Directors’ Liability

March 10, 2011

Greg Shields was happy to respond to the request for a second article by the Canadian Society of Physician Executives (CSPE) Newsletter (www.cspexecs.com). With their permission we have re-published it here.

Directors’ Liability
By Greg Shields

All good things come with risk and reward. Company director is a vital role. Our organizations, whether they are large or small, public, private or non-profit, require strong, educated and dedicated people in a governance capacity to be successful. However, it is easy to find somebody who will tell you that you would be crazy to take on a director position, especially of a public company, and sometimes that is the only excuse we need to say no. But you would be missing out on a great opportunity. These roles allow you to make a real difference in the community. Your experience, education and leadership will allow for better decisions by management and help create a growing and successful operation. A strong and active board will help identify and attract quality management, will help raise funds (donations or capital), and protect investors, employees and clients from negligence and fraud. A broadened network, introductions to people you would never otherwise have the opportunity to meet and the challenge of developing new skills and abilities are some of the material benefits from taking on a directorship function.

There are also real risks that should not be ignored. Over 150 pieces of legislation have to do with some aspect of risk of personal liability for an individual director. The most obvious is unremitted source deductions if the corporation goes bankrupt. The Canada Revenue Agency is not afraid to pursue these claims, which include income taxes, Canada Pension Plan contributions and employment insurance premiums. There is also potential recourse against directors for sales tax, severance pay, vacation pay, workplace liabilities, and environmental liabilities. In addition, there is a civil liability a shareholders, employees, clients, creditors, competitors and other stakeholders in the organization.

 While considering these sources of risk, it is important to remember that meaningful protection is built into our laws. The due diligence defence is the strongest of these. Arguments demonstrating that specific actions were taken to attempt to prevent loss will almost always prove successful. The courts will consider the knowledge and education of the individual directors and look at their actions to determine if they acted in good faith and in the best interest of the organization, thereby fulfilling their duties of care, loyalty and obedience.

This may be obvious from some of the very public directors’ liability cases, but, the courts have not set a very high bar for directors. Acting in a manner that is free of conflict of interest and self dealing; gaining an understanding of withholding and remittance requirements to a level of a reasonably “like” person (if you are not a chartered accountant, you will not be required to have the knowledge and experience of one); establishing some policies for reducing unremitted source deductions and other liabilities; and relying on management and independent experts for advice will go a very long way toward mitigating director risk.

I also recommend the use of personal contractual indemnity agreements for all directors of organizations that have the financial ability to indemnify its directors. Indemnification provisions are built into the Canadian Business Corporations Act, Ontario’s Business Corporations Act, many corporate by-laws and most of industry specific acts, but, these are not all created equal and none of them is as good as a well vetted individual contractual indemnity.

Another risk mitigation tool is Directors’ and Officers’(D&O) Liability insurance. This insurance coverage is demanded by directors of most non-profit and publicly traded entities and is gaining popularity with private companies.  This insurance is not a panacea of coverage. It should not be a priority over good general liability, property or operation-specific products, such as professional liability (includes medical malpractice), errors and omissions liability (E&O), environmental, fidelity/crime, and cyber/media/privacy insurance policies.  And D&O is not a priority over good governance, risk management and compliance (GRC) activities.

But, when these other issue have been considered, and some investigation and action taken, the D&O purchase should not be taken lightly. Far too often this insurance is sold, not purchased. Somebody says they want it, and then it is left up the insurance broker to decide what is best. The outcome of this method is “insurance risk” that has not been identified or managed. Insurance risk is the failure of the policy to act as anticipated.

A decision to purchase D&O insurance should be based on the limit liability, not on the insurance premium. The limit of liability has, or should have, a value that is material to the corporation, whereas the premium often does not. Even for a small non-profit, this is a $1-2 million dollar decision. For a small publicly traded company it is a $5-15 million dollar decision. For a large public company the range is $25-100 million. The purchase decision deserves this level of attention.

Second, the purchaser should contemplate and prioritize the separate interest of all potentially insured parties under the policy. Special attention must be paid to the personal liability of the individual directors and officers. Most directors and officers make the critical assumption that their D&O policy is designed to cover their personal liability. For many, and perhaps even most, directors in Canada, that assumption is incorrect. Through aggressive competition among insurance companies and under-educated, over zealous insurance brokers, policies have been “broadened” to such an extent that they may now be a detriment to individual directors. Claims made against the corporate entity and coverage for non-traditional parties and matters are now fair game under many D&O policies. This level of coverage can be very attractive to aggressive plaintiffs and their even more aggressive lawyers, because a broader policy means a better chance for at least a modest settlement, which reduces the risk of pursuing  a long-shot chance of discovering the smoking gun that will produce the a settlement made up of the entire policy limits, plus corporate contribution, plus third party contribution, plus individual director or officer contribution.  However, there is only one limit of liability that is shared by all parties for all claims; thus, a loss by the corporate entity or other party can erode or even fully exhaust the limits otherwise available  to the individual directors.

Third, it should be fully understood that there is no regulation of (specialty lines) policy wordings in Canada. Dozens of insurance companies, managing general agents, captives and reciprocals provide D&O insurance coverage and there are hundreds of versions of policy wording, endorsements and applications, any part of which can determine the difference between coverage and denial. There are also many brokers who are willing to pass themselves off as independent experienced brokers, when in fact they limited or no direct experience with D&O policies and claims, and when they owned by, or have a material debt or non-standard remuneration agreement with, an insurance company. Therefore, the decision purchase D&O insurance should include, 1) a direct request of all brokers to disclose all potential conflicts of interest, including any “exclusive insurer” programs, 2) direct questions of all brokers to explain to your satisfaction the key issues regarding all coverage options as they relate to your operations, and, 3) a direct request of all brokers to not approach any insurance markets on your behalf until you have made your choice of broker.

With the inherent protection built into statute and legal precedent, an ounce or two of loss prevention, a solid individual contractual indemnity and a well-negotiated D&O policy, the benefits of a board position will far outweigh the risks. And your industry and the Canadian business community will be much better served by the involvement of independent, dedicated and experienced corporate directors.

Greg Shields is a Partner with Mitchell Sandham Insurance brokers, an independent company providing commercial, private client and financial services insurance. He specializes in casualty products that address directors’ and officers’ risk, crime, fiduciary liability, professional errors and omissions and cyber / media risk. He provides insurance negotiation and risk consulting services, coverage and claims advice to small and medium-sized enterprises, multi-nationals and nongovernmental organizations. Greg can be reached at 416 862-5626 or gshields@mitchellsandham.com .


Canadian Directors’ and Officers’ Liability Insurance (D&O) and the Recent IMAX Decision

February 22, 2011

Canada is seeing a material change in home-grown D&O loss experience. On Valentines day we saw a new decision in the first case to be brought under Ontario’s new, at the time, “Bill 198”, aka, part XXIII.1 of the Ontario Securities Act (the “Act”), section 138.3, which provides a statutory cause of action for secondary market misrepresentation. In the IMAX case, the underlying securities litigation commenced September 20, 2006, when Siskinds LLP, here, and Stutts, Strosberg LLP, here, brought their case alleging misrepresentation and breach of duty of care. Justice K. van Rensburg, in her decision, here, certify class proceedings. The defendants appealed this decision,  here, and on Feb. 14, 2010, Justice D.L. Corbett denied the defendants motion for leave to appeal.

We all know what happens to settlement amounts when a court decision goes in favour of the plaintiff class, but here we can consider what could be material to directors and officers in Canada. The IMAX 2005 information circular listed a D&O policy with a $70 million limit of liability. Though the circular does not provide a lot of detail, it does say they had a split deductible of $100,000 “for each claim under the policy other than claims made under U.S. securities law as to which a deductible of $500,000 applies”, and paid an annual premium of $962,240. This split deductible suggests at least some portion of that tower of D&O coverage was extended to cover the corporate entity for some of its individual loss and expenses.

There is a lot of litigation left in this case, but a full limit loss should not come as a surprise to anyone. Outside of the magnitude of an insured loss on this size of D&O coverage in Canada, the materiality of the case will depend on potential for loss above the limit. More importantly, loss above the limit if any part of it is borne by the individual directors and officers.

In 2005-2006, and even today, Excess Side A DIC (Side A = loss not indemnified by the corporate entity, DIC = difference in conditions, or an excess policy written to be broader than the underlying policy) was not a guaranteed purchase for public corporations of this size in Canada. Therefore, if the (assumed)  A, B, C primary policy extended through the entire limits of the tower, then the comfort level of the individual directors would be largely based on the size of the limit of liability. (In case it needs explaining, A is the insuring agreement in the D&O policy that responds to loss not indemnified by the corporation; B is the insuring agreement that protects the corporate entity for loss it incurs on behalf of the individual directors and officers; C is the insurance agreement that protects the corporate entity for its own loss and expenses in certain claims, like securities claims. But, this is just a glancing overview because an appropriate explanation requires discussion on “presumptive indemnification”, “hidden entity coverage” and many other D&O coverage issues.)

 Now we can start to see the very reasonable misconception in the D&O policy. It is marketed as a D&O policy, when, much to the surprise of individual directors, it is in fact a corporate entity policy.

The problem (for individual directors): $70 million may seem like a large limit, and may have looked good on a benchmarking chart, but there  was, and is, no legal precedent of insurability of a Bill 198 claim in Canada. From the little I know of Strosberg, here, and Lascaris, here, I will be shocked if they settle this case at policy limits. As far as I know there is no institutional plaintiff, but, the entire class pool has yet to be identified, and I imagine Silver and Cohen would be willing to bough-out in favour of a large pension plan, if that is what is necessary to fund a “scienter” position and a removal of the liability cap. Though there are only a few cases of personal (unindemnified, uninsured) director contribution settlements in Canada, institutional plaintiffs in the US are known to agree to a settlement only after they have won some level of personal contribution.

The directors might also seek comfort in the “priority of payment” provisions in the policy, but, these were not as common in 2005-2006, and there is limited precedent. My concern for their use is they may motivate a follow-on shareholders claim, or a (current) shareholder attempt to block proceeds of the policy from being eroded by individual director’s defence. Thanks to the Insured vs. Insured exclusions, or other policy limitations, this follow-on claim may be excluded, or further erode the available policy limits.

There may be some critics who will suggest that IMAX will not have a material effect on Canadian directors and officers. For those people I will include a link to some light reading of the recent NERA report, here, on Canadian securities class actions.

I think IMAX will have a material effect on directors, officers, and D&O premiums in Canada, but it might take years for it to play out. If you are not willing to wait that long to fully understand your D&O policy coverage, and the key issues of “continuity”, “sharing of limits”, “limit erosion and exhaustion”, “severability” and the 96 other important terms, please don’t hesitate to contact me directly; Greg Shields, Partner, Mitchell Sandham Insurance Brokers, 416 862-5626, gshields@mitchellsandham.com.

CAUTION: The information contained in the Mitchell Sandham website or blog does not constitute a legal opinion or insurance advice and must not be construed as such. It is important to always consult an experienced and truly independent registered insurance broker and a lawyer who is a member of the Bar or Law Society of the relevant jurisdiction with regard to this material before making any insurance or legal decisions. All material is copyrighted by Mitchell Sandham Inc. and may not be reproduced in any form for commercial purposes without the express written consent of Mitchell Sandham Inc. Anyone seeking to link this site from any external website must receive the consent of Mitchell Sandham Inc. by sending an e-mail to gshields@mitchellsandham.com


D&O Liability and Governance Discussion Points:

February 18, 2011

XBRL:

Many directors and officers know nothing about the SEC deadline, of June 15, 2011, for foreign private issuers (XBRL.ca, here, says there are 350 in Canada) to meet interactive data reporting requirements (explanation of XBRL, here). I have not been able to develop an opinion on the potential ramifications of XBRL on Canadian governance and compliance risk, or on directors and officers liability, but, change never comes without some costs.

IFRS:

IFRS is for many people a thing of the past. But the repercussions on governance, risk management and D&O insurance have not even started and may not be known for years. The concern of D&O underwriters is the significant increase in reliance on management assumptions and estimates in corporate financial statements. Some accountants are suggesting that the number of notes to the financial statements will jump from 30 to 300. Others have even said that had Nortel been reporting under IFRS the corporate problems would have gone on much longer, and loss to stakeholders would have been much larger. This over disclosure will do far more harm than good, especially to directors. Disclosure and transparency is a good thing. But when it becomes overwhelming for investors, and even for professional analysts, the result will be a more confusing and unreliable financial statements than before our current level of disclosure was mandated. The difference is that the over disclosure will allow more protection for “allegedly” negligent executives, and their outside auditors, accountants, analysts, investment advisors and lawyers, because when a professional liability lawsuit is launched they will be able to point the four words  (out of 10,000) in two obscure notes as their get out of jail free card. That escape from liability has a good chance of driving an increase in “risky” behaviour, and it leaves the shareholders, creditors, employees, suppliers, and the directors, holding the bag.

If you would like to receive more information please contact me, Greg Shields, Partner, Mitchell Sandham Insurance Service, gshields@mitchellsandham.com, or at 416 862-5626.

CAUTION: The information contained in the Mitchell Sandham website or blog does not constitute a legal opinion or insurance advice and must not be construed as such. It is important to always consult a registered insurance broker and a lawyer who is a member of the Bar or Law Society of the relevant jurisdiction with regard to this material before making any insurance or legal decisions. All material is copyrighted by Mitchell Sandham Inc. and may not be reproduced in any form for commercial purposes without the express written consent of Mitchell Sandham Inc. Anyone seeking to link this site from any external website must receive the consent of Mitchell Sandham Inc. by sending an e-mail to gshields@mitchellsandham.com.