Protecting directors and officers: a growing concern

Business Horizons, Nov-Dec, 1990 by James S. Trieschmann, E.J. Leverett, Jr.

The business executive faces many risks in managing a firm in today's environment. There are aggressive national and international competitors, constantly changing tax laws, the threat of merger or acquisition, more demanding consumers, and investigative governmental bodies. Some days it must seem that it is the directors, officers, and stockholders against the world. However, even that has changed. if the stockholders believe the directors and officers do not act properly, they will instigate a suit.

Twenty years ago this action by stockholders or other parties was rare. For instance, in 1975, according to the survey taken by The Wyatt Company (1988), there were 24 D & 0 claims among the firms surveyed. In 1988 the number had risen to 157, an increase of more than 500 percent in 13 years. The Wyatt Company uses an index to track the rising cost of D & 0 claims. This index takes into consideration premium increases, corporate asset size, policy limits, and deductibles. Using 1974 as the base year with an index of 100, the index stood at 746 in 1988. Obviously there has been a large increase in the cost and frequency of D & 0 claims over the last 15 years.

Stockholders represent the major source of all claims-35 to 50 percent. Employees or former employees, customers, governmental agencies, and prior owners of acquired companies account for another 35 to 45 percent of the claims. Given the increasing magnitude of this loss exposure, directors and officers need to become better informed as to how insurance and other risk management procedures can be used to minimize loss exposure and its related costs.

THE DIRECTORS AND OFFICERS LIABILITY LOSS EXPOSURE

he first step in the risk management process

is to identify the loss exposure. To a

director or officer, the loss exposure is the possibility of being sued and a judgment being rendered because of an alleged failure to perform his or her duty as a corporate director or officer. Some of these duties include exercising reasonable care in managing the firm, being loyal to the corporation and the stockholders, making proper disclosure to all persons having a right to know about corporate matters, and fulfilling duties required under the Employee Retirement Income Security Act of 1974.

Besides these fiduciary duties, directors are also charged to properly conduct certain activities. These include, but are not limited to, the following: establish the basic objectives and broad policies of the corporation; elect corporate officers and advise, approve, and audit them; safeguard corporate assets; approve important financial matters and see that the stockholders receive accurate annual and interim reports; delegate special powers to others to sign contracts and conduct the business of the firm; and maintain, revise, and enforce corporate rules and regulations.

Directors and officers are not required to always be right in conducting their duties, but they are required to be prudent. They must be reasonably diligent in performing their jobs, acting in the corporation's best interests, and not having personal interest in transactions with the corporation. For a stockholder to have a successful lawsuit against a director or officer, the stockholder should prove that the director or officer was negligent in one or more of these areas.

Other parties, such as customers (extension of credit and loan foreclosures are the two largest sources of these claims) and former employees (wrongful termination and individual employee contract disputes are the two major sources of these claims), may file suit for damages caused by negligent or fraudulent behavior of the directors or officers. In fact, the most frequent loss exposure in the D & 0 area is the legal expense of defending claims. Regardless of whether the claim has merit, it must be defended, and defense costs can be expensive.

MEASURING THE SIZE AND FREQUENCY OF THE LOSS EXPOSURE

Having identified the potential sources and causes of losses, one needs to determine mine the size and frequency of losses so that proper courses of action can be planned.

The Wyatt Company survey of corporations reports the magnitude and frequency of D & 0 claims and the dollars actually paid for such claims. As previously reported, the trend is upward. Table 1 shows an increase in the number of claims per year from 28 in 1979 to 157 in 1987. The Wyatt Company estimates that claims costs are increasing 10 percent per year and that claims made in 1988 will eventually have an average cost of $3,048,000. Of course these claims may not be settled until 1994 or later. In Table 2 several large paid claims are represented. These claims are actual losses that occurred and were paid, and they illustrate the magnitude of D & 0 losses.

Because 60 percent of all claims result in no payment to the claimant, defense costs become an important aspect of the size and frequency of losses. Regardless of whether the claimant is paid, defense costs will be incurred. On the average, the ultimate defense costs have risen from $182,000 in 1974 to $693,000 in 1988. These figures include defense costs for all types of claims and represent what is expected to be paid on claims still being adjusted or litigated.