When asked to become a director, there are certain things a person should check before accepting a directorship of an organization. This article focuses on checking protection for a director in his or her efforts for the corporation whether a business or a nonprofit. Even if the protections are not there, it is better to know in advance what protections are missing so that if a person accepts an invitation to be a director, he or she can conduct himself or herself accordingly.
The first thing that a possible director should check is whether or not the organization is incorporated. Although it is possible to be an unincorporated association in Pennsylvania, such organizations provide no limitations as to the liability of directors and members. Incorporation for business corporations and for nonprofit corporations is relatively simple. Under the modern Pennsylvania business and nonprofit laws, organizational operation is fairly straight forward. Certain corporate functions are delegatable by statute to directors and officers. With an association, essentially all decisions must be made or ratified by the members guided only by parliamentary law and procedure. This is, at the very least, cumbersome, and in some cases, a vague standard under which to operate.
There are other business organizations in which liability can be limited by law. For instance, there are limited liability corporations (LLCs), limited liability partnerships (LLPs) and limited and general partnerships. These organizations are not within the scope of this article, but some of the things to review in deciding whether to become a corporate director are the same as should be reviewed in deciding whether to participate in the governance of such organizations.
Under Pennsylvania law, a person has the highest duty of care, a fiduciary duty, in his or her actions with regard to the corporation for which he or she is a director. However, when an organization is incorporated, directors of both business and nonprofit corporations can assert as a defense the Business Judgment Rule. This rule allows a director in performing his fiduciary duties to the corporation to rely on “information, opinions, reports or statements including financial statements prepared and presented by 1) corporate officers or employees reasonably believed to be reliable and within their competence, 2) legal counsel, public accountants and other experts reasonably believed to be reliable and within their competence and 3) a corporate committee on which the director does not serve reasonably believed to be reliable and within its competence.”
In evaluating whether to become a director, a person should review the corporate bylaws to see if there is an additional limitation of director liability provision for monetary damages. Under Pennsylvania law, directors are not personally liable for such damages unless a breach of fiduciary duty constitutes “self-dealing, willful misconduct or recklessness”. This limitation of liability must specifically be in the corporate bylaws. There are two exceptions to the limitation. These are responsibility or liability under criminal statutes and liability for payment of taxes.
Pennsylvania business corporations and Pennsylvania nonprofit corporations are required to indemnify directors if they are successful in a third party action, an action brought by a person not a director, shareholder or member, or in a derivative action, an action brought by a shareholder or member. Pennsylvania business corporations and Pennsylvania nonprofit corporations may indemnify directors against expenses while those actions are being brought i.e. pay legal fees. Such indemnifications are only a protection for a director if the assets of the corporation are sufficient to fund those indemnifications. This may be a problem especially with nonprofits.
Pennsylvania business corporations and Pennsylvania nonprofit corporations may purchase D&O insurance to cover potential indemnification liability. A person thinking of becoming a director should ask whether the corporation has D&O insurance. Directors and officers liability insurance provides for the cost of a legal defense and pays damages in the event directors are sued along with their corporation because of their decisions. D&O insurance is protection in cases where a director can be held personally liable. Frequently, cases of this type are ones involving employment practices in accordance with policies approved by directors. This insurance is often conditioned on the availability of a limitation of liability in the bylaws discussed above.
D&O insurance can also be purchased by business corporations and by nonprofit corporations without having indemnification provisions in the corporate bylaws. Sometimes, there is a choice of having either corporate indemnification or D&O insurance. As indicated above, an indemnification is limited by the value of the assets of the corporation. However, there may be a deductible in the D&O insurance coverage, making necessary indemnification to cover all of a director’s liability. On the other hand, there is the risk of the corporation not paying the D&O insurance premium. We think the safest course for a director is for the corporation to have both. A question arises as to whether it is self-dealing for a director to recommend D&O insurance and indemnification. Because the presence of that insurance and indemnification is so important to attracting knowledgeable and attentive directors, it is well within the fiduciary duty of a director, and probably a requirement under such a duty, to make such a recommendation.
Professionals such as lawyers and accountants are often asked to serve as directors because of their expertise. With regard to insulation from liability, this presents a special problem. Professional liability insurance does not generally cover serving a director. Probably, if a lawyer or accountant answers questions put to him by officers or directors of a corporation of which he is a director, the D&O carrier will say he or she is acting in his professional capacity and is not covered by the D&O policy. This raises a question of fact which could involve much time of the professional director if the claim is significant. In evaluating whether to become a director, a professional should ascertain whether the corporation has a lawyer or accountant to whom legal or accounting questions should be referred for a final answer to such questions. If the corporation is expecting free legal advice or accounting services, such questions should be answered as if the corporation was a client and not as a director. Note the reliance by other directors on such answers discussed above in the application of the statutory Business Judgment Rule.
D&O insurance does not cover liability claims for compensatory and general damages sustained as a result of bodily injury, property damage, personal injury, and advertising injury (damage from slander or false advertising). This is what general liability insurance covers. A person thinking of becoming a director should inquire whether the corporation has general liability insurance. If it does not, the question then becomes what is the extent of exposure of the corporation to such liability. Note that punitive damages are not covered under general liability insurance policies because they are considered to be punishment for intentional acts.
Unfortunately, corporate losses of money, securities and other property as a result of wrongful acts of employees, such as wrongful use of a corporate credit card, are becoming more and more frequent. A director could be brought into recovery of the loss if a policy approved by the directors helped or allowed the employee to commit the fraudulent act. A person thinking of becoming a director should inquire whether the corporation has an employee dishonesty policy or that coverage in an Office Package. If it does not, the question also becomes what is the extent of exposure of the corporation to such liability.