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Elon Musk was
sued and recently lost in Delaware
over his ginormous compensation. He seemed shocked that this could happen and decided to move the company from Delaware and incorporate in Texas.
A former client of mine was under investigation by the Department of Justice for various alleged nefarious acts. I was brought in to control cash. A new board came in, fired my client, and sued him. He was also surprised (although he did eventually plead guilty to several charges and was sentenced to Federal prison).
Right or wrong, in much of my work, directors and officers get sued, fired, and thrown under the bus.
Sometimes, it's creditors seeking recovery. Sometimes, it’s an investor or other directors(s) looking for political cover with their own investors after making a bad decision. Sometimes, it’s the result of the director or officer in question doing something shady.
To make matters worse, public relations firms and attorneys often advise Boards to single out the now-ex-CEO as a way to protect their own or the company’s reputation. In addition, under what is known as the
Yates Memo
— a Justice Department policy that essentially trades company-provided information and cooperation regarding individual misdoings in exchange for leniency on fines and penalties —
individuals at the top have become prime legal targets.
Of course, step one in avoiding legal problems down the road is to act in an ethical manner. But that’s not enough. First, because what is considered ethical or standard practice today may no longer be so tomorrow.
Second, because as noted above,
though you may not be at fault, there will be plenty of people looking in your direction when things go bad.
Even if you have what you believe are good corporate legal documents and D&O insurance, plaintiffs like to charge former CEOs with claims that aren’t typically indemnified by the company or these instruments, such as fraud. If this occurs, you may not have access to company funds or protection.
With all this in mind,
what follows are precautions that, when taken, put yourself in the best position possible when the hungry wolves arrive.
Understand Your Legal Obligations
As a director or officer, you have corporate and fiduciary obligations to shareholders, including minority and non-voting shareholders.
These obligations are a function of state law and key corporate documents, such as the Articles of Incorporation or Organization.
Make sure qualified legal counsel explains these to you. If you are involved with forming a new legal entity, evaluate the obligations implied by both your choice of organization and state of incorporation.
Then, make sure you protect yourself in the corporate documents, of which there are many to consider. Most obvious are those that spell out the company’s commitment to indemnify directors and officers —
and pay for their defense.
To defend yourself properly, your attorney will need access to documents in the company’s possession; these agreements should explicitly provide for that.
Another important set of documents are those related to the financing of the company, be it debt or equity.
Litigators want to sidestep corporate indemnification, so they will look to these types of transactions for claims that aren’t usually indemnified. If you limit what you represent as true in financing documents, that can make suing you harder. Special care should be taken with transactions involving insiders, particularly when there are multiple owners (an Elon Musk mistake).
Further, Corporations, as opposed to LLCs and Partnerships, have particular requirements, such as a formal board meeting with minutes, board resolutions, and so forth. For other forms of legal organization, these requirements are often set in the core formation documents, something that is easy for private companies with just a few shareholders to miss.
Have legal counsel advise you as to proper form —
then follow it.
Purchase Good D&O Insurance
In particular,
you’ll want something called “A” side coverage which directly insures the directors and officers.
This is important if the company refuses to indemnify and/or defend you or there are no funds to do so.
Good “A” side coverage will cover events that the corporate documents don’t — things like criminal misconduct and fraud. If your “A” side coverage only mimics the corporate indemnification agreements, you leave yourself open to a time-proven path of attack.
Also,
look for “insured vs insured defense costs.”
This kicks in if an existing director, officer, or the company itself sues you (most policies deliberately exclude such coverage). This is particularly important where your equity ownership is minor or you are just an employee.
You’ll also want “A” side coverage that has a low bar for events that trigger a claim.
If you must wait for a formal lawsuit to be filed, for example, you won’t be covered for the legal expense in protracted negotiations, threats, and so forth. A good policy will kick in after an email exchange.
Finally, consider umbrella coverage. Besides adding another layer of coverage, some foreign D&O carriers offer umbrellas that “drop down” when US Courts bar the coverage from the US insurance company.
The Landscape Keeps Changing
The political and legal landscape is full of land mines and booby traps — and it’s constantly evolving. A few more pointers on how to navigate it…
Use qualified legal counsel.
I look for lawyers that specialize in the particular type of matter as spelled out above and who do so in the state with governing law.
For example, I have had several liquidation clients where the opportunity to reorganize or sell was long gone. For some of these situations, I have been blessed with a litigator and an entity expert from the governing state. These teams have sliced up corporate documents drafted by big name (read: very expensive) attorneys that don’t practice locally. Even if all you need is someone to review the documents before you come on board, consider a litigator that is well versed in the relevant state’s law.
Purchase insurance through a broker with a department dedicated to D&O insurance.
They should both know the ins and outs of coverage and have the in-house expertise to advise on filing a claim, etc.
Take time and care to properly complete D&O renewal forms.
Don’t let a minion in the organization blindly fill out the annual renewal paperwork. If you are on the Board, make sure you understand your policy, particularly the section about when the carrier must be advised about a potential claim.
Make sure your D&O policy has priced in “tail insurance.”
D&O insurance only covers claims made during the policy year. If your company goes out of business, it needs “tail insurance” for claims made in the future. A three-year tail is a minimum, a six-year tail is ideal.
Upgrade counsel and insurance brokers as your company grows.
Make sure the upgraded team reviews important past transactions and corporate documents. Same for the officer that keeps getting promoted and eventually lands the brass ring.
When bad things happen, get legal counsel ASAP, contact your insurance broker, and be prepared to switch legal counsel to one for which the insurance carrier will pay.
Conclusion
Being an officer and/or director sounds — and is — cool. Until it isn’t.
With those added responsibilities and rewards comes risk, some of which may not be properly protected when the attack comes.
And by the way, all of this applies to non-profits, even your local Babe Ruth Little League.
Before diving in, know what you are agreeing to and get adequate protection. Then monitor things over time.
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