Know your risks: a crucial part of a Board's risk management strategy must be assessment and evaluation of its directors' and officers' personal liability.

A recent survey of boards of directors of TSX-listed companies found that Canadian directors consider their current risk of potential claims to be high, with future risk even higher. The study shows some remarkable results for Canadian companies compared to their U.S. counterparts.

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The survey was commissioned by Bishop Phillips and conducted by the CIBC Centre for Corporate Governance and Risk Management at Simon Fraser University's Segal Graduate School of Business and is the first of its kind in Canada in 10 years. The survey looked at the nature of risks directors face and their attitudes and practices in the face of those risks. It was sent to all TSX-listed companies and 70% of the respondents were the Board Chair, the CEO or both.

D & O essentials

Respondents say they expect that changes in Canada's business climate will result in increased litigation and mounting legal costs, with the greatest potential claims arising from inadequate or inaccurate disclosure. The greatest source of those claims, respondents say, will be from shareholders and large institutional investors.

The respondents strongly agree that Directors and Officers (D & O) insurance is important for the recruitment and retention of qualified directors. And with 60% of current directors due to retire by 2009, the recruitment of new qualified directors is paramount.

As one survey respondent said: "Ten years ago we said, 'If you conduct yourself in a prudent manner you don't need D & O insurance.' The outside environment has changed. You will not attract good directors without D & O."

The chances of being sued, the cost of defending claims, the ease of class actions, and the size of settlements have all soared in recent years. The survey showed that reporting Canadian companies receive claims against directors at about the same rate as U.S. companies. Boards need to evaluate whether their company's indemnities and insurance are providing adequate coverage.

As Elissa Sirovatka, principal of Tillinghast, a risk-management consulting firm owned by Towers Perrin, points out: "The inclusion of directors' and officers' personal assets in the Enron and Worldcom settlements accelerated the number of inquiries from boards. Board members now recognize their accountability and are questioning their own levels of coverage."

Reviewing policies

According to the new Canadian survey, 25% of independent directors engaged an insurance consultant to review their policy coverage and close to 40% requested changes to their policies including special clauses, extra coverage, and changes in policy language. These figures are high compared to the U.S. and are another sign that Canadian directors are increasingly paying attention to their personal risks. Sixty-eight per cent of the companies who responded to the survey engaged the services of an insurance consultant with special expertise in D & O insurance; 62% of respondents have their corporate counsel review the annual application and policy with 42% of respondents retaining external legal counsel.

A common fallacy is that all D & O insurance policies are alike. When asked "Do you think that most D & O policies sold in Canada offer generally similar terms and use substantially similar language?", 63% of the survey respondents said yes. The truth is, there is a huge disparity in exclusions, extra cover and definitions. D & O policies are complicated. As one respondent pointed out: "The D & O policies are almost incomprehensible (and I am a corporate lawyer!). It is almost impossible to deal with issues such as priority of payments, allocation, insured versus insured exclusions, cancellation rights, non-renewal, extended reporting and a number of other exclusions."

Sarah Robson of Marsh Canada and Trevor Mapplebeck of Mercer Oliver Wyman in Toronto point out in the March 2006 issue of Canadian Insurance: "In the current marketplace, coverage is negotiable, D & O coverage is extremely complex, and no two wordings are alike so it is essential that a detailed coverage analysis be completed to understand the nuances in the various coverage offerings."

Risk ranges: Canada and the U.S.

The survey also revealed that just over half of the respondents know if their coverage will still be valid if the company's staff or other directors provide inaccurate information or omit key information in the annual application for insurance. And only 28% say their company has financial reserves or money in trust to cover directors' legal fees or liability incurred before D & O policy deductible is exceeded.

Often directors assume that, since they are covered by the same policy as the CEO, they have first-class protection. The truth is that rarely do CEOs get involved in evaluating the quality of their D & O policies. They often rely on a non-legal employee or corporate counsel who negotiates one D & O policy a year. Match that with an underwriter who negotiates policies every day of the year and you have an unfair advantage in favour of the underwriter, which can lead to harsh results for the insured.

Another fallacy is that the majority of lawsuits are made against very large corporations. According to AIG, in 2004, only 1 in 18 companies facing a class action lawsuit was a Fortune 500 company. The overwhelming majority are companies with sales of less than $100 million.

Understanding the risks and ensuring insurance policies cover those risks is crucial. A 2004 study indicated Canadian directors are twice as likely as U.S. directors to have the insurer deny coverage of a claim (14% in Canada compared with 7% in the U.S.). But that number is on the rise. In the most recent study, although the actual number of claims was small, a staggering one-third of the coverage was disputed by the insurance company.

This presents a serious problem for companies trying to recruit directors. Do you tell a prospective director that if there is a claim, there's a 33% chance the insurance company may not step up to cover it?

And that's not the only issue Canadian directors and officers face. Being a director of a Canadian company carries a much wider range of risks than U.S. directors. Canadian directors are personally liable for unpaid taxes, unpaid wages, and environmental damages. If a company's operations have resulted in contaminated water and the company goes insolvent, directors are personally liable for clean-up costs. Statistically it doesn't happen often, but Canadian directors seem unaware that they are personally liable under a range of laws that is much more extensive than those affecting directors of U.S. companies.

Changes

But things are changing. Eighty per cent of survey respondents reported taking measures to strengthen the role of independent directors, to improve transparency in reporting, and to strengthen audit and risk management committees. Although this may be prompted more by new compliance legislation designed to boost investor confidence, this actually offers greater opportunity for enhanced performance. As Robson and Mapplebeck say, this can "create meaningful information about the business that the board and management can use to ensure risk management is about more than mere compliance, but about advantage."

Melanie Woodard McGee, CPA, agrees. In her November 2005 CMA Management article she notes: "Although compliance requirements may be the catalyst for leaders to address the issues of risk management, effectively managing organizational risks carries with it the potential to yield significant benefits. Indeed, properly identifying, measuring and managing organizational risks offers real opportunities for improved performance."

Clearly, boards need to review all aspects of their D & O risk including: corporate indemnity (a necessity whether or not there is D & O insurance); qualifications of insurance broker or consultant; reputation of the insurance company; terms of the existing policy; and key issues in making a claim.

With a solid D & O policy in place, companies can confidently attract and recruit the most qualified directors.

Paul Reynolds ([e-mail]) is a former law professor and general counsel to three multi-national corporations. He serves as secretary to the Canadian Corporate Counsel Association in BC and is a director with Bishop Phillips Consulting Canada, a Vancouver-based risk management firm.