A request to join the board: how to determine whether an invitation to the boardroom really means a trip to the courtroom.

Anyone who has been asked to join the board of directors of a public company, especially for the first time, has every right to feel flattered by the invitation. After all, the person's wisdom and judgment are being sought by the company and the invitation also reflects the trust that the chief executive is reposing in the invitee to be both a "stand-up" individual while being able to keep the best interests of the corporation and its constituencies uppermost in his or her considerations. Once the cranial swelling subsides and reality sets in, however, board membership is not something that should be accepted cavalierly or automatically, as it may be fraught with the potential for litigation and personal financial risk. A cautious, thoughtful, and careful approach to board membership before accepting the invitation can help avoid enormous exposure later on.

Due diligence 

Given the litigious nature of our society and the large potential exposure that can attend a variety of board actions, ranging from the treatment of acquisition proposals to the responsibility for the accuracy of the company's public filings, a prospective board member may be putting his or her personal assets behind the board's decisions. The recently enacted Private Securities Litigation Reform Act of 1995 (the "Reform Act") does provide certain important procedural and substantive protections to directors against federal securities laws claims, which have been a major source of potentially large financial exposure for directors. These protections include more exacting pleading standards to assert fraud claims, a "red light" to costly discovery while a motion to dismiss is pending, a statutory safe harbor for certain unrealized forward-looking statements, the elimination of joint and several liability except for knowing violations, and additional hurdles for would-be class-action plaintiffs.

Nevertheless, recent studies show that the volume of federal securities class actions has not fallen below pre-Reform Act levels. In this context, prudence dictates conducting at least a minimum level of due diligence before agreeing to serve on any board of directors.

Review public filings and check references

Anyone making a substantial investment in a company would read its SEC filings for the past several years. No less is appropriate before joining a company's board. The prospective director's syllabus should include, for at least the two previous years, if possible, the company's Form 10-K annual reports, 10-Q quarterly reports, 8-K interim reports, proxy statements, and the company's latest prospectus. In addition, the company's existing board members, officers and outside advisers can offer a wealth of information about the company, shed light on current issues of particular concern to the board, and provide insight into the degree to which the CEO actually expects the directors to exercise independent judgment. With these resources at hand, the prospective director should personally try to conduct due diligence on the following issues:

Company's Financial Condition. Of course, it is crucial for any new board member to become familiar with the financial situation of the company before joining the board. To be sure, a robust financial condition today cannot guarantee the company's prosperity next year. And no amount of financial success can assure the directors that lawsuits will not be filed against them. However, if the company is on the verge of going into the tank, i.e., filing a petition for Chapter 11, it may present a challenge that a prospective board member may prefer to decline.

Litigation History. Special attention also should be paid to the litigation disclosures contained in the company's SEC filings. Such disclosures should reveal both civil litigation involving the company that is considered "material" from a financial point of view and any proceedings commenced by governmental agencies against the company and the directors, including, for example, any consent decrees involving violations of the federal securities laws by the company's officers or directors over the past five years. A prior consent decree entered into with the Securities and Exchange Commission can be important because it could disqualify the company from availing itself of a valuable protection against some securities class-action litigation, which can create potentially large financial exposure to board members. Specifically, the Reform Act provides a useful "safe harbor" provision that protects a company from liability for certain forward-looking statements, e.g., the projections and estimates investors particularly crave and plaintiffs so easily seize upon when they are not realized, so long as the statements are accompanied by carefully tailored disclaimers and are not knowingly false when made. A "bad-boy" exclusion, however, withdraws this statutory safe harbor from issuers which in the three prior years have been enjoined, judicially or administratively, from violating the antifraud provisions of the federal securities laws.

In this same vein, a little independent research on the company may uncover litigation, and other pertinent matters, that never made it into the company's SEC filings. Today, it is easy to run a computer search to obtain all published references to the company in the financial and popular press as well as in any published court decisions or administrative agency reports. Of course, neither a history of acrimonious litigation nor one of legal tranquility will ensure a similar future course for the company. Nevertheless, in weighing the decision whether to become a member of the board, a modicum of research at the outset can help avoid nasty surprises later on.

Guilt-edged associations

Who Are the Other Directors? Readily accessible from the company's public filings are the identities and affiliations of the other board members who have already made the same decision faced by a prospective board member. The composition of the board can provide valuable insights into the company and how it is managed. If the other board members are respected individuals with impressive credentials or ties to established companies, this may provide increased comfort to a prospective board member. It is also a good sign if outside board members outnumber the management directors.

An active audit committee composed of independent directors is also a must. The NYSE, the American Stock Exchange, and the Nasdaq mandate that companies listed on these exchanges maintain audit committees composed predominantly, or in the case of the NYSE entirely, of independent directors. Indeed, certain new auditor reporting requirements created by the Reform Act make an active and independent audit committee a critical first line of defense against directors' potential exposure for accounting improprieties. New Section 10A of the Exchange Act requires auditors to develop procedures to detect illegal acts and to report them to management, the audit committee, and the board of directors, and if still not corrected, to the SEC. An active and independent audit committee may ensure the prompt adoption of corrective action to avert a report to the SEC, and the SEC investigation or enforcement proceeding that would likely ensue.

Who Are the Independent Auditors and Legal Advisers? It is also important to identify the corporation's independent auditors and legal advisers. It goes without saying that even the most highly respected outside auditor and the most prestigious outside counsel cannot guarantee that entering the boardroom will not ultimately lead to a trip to the courtroom. But, a company that surrounds itself with the best and the brightest independent advisers certainly will decrease the chances that litigation will occur and will maximize the chances that the outcome will not be catastrophic. It also speaks well of management's concern for compliance issues that the outside advisers are respected.

Stature of the general counsel

Another barometer of a company's attitude toward legal risk management is the stature of the company's general counsel within the organization. To be sure, legal departments generally are not considered to be profit centers, and not every publicly traded corporation has or needs a large inside legal staff or a high powered general counsel. On the other hand, especially for companies that operate in regulated environments, an inside general counsel is often in the best position to provide an early diagnosis of a potentially serious legal issue and to obtain the appropriate assistance to avoid a major problem. Where the corporation's general counsel occupies a top management position, serves on the board of directors, and has "clout" with the other members of senior management, it bespeaks a healthy respect for legal and compliance issues that can reduce the risks both to the corporation and to its board members.

Board member interface with senior management

Because directors play a vital role in the corporate decisionmaking process, and must fully inform themselves about any decision the board makes in order to discharge their duty of care, the board needs adequate and timely information to make informed decisions. Any corporation that treats an outside director as the occupant of a purely ceremonial position is doing itself and that director a serious disservice.

The manner and frequency with which the management interfaces with the board can be illuminating to a potential new board member. It is important that directors be kept abreast of significant corporate developments, especially about any matter requiring board action. Frequent board meetings and interim communications from senior management help the outside directors remain connected to the company's general business climate and trends and create a healthy environment for the board to properly operate within. Certainly, any information necessary to understand the complexities of any matter requiring board action should be provided to directors as far in advance of a board meeting as practicality permits and any outside advisers necessary to provide insight or respond to questions should be available to board members.

Ethics and compliance policies

Over the last several years, increased focus has been placed on the separate identity that the corporate entity maintains from its management. This dichotomy is especially important in assessing responsibility for violations of the myriad criminal and civil legal obligations applicable to public companies because of the potential conflicts of interest between the corporation and its management.

This potential clash of interests is exemplified by situations, increasingly common, in which the corporate entity can escape liability altogether if severe sanctions are imposed on one or more of its senior officers who have caused the alleged wrongs. Of course, as the ultimate guardian of the company's interest, boards can adopt policies and compliance programs that mandate that the business be operated in a lawful manner. Among the important matters commonly addressed by such policies and programs are compliance with antitrust laws, the Foreign Corrupt Practices Act of 1977, and insider trading and sexual harassment laws.

The promulgation and diligent enforcement of such policies can provide defenses to, or at least reduce penalties against, the corporate entity in a variety of situations by permitting the corporation to contend that it is not legally responsible for any violations of law because any inappropriate conduct was the result of aberrant conduct by members of management. This can provide a measure of protection to directors who might otherwise be criticized for inaction if an avoidable liability were to be imposed on the company. Accordingly, it may be prudent for a prospective board member examining the company's risk management profile to explore what, if any, compliance programs are in place and to verify that the corporation has in place procedures to monitor and enforce such programs.

Directors and officers protection

Even the most careful and law-abiding corporation can find itself, and its board of directors, embroiled in time-consuming and costly litigation. Accordingly, before joining a board, it is imperative to verify that the corporation provides in its bylaws and charter adequate protections for its directors.

Statutory Protection. Certain states, such as Delaware, have permitted corporations to amend their charters to provide protection to board members from lawsuits based on claims that directors have breached their duty of care to the corporation [see Del. Code. Ann. tit. 8 [section] 102(b)(7)]. Statutes like this, which were passed in reaction to the famous Van Gorkom decision of the Delaware Supreme Court [Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985)] imposing substantial financial liability on individual board members for approving a merger at an unfairly low price, make it more difficult to prevail against claims rooted in negligent or reckless actions. In order to avail itself of these statutes, a charter amendment that requires shareholder approval is needed.

It bears emphasis that adoption of the statutory protection is not a panacea for board members because it still leaves open the possibility of lawsuits for breaches of the duty of loyalty, which is not always clearly defined. And such statutes offer little help in defending against claims based on the federal securities laws. Nevertheless, a prospective board member can take a measure of comfort that such statutory protection will make some litigation against directors less likely and harder for a plaintiff to win.

Indemnification. State corporate laws govern a corporation's ability to provide indemnification to directors for judgments, fines, and amounts paid in settlements, including attorneys fees, in the event of litigation arising out of the director's service as a director. Typically, such statutes permit indemnification of directors against such costs provided the director acted in good faith and in a manner reasonably believed to be not adverse to the corporation [see, e.g., Del. Code Ann. tit. 8 [section] 145].

Still, a prospective director must ensure that the corporation has exercised its statutory indemnification authority through the necessary charter provisions and bylaws. Moreover, a candidate for director should look for mandatory indemnification provisions, and language expressing the corporation's intent to indemnify its directors to the fullest extent of the law. Indemnification contracts may also provide better protection than relying solely on charter and bylaw provisions.

Advancement of Legal Fees and Expenses. Even if mandatory indemnification is assured, such relief comes only at the end of a case. While a lawsuit proceeds, the costs associated with litigation can be staggering. Whether a board member can be required to pay his or her own legal fees during the pendency of the case depends on the corporation's rules governing "advancement."

Although the decision to advance legal fees on behalf of directors generally is a discretionary one, advancement is customarily authorized, except in extremely rare instances. But, there are occasions when it is not, such as when the board is divided over an issue relating to the litigation. To avoid leaving this matter to chance, a prospective director should determine whether contractual or other enforceable provisions have been made not only expressly permitting the advancement of legal fees but also mandating such advancement.

D&O insurance

No matter how careful a prospective board member may be before accepting an invitation, it is impossible to predict with certainty the prospect of serious litigation. Similarly, while the corporation may appear to be financially sound at the time board membership is accepted, there can be no guarantee of its continued financial well-being. And, while corporate advancement and indemnification obligations to board members are comforting, they are only as good as the company's financial wherewithal to discharge them.

Fortunately, however, directors and officers insurance exists to provide the ultimate barrier to personal financial exposure. It is crucial to fully investigate the nature and extent of the company's insurance coverage. The absence of insurance can dramatically simplify the decisionmaking process. It almost seems too obvious to state that no one with any personal assets (or who expects to have any) should serve on the board of a public company without adequate insurance, absent the most compelling reason.

More difficult to answer, however, is how much directors and officers insurance is enough. There is no exact mathematical formula to determine the proper amount of insurance. However, the larger the corporation's market capitalization, the more insurance coverage that is required. It is also important to bear in mind that the stated coverage amounts typically apply to both litigation expenses and settlements of actions. As a result, legal expenses, especially if several sets of lawyers are required, can deplete the coverage amount quickly if it is not high enough, leaving the board members potentially exposed to any amount that must be contributed to achieve a settlement or to pay a judgment.

Care, prudence, homework

As important as it is to assure that a company has, and maintains, adequate directors and officers insurance, such coverage, standing alone, is by no means a substitute for prudent corporate conduct and cannot obviate the need for careful and cautious consideration before joining a board. Even very large policies may not suffice to cover the potential exposure in a major case, and it is also possible that the carrier may dispute its coverage obligation when the time comes to pay. So, before accepting a board membership that may turn out to be an extremely high risk, care, prudence, and some homework are a must.

The views expressed in this article are those of the author only and do not necessarily reflect the views of the firm.

Jonathan J. Lerner has been a member of the law firm of Skadden, Arps, Slate, Meagher & Flom since 1981. He has written and lectured extensively on director liability, mergers and acquisitions, securities litigation, and other areas of law.