Implementing a behaviour control internal gatekeeper service / D&O insurance...

Hi Saliha,

In a litigious society such as the U.S., one step that a company can take is to purchase Corporate Director Liability Insurance. This is because it is only realistic to suppose that at one point a company's shareholders will file a derivative lawsuit (on behalf of the corporation) or a class action lawsuit (on behalf of themselves as wronged shareholders) against the board of directors. (The board is named as a defendant because it is the governing body for the corporation.) Even with insurance, however, a state's Business and Corporations Law (as it is called in NJ) may limit a company's ability to indemnify its directors where they have not acted with the prudence and care ordinarily expected of a fiduciary. (The board is in a fiduciary relationship -- holds a position of trust -- vis-à--vis the shareholders.)

Aside from director indemnification insurance -- depending on the state of incorporation -- a company's incorporating and organizational documents (Charter, Certificate of Incorporation, and By-Laws) can establish a low standard of board accountability to shareholders by making most board actions fall within the ambit of a board's discretion. This protects a board in the same way that the Business Judgment rule protects managers from "nuisance' lawsuits based upon charges that management has been negligent or reckless in carrying out the day-to-day operations of the business.

However, a lenient state of incorporation (like Delaware here in the U.S.) may not be the last word on whether the incorporators of a company can give the board a "free ride" with organizational documents providing for a low level of board accountability to the shareholders. At least such is the case in the U.S. where federal laws like Sarbanes-Oxley and Dodd-Frank have been intruding more and more into the corporate governance area and thus pre-empting lenient state laws that give those forming corporate entities the power to weaken the accountability of corporate boards to the shareholders of their companies. See my article on RG "Legislative Excess or Regulatory Brilliance? Corporate Governance after SARBOX."

A final tactic is to "save the Board from itself" by requiring new directors to attend a "New Board Member Boot Camp" and by having an annual Ethics and Compliance training session for the board on the whole. Of course, it goes without saying that all Boards should have an Audit Committee, Nominating Committee, and Compensation Committee whose membership is comprised of a majority of independent directors. it is important to avoid conflicts of interest or the perception that there are conflicts of interest on matters that come before the board. A board also benefits from holding meetings more frequently than 4 times a year. Moreover, the board should go into "executive session" (kick out the CEO) at each meeting for at least 15 minutes. For more on Best Practices to keep a Board out of trouble, see "From Lapdog to Watchdog: The Post-SARBOX Corporate Board" among my RG "Contributions."

Gwen

 HI

I quite agree with Gwendolyn 's answer, but I am really wondering if it is a good idea to lower the accountability of directors. Insulated from litigation problems they may be induced by insurance to untertake wrongdoing projects. Perhaps this may encourage a certain level of fraud inside the compagny. See the following papers:

Baker, T. and S. Griffith, 2010. Ensuring Corporate Misconduct: How Liability Insurance Undermines Shareholder Litigation. University of Chicago Press, Chicago IL

Boubakri, N., M. Boyer, and N. Challeb, 2008, Management Opportunism in Accounting Choice: Evidence from Directors' and Officers' Liability Insurance Purchases, working paper, HEC Montreal.

Cao, Z. and G.S. Narayanamoorthy, 2014. Accounting and Litigation Risk: Evidence from Directors' and Officers' Insurance Pricing 19(1), 1-42.

Chalmers, J.M.R., L.Y. Dann, and J. Harford, 2002, Managerial Opportunism? Evidence from Directors’ and Officers’ Insurance Purchase, Journal of Finance 70(2), 609-636.

Dear  Saliha,

I agree with Patrick that a reduction of directors' liability may not be a good incentive. Especially, it would rather intensify the entrenchment problem - directors "captured" by management through personal relationships or percs could be assured of a limited responsiveness in case of a failure. This would diminish their monitoring role even further to the detriment of the shareholders.

Paul