Outside Director Liability

Abstract

Outside directors can do a bad job, sometimes spectacularly. Yet outside directors of U.S. public companies who fail to meet what we call their "vigilance duties" under corporate, securities, environmental, pension, and other laws almost never face actual out-of-pocket liability for good faith conduct. Their nominal liability is almost entirely eliminated by a combination of indemnification, insurance, procedural rules, and the settlement incentives of plaintiffs, defendants, and insurers. The principal risk of actual liability is under securities law, for an insolvent company (which can neither pay damages itself nor indemnify the director) with one or more seriously rich (hence worth chasing) directors, where damages exceed the D&O insurance policy limits and the director does not represent an institution that can indemnify him. The principal sanction against outside directors is harm to reputation, not direct financial loss. In a companion paper, Bernard Black & Brian Cheffins, Outside Director Liability Across Countries (2003), we study six comparison common-law and civil-law countries (Australia, Britain, Canada, France, Germany, and Japan). We find huge differences in legal rules and nominal liability. Securities and corporate law risk recedes, while nominal liability under other laws becomes central. Yet we find a similar pattern of a tiny but nonzero risk of actual liability. This suggests that a barely open window of actual liability is a stable solution, both politically and in the D&O insurance market. A barely open window may also be a sensible policy solution, given the multiple goals of incenting directors to be optimally (not maximally) diligent, wanting directors to be aware of potential liability for misconduct yet not overly risk averse, and wanting good candidates to become directors. The details of where the liability risk comes from may have only a small effect on director behavior.

Accountability of independent directors: Evidence from firms subject to securities litigation

“…Fear of legal liability has long been perceived as deterring individuals from serving as directors (Romano, 1989;Sahlman, 1990, Alexander, 1991 and causing directors to be risk averse, thus reducing board effectiveness (Black, Cheffins, and Klausner, 2006a). These concerns have led to recommendations for greater protection of independent directors from securities lawsuits (Committee on Capital Markets Regulation, 2006).…”

“…Multiple defendants exhaust D&O insurance faster reducing the funds available for settlement and attorney fees. Finally, Black, Cheffins, and Klausner (2006a) suggest that trying a case with many individual defendants can confuse the jury jeopardizing the lawsuit. They thus posit that plaintiffs name independent directors initially for strategic reasons but eventually may remove their names.…”

“…These combined with supplemental findings on the effect of independent directors on settlements present a fuller picture of the mechanisms that shareholders have to hold directors accountable and which directors they hold accountable for financial fraud. Black, Cheffins, and Klausner (2006a) show that independent directors have been held personally financially responsible in securities litigation only occasionally-in only thirteen cases since 1980 has a director made a personal payment for settlement or for legal expenses. Financial costs for settlements, since suits rarely go to trial, are normally indemnified by the company or paid by director and officer (D&O) insurance.…”

“…However, financial risk to directors, while small, increases when a firm has inadequate D&O coverage, when the D&O insurance does not cover directors involved in fraud, and when a sued firm or its D&O insurer becomes insolvent. Black, Cheffins, and Klausner (2006a) conclude that "the principal threats to outside directors who perform poorly are the time, aggravation, and potential harm to reputation that a lawsuit can entail, not direct financial loss" (p. 1056).…”

Corporate Governance and Accountability

“…Finally, exculpation, insurance, and indemnification provide additional protection to corporate officials by covering litigation costs and most judgments and settlements. The cumulative result of these doctrinal and procedural protections is that outside directors almost never pay personally for the breach of their duties to shareholders (Black, Cheffins, and Klausner 2006). The absence of an effective enforcement mechanism for fiduciary duties has led many to conclude that state corporate law may be best understood as providing merely aspirational guidelines for how directors should manage a corporation's affairs (Rock 1997;Stout 2003).…”