Being an honest and thoughtful person only goes so far in safeguarding directors and officers from personal liability.
Most business people know that a corporation is a separate legal entity, and that corporate law holds that employees, officers and directors are not personally responsible for the debts of the corporation.
But there are some key exceptions to that rule.
Entrepreneurs generally incorporate for tax purposes and to be protected from personal liabilities. Starting a new corporation or becoming a director or officer is an exciting time, as individuals are focused on turning a new business venture, invention or idea into the next big thing.
Too often, in all that excitement, newly minted directors and officers forget to actively consider how they should protect their personal assets from potential liabilities.
Laws governing corporations set basic standards of conduct for directors and officers. Broadly, those duties are to behave honestly and in good faith in the best interests of the corporation, and to exercise the care, diligence and prudence that a reasonable person would in similar circumstances.
I have yet to meet anyone who became a director or officer and expected their personal assets to be at risk while doing the corporation’s work. But being an honest and thoughtful person only goes so far, and there are hundreds of statutes that impose personal liability in different circumstances.
Thankfully, there are ways to protect oneself when an individual steps into such a position. It starts with effective corporate governance documents, as well as the right directors and officers liability insurance policy.
Corporate documents
Any director or officer should familiarize themselves with their corporation’s bylaws.
If you’re considering becoming a director or officer of an existing corporation, or if you’ve ignored your corporate bylaws for a while, know that they need to be reviewed and updated.
Most corporate bylaws contain a section outlining the cases in which a governing member can be indemnified – or, put more simply, the corporation agrees to pay costs and damages that would otherwise be payable by the director or officers from their personal assets.
There are three possible outcomes when the question of indemnification comes up: indemnification is barred; indemnification is required; or indemnification is allowed, but not required.
It is the third category that is of particular importance to directors and officers. Permissive indemnities permit the corporation to indemnify directors and officers against all costs, charges and expenses, including monies paid to settle claims.
A corporation can only indemnify its directors and officers to the extent allowed by statute and by its own bylaws. It can be personally devastating to learn that one’s own assets are exposed simply because the corporation omitted to indemnify its directors and officers when that option existed.
Creating appropriate bylaws and having them properly approved by the shareholders is a valuable way to protect your personal assets.
It’s also wise to adopt indemnification agreements between each of the directors and officers. While there is often overlap between these agreements and modern bylaws, this allows the directors to tailor the indemnity and clarify ambiguities.
Indemnification agreements also have the added bonus of being contractual in nature. Bylaws can be changed with board and shareholder approval, whereas a contract cannot be unilaterally changed by either party.
D&O insurance
Even great corporate documents won’t keep a corporation solvent, and most director and officer liabilities arise when the corporation is in financial distress. By that time, it’s too late to realize that your D&O insurance policy doesn’t cover what you need it to.
A good example is dishonest conduct by a director. Not all D&O policies contain severability clauses that would require the insurer to cover the innocent directors.
It’s bad enough to find out that your co-director has emptied the corporate accounts and vanished; add to that the fact that the corporation has been rendered insolvent, and that your D&O is not going to cover your liabilities as a director because there is no severability clause and you have an unmitigated disaster on your hands.
You will also want to make sure that the insurer’s only right to terminate the policy is for non-payment of premiums. That one is pretty simple. No one wants their D&O insurance policy to be terminated just before it’s needed.
While all of this may sound a bit daunting, it doesn’t have to be. Having open and frank discussions among directors and officers should lead to reasonable indemnification agreements, and appropriate bylaws approved by shareholders.
When a director or corporate officer knows their personal assets are safeguarded, they can focus fully on balancing the risks and rewards for the company to build a more prosperous business for shareholders.
