-Oxley, new regulations create more time pressures and focus heightened attention upon board members as those increasingly responsible for ensuring that the companies they serve are transparent and compliant with the new rules. Failure to meet the increasing demands results in shareholder and regulatory actions that bring the possible result of considerable defense costs; large settlement amounts and possible fines and penalties. In a very real sense, the bar gets reset at a higher level for what it takes to fulfill the fiduciary duties of a director.
Recent statistics bear this out. D&O shareholder claims alleging violations of the federal securities laws and breaches of fiduciary duty are at their highest level in more than three years. Although the burden upon plaintiffs in asserting securities law fraud claims was increased following the Private Securities Litigation Reform Act of 1995 and supported in subsequent U.S. Supreme Court decisions; it only means in many situations that the cases are investigated and litigated that much more vigorously, adding millions if not tens of millions of dollars to the defense costs incurred on behalf of directors and officers to contest these claims. The stakes are higher, which only means that the early stages of the fight with plaintiff lawyers is that much more important if a company is to get litigation against its board members dismissed before going into full-blown discovery. More aggressive regulators, at both the federal and state level, have created yet another challenging front for board members as they defend themselves and their prior actions. One cannot help but wonder these days if the benefits of board service are worth the consequence of dealing with a myriad of increasingly critical constituent groups.
CBM: What are the most important questions that board members should be asking about their D&O policy?
Anderson: Board members need to ask more questions about both the quality and quantity of D&O coverage purchased on their behalf. Too often, the board discovers after a potentially serious claim has been filed against them that the D&O coverage in place contains gaps or exclusions that are likely to cause the respective insurers to challenge the efficacy of the coverage. Quite often, the coverage dispute results from policy language dealing with alleged or actual misrepresentations made in the underwriting process or in the personal conduct of certain directors and officers whose wrongful acts are the basis of the plaintiff’s allegations in the underlying claim. Although competitive conditions in the D&O market in recent years have enabled many policyholders to protect themselves by limiting certain exclusions and imputations of bad behavior to those whose culpability may be grounded in dishonest or fraudulent acts; that is not universally true for all D&O policies. Thus, board members need to make sure that their D&O policies provide severability with respect to wrongful acts and that coverage is non-rescindable at least as it applies to personal asset protection, commonly referred to as Side-A coverage.
Moreover, board members need to be sure that the aggregate limit of D&O coverage in any given year has been benchmarked, not only against what other companies of similar size and shape buy, but based upon an objective analysis of their own risk profile. Buying too much D&O insurance can be an attractive nuisance for plaintiff attorneys; whereas buying too little coverage, particularly if a company is forced to file for Chapter 11 bankruptcy protection, can create real personal asset exposure for the directors. As one CFO once told me, “I want enough D&O insurance that my board sleeps well at night, but not so much that the plaintiff attorneys sleep well.” Directors need to make sure that their D&O insurers; especially the primary underwriter, has strong financial standing and a great deal of experience resolving D&O claims. Virtually any D&O claims attorney will admit that settling complex D&O claims is as much about art as it is science. If the primary D&O insurer lacks the requisite expertise handling complex D&O claims; it can become a hindrance to rather than a constructive part of resolving the claim. With D&O coverage, you need the D&O insurers to be your partners in the event trouble strikes.