Publications & Resources

April/May 2002
Focus: Directors' Issues

When Directors are Sued, Who Pays?

By Bud Scully

Whatever actions directors decide to take or not take, there will always be dissident voices that will disagree with their decision. Monday morning quarterbacks abound. Hungry lawyers are not far behind them.

Bank directors and officers may expect to be sued, but they never expect to pay. Indeed, their logical assumption is that the bank or the insurance company will pick up the tab.

The primary sources of litigation directed at bank boards are:

Employees 40%

Shareholders 35%

Customers 20%

Other 5%

Employment discrimination is the most frequent cause of action cited in litigation against the corporation and its directors and officers. Discrimination is not necessarily related to race, gender or religion (although these factors are usually included within the claim if they will enhance the claimant’s cause).

Wrongful Termination is another frequent cause of action alleged by former employees.

Constructive Termination usually infers that a failure to promote, or a transfer to a position of equal or lower status equates to an improper job evaluation due to inaccurate information, or prejudice, placing a lid on advancement or pressure to force a resignation.

Sexual Harassment inevitably weaves its way into many employment related lawsuits. The heavy social impact of these accusations often lead to profound circumstances which can become personally devastating to the accused person and corporation, not to mention generate pressure to settle financially, so often undeservedly.

Mergers, acquisitions and stock offerings are frequent causes of claims against bank directors and officers. Inadequate or inaccurate disclosure including, financial reporting are the most frequent allegations in shareholder claims. Many of these disclosure claims are due to alleged violations of Section 10(G) of the Securities Exchange Act of 1934. This litigation relates to securities trading decisions which have led to financial loss, or loss of financial opportunity due to inadequate or inaccurate disclosure.

Other potential causes of action against directors that may result in substantial exposure and loss are: negligent oversight of management, conflict of interest, self dealing, and bank regulatory agency complaints.

Enron’s recent collapse has heightened awareness for the need for thorough and accurate accounting and financial disclosure. This has starkly illuminated the directors’ responsibilities to ensure that the financial information received is a full revelation of all the pertinent information necessary to understand the financial condition of the bank.

The cost to defend D & O claims can be very high, regardless of whether the plaintiff’s allegations are legitimate or the settlement demand is justified. If a settlement or judgment ensues, the cost can be in the thousands to millions depending on the legitimacy of the allegations and the circumstances of the claim.

Protections Afforded The Director

Corporate Indemnity is the first step in the protection process. It is also a normal consideration granted to members of the board: The corporation agrees pay the cost of defense and/or any settlement of litigation involving a member of the board of directors. The agreement is drafted by legal counsel and then approved by the board.

There is the ongoing risk that a board could ignore or deny the existence of an agreement against a current or former director who has fallen out of favor, forcing the director to seek legal action to enforce this recovery. This is especially the case when a sale or merger occurs, and the directors of a former corporation find themselves subject to an indemnification agreement granted by the nonexistent entity. The directors have no protection unless they have previously acquired D & O Tail Coverage. This extension of D & O insurance may be purchased prior to a merger or sale for a period up to six years—the equivalent of the Statute of Limitations in many states.

Virtually 100% of banks in the country purchase D & O insurance; however, contracts may vary in their coverages. Originally, the insuring agreement covered only directors and officers. Now all employees are covered.

It is also vital to cover the corporation under an Entity Coverage provision. If there is litigation involving the directors, the corporation will also inevitably be named as a defendant. If the entity is not insured, but is involved in the litigation, allocation of the cost of defense and a settlement will usually be determined on a 50-50 basis between directors and the corporation. If the directors are dismissed from the lawsuit and there is no Entity Coverage, the corporation must confront the alarming shock of total exposure.

What Insurance Options Should Be Included In Your D&O Policy?

The D&O broker should present quotations which include these insuring options:

Entity Coverage (Includes Corporation)
Bankers Professional Liability (Includes Insurance, Investments, Escrow, Trust, etc.)
Lender Liability (Suits by Borrower)
Employment Practices Liability
Internet Liability

Although the D&O insurance market is relatively stable, prices are increasing 10% to 20% for renewals this year. In evaluating a proposal for D&O insurance, the directors and officers must consider—in descending order of importance—the financial strength of the insurer, the terms of coverage offered and the premium charged.

Bud Scully is president of Financial Guaranty Insurance Brokers, Inc., a WIB-endorsed Value & Income Program (VIP) Partner. He can be reached at buds@fgib.com or (626) 793-3330.