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Directors: protect your personal assets; The more personal assets you have, the greater your financial risk. What you can do to protect against creditors.

THE TERM "board of directors" has traditionally called to mind a certain honor, prestige, and status. Today, however, we're just as likely to associate the term with pressure, exposure, and risk. Board service since the passage of the Public Accounting and Investor Protection Act of 2002, more commonly known as Sarbanes-Oxley, creates clearer and perhaps greater risk to a director's personal assets and reputation. Like any risks, these warrant careful analysis and management. Taking steps before the fact to mitigate exposure can often make a significant difference later on.

While directors have always been accountable to shareholders, Sarbanes-Oxley has codified many director responsibilities into law, thereby increasing the possibilities for lawsuits involving claims against public company boards. Directors and officers (D & O) insurance covers this liability to a degree. As the number of D & O claims paid rose from $9.62 million in 2002 to $23.35 million, the premiums for this insurance increased by as much as 500 percent. For any given policy, if the premiums didn't go up, chances are the coverage was reduced. In the same Pearl Meyer survey, 63 percent of respondents said they believed Sarbanes-Oxley had made it more difficult to get adequate D & O insurance.

Further straining the ability for directors to limit their personal liability are rising legal defense costs. According to a recent Reuters report, "Hefty legal defense bills are now frequently consuming the bulk of funds provided by a D & O policy, leaving plaintiffs responsible for covering the shortfall with personal assets."

First line of defense: Know your coverage

As a director, your first responsibility to yourself is to understand what your D & O insurance covers and how that compares with your personal net worth. You may know, for example, that the policy's liability limit is $100 million, but do you know whether that limit applies to each individual director or to the board as a whole? Would your defense costs be included in that limit or separate from it? Does the policy allow you to choose your own legal representation? Under what conditions might you be excluded from coverage?

It's a good idea to have an attorney (perhaps your personal attorney or one who has securities law experience) review the D & O policy for you. He or she should assess whether you run the risk of having to pay to sue the insurance carrier while simultaneously defending yourself from a class action. You may also want to have the attorney look at the company's indemnity obligations. Also, check the company's bylaws and the statutes of the state where it is incorporated, which may offer some additional protection.

Your second step is to retain that healthy paranoia you may have developed in the wake of Sarbanes-Oxley. The threat of suits is both real and perceived. The Delaware Court of Chancery, which has jurisdiction over companies incorporated in Delaware (as most are), is hearing (as this issue of DIRECTORS & BOARDS goes to press) a plaintiff's suit against Disney over Michael Ovitz's $140 million pay package for less than a full year's service as CEO. This ground-breaking suit alleges that Disney directors approved the package without seeing it. If true, their actions would constitute a lack of "good faith" or "intentional misconduct" rather than merely bad "business judgment," which has been the typical cover for directors until now. If the verdict finds the directors failed to act in good faith, Delaware law prohibits their D & O insurance from covering the damages, which means they may be writing checks for any claims awarded.

Extra protection: A personal asset trust

The more personal assets you have, the greater your financial risk as a director. If your D & O coverage falls short of your net worth, you should consider taking steps to protect your assets. There are a variety of mechanisms that can be employed to protect against creditors, but all have significant trade-offs, particularly over control. It may not be as easy as simply retitling some assets to your spouse or children or putting some of them in trust.

Part of any discussion is to closely evaluate what level of protection is needed and what measures you are willing to take to get this protection. When working with clients who serve on boards, I generally advise consulting with an attorney to review which assets may already be protected by state statute. Depending on your state of residence, its laws may shield your primary residence, IRAs, pension plans, proceeds of life insurance policies, annuities, and prepaid college tuition plans from creditors, as well as potentially protecting some of your wages.

Registering ownership of assets in a favorable state where you also have a residence is often the only foolproof way to protect your assets from creditors, and certainly the easiest to implement. However, for many clients, changing state domicile is not feasible, nor do these state laws protect a sufficient percentage of their assets to provide the comfort required. If your board tenure is coming to an end, or if you are concerned more with creditor protection generally, often more common structures can be used to provide some limited protection. Assets placed in trusts for children that have so-called spendthrift provisions attached to them can be used to provide some creditor protection, as can family limited partnerships (although to a lesser extent).

For extra protection, many directors and corporate executives, in addition to wealthy individuals concerned about litigation, are turning to asset protection trusts. While many asset protection schemes in the news are just that--promotions by less than reputable providers to avoid taxation or defraud creditors--the asset protection trust is gaining in popularity as a mainstream vehicle for liability protection. Yet it is neither a foolproof measure nor a "one shot" solution and should be coupled with the state statutory protections described earlier as part of a broader asset protection strategy.

An asset protection trust is a self-settled trust. The grantor of the trust can name himself or herself a primary beneficiary and give discretion to a trustee on whether to distribute assets to the beneficiary. Although an independent trustee must control and distribute the assets in the trust, which is irrevocable, you as grantor can provide a detailed asset management plan.

In theory, an asset protection trust will remove assets from your estate and put them beyond the reach of creditors because the trustee will choose not to distribute assets if there are judgments pending against the grantor. The choice of situs, or where the trust is located, depends on a number of factors. Onshore (or domestic) asset protection trusts have been getting a lot of attention lately. Some states have been amending their laws to make themselves more attractive to grantors seeking to fund a domestic asset protection trust. So far, state laws in Alaska, Delaware, Nevada, Missouri, Rhode Island, and Utah have added provisions to allow for the creation of domestic asset protection trusts.

The existence of an asset protection trust, coupled with the various limits on creditors under state laws to challenge the funding of these trusts, should serve as enough of a barrier to assets to avert a lawsuit or at least compel a settlement. Keep in mind, however, that the protection afforded by domestic asset protection trusts has not yet been tested in courts. The U.S. Constitution requires states to provide "full faith and credit" to the judgments of other states, and a major concern among the legal community is whether a domestic asset protection trust would withstand a challenge on these grounds.

The alternative is to choose an offshore trustee who will not be subject to U.S. jurisdiction and cannot be compelled to act by the U.S. court systems. Generally, these trusts are in jurisdictions that have enacted special legislation to protect debtors against foreign creditors. Offshore asset protection trusts can make it more costly and difficult for those creditors to locate assets, but they are truly effective only if you are also willing to flee the country to retain your assets should you have a judgment against you. (Clearly, this is not an acceptable solution to most people.) A recent trend of cases in the U.S. has thrown a damper on the creation of offshore asset protection trusts, as the courts have chosen to hold the creators of the offshore trusts in contempt in an effort to compel them to force the trustee to distribute assets in the trust.

Most directors who decide to use an asset protection trust seem to choose a domestic trust over an offshore alternative, perhaps owing to the reputational risk, which is often more important than pure creditor protection. Although many offshore accounts are perfectly valid legal structures, they connote "hidden assets." They have become an object for increased disclosure and due diligence under the Patriot Act and are increasingly scrutinized by the IRS. The recent contempt cases have also dampened some of the enthusiasm for offshore trusts. While subject to Constitutional challenge, domestic alternatives offer many of the same benefits for a considerably lower price.

Defending against reputation risk

Reputation risk is often the most significant risk directors face, particularly when taking steps to control the extent of their personal liability for board activities. Reputational risk focuses mainly on conflicts of interest, an area where perception is also as threatening as reality. Following Sarbanes-Oxley, many companies refined their conflict of interest policies to the point at which any personal gain from board service can only be spiritual; any hint of material profit will be a violation. Your best defense against reputational risk is to govern well and ask questions, particularly about executive compensation and accounting practices. Secondarily, you should take advantage of the tools available to protect yourself from allegations of conflict of interest, such as a 10b5-1 trading plan or a blind trust (see sidebar).

Asset protection can take many forms, and there is no one "right" way to ensure that your personal liabilities are minimized. Every investor will have different levels of risk tolerance, willingness to cede control over assets, or assessments as to the risk posed by board membership. The best defense is a good offense, and more and more directors are asking tough questions up front and staying focused on reputational and legal issues throughout their board tenure.

Despite the risks, dedicated board service is the best way to uphold and enhance our system of corporate governance. Just remember, it's your responsibility to understand the risks involved and take the steps necessary to manage them.

RELATED ARTICLE: Precluding any appearance of conflicts

If you are compensated for board service with stock, you should take advantage of a 10b5-1 trading plan if offered by the company. Effective since October 2000, SEC Rule 10b5-1 provides for the establishment of a written plan for the trading of securities while the person establishing the plan is not in possession of material, non-public information. These plans allow you to diversify your holdings gradually over time while avoiding concerns over whether purchases and sales occurred when you possessed insider information.

If you serve on multiple boards and have a substantial stock portfolio, you may also consider putting your assets into a blind trust. Blind trusts can be established for a limited period of time, or for as long as certain situations exist, such as the time you serve as chairman of a board.

With a blind trust, you let someone else make your trading decisions according to your guidelines but without your involvement or even knowledge. You can set some broad parameters, such as avoiding an industry in which you are involved. A blind trust puts your investment decision beyond reproach when it comes to conflict of interest, but it also forces you to relinquish control. You need to have a lot of trust in your money manager, and accept the fact that you may not be able to take advantage of the investment opportunities that come your way.

Your manager may provide you with quarterly and annual financial reports containing the trust's aggregate market value of the assets and the net income or loss. However, you may not receive any report on the holdings and sources of income of the trust. Investors who directly handle their own investments, including selecting individual stocks or bonds for their portfolios, are usually uncomfortable with ceding management control over their assets and tend to find the concept of a blind trust unnerving. Investors who are used to selecting managers, rather than stocks, tend to be more comfortable ceding control over manager selection to a trustee, particularly since this will enable the investor to stay somewhat more involved in the trust. Discussions with the trustee as to the types of managers selected and their styles or focuses can assuage fears of loss of control while retaining the blind nature of the underlying trust investments.

Most blind trusts use a corporate trustee. This can also provide a greater measure of comfort, as corporate trustees will have a more formalized investment process and over-sight mechanisms in place, which can ensure consistency with respect to investment decision. Many grantors will also retain the right to replace the trustee with another corporate trustee, thus ensuring that a poorly performing trustee may be removed before the portfolio suffers a long-term impact.

--Holly Isdale

Holly Isdale is a managing director of Lehman Brothers Inc. and heads the firm's Wealth Advisory Services. She provides tax and estate counseling to corporate directors and senior executives.

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The author can be contacted at holly.isdale@lehman.com. Neither Lehman Brothers nor its employees provide legal advice. Please consult with your accountant, tax adviser, and/or attorney for advice concerning your particular circumstances.
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Title Annotation:LIABILITY AND LITIGATION
Author:Isdale, Holly
Publication:Directors & Boards
Geographic Code:1USA
Date:Jan 1, 2005
Words:2280
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