Outside Director Liability
Bernard S. Black
Northwestern University - Pritzker School of Law; Northwestern University - Kellogg School of Management; European Corporate Governance Institute (ECGI)
Brian R. Cheffins
University of Cambridge - Faculty of Law; European Corporate Governance Institute (ECGI)
Stanford Law School
as published in Stanford Law Review, Vol. 58, pp. 1055-1159, 2006
ECGI - Law Working Paper No. 68/2006
Stanford Law and Economics Olin Working Paper No. 319
U of Texas Law, Law and Econ Research Paper No. 76
This Article analyzes the degree to which outside directors of public companies are exposed to out-of-pocket liability risk - the risk of paying legal expenses or damages pursuant to a judgment or settlement agreement that are not fully paid by the company or another source, or covered by directors' and officers' (D&O) liability insurance. Recent settlements in securities class actions involving WorldCom and Enron, in which lead plaintiffs succeeded in extracting out-of-pocket payments from outside directors, have led to predictions that such payments will become common. We analyze the out-of-pocket liability risk facing outside directors empirically, legally, and conceptually and show that this risk is very low, far lower than many commentators and board members believe, notwithstanding the WorldCom and Enron settlements. Our extensive search for instances in which outside directors of public companies have made out-of-pocket payments turned up thirteen cases in the last twenty-five years. Most involve fact patterns that should not recur today for a company with a state-of-the-art D&O insurance policy.
We offer a detailed assessment of the liability risk outside directors face in trials under corporate and securities law, including settlement dynamics. We argue that, going forward, if a company has a D&O policy with appropriate coverage and sensible limits, outside directors will be potentially vulnerable to out-of-pocket liability only when (1) the company is insolvent and the expected damage award exceeds those limits, (2) the case includes a substantial claim under section 11 of the Securities Act or an unusually strong section 10(b) claim, and (3) there is an alignment between outside directors' or other defendants' culpability and their wealth. Absent facts that fit or approach this perfect-storm scenario, directors with state-of-the-art insurance policies face little out-of-pocket liability risk, and even in a perfect storm they may not face out-of-pocket liability. The principal threats to outside directors who perform poorly are the time, aggravation, and potential harm to reputation that a lawsuit can entail, not direct financial loss.
A companion article, Brian Cheffins & Bernard Black, Outside Director Liability Across Countries, 84 Texas Law Review 1385-1480 (2006), http://ssrn.com/abstract=438321, studies six comparison common-law and civil-law countries (Australia, Britain, Canada, France, Germany, and Japan). This article and Outside Director Liability Across Countries are the most fully developed of our articles on outside director liability.
Earlier pieces of this overall project are listed below.
http://ssrn.com/abstract=382422 (a pre-Enron and WorldCom version of this article)
http://ssrn.com/abstract=878135 (policy analysis)
http://ssrn.com/abstract=628223 (study of Korea)
http://ssrn.com/abstract=682507 (summary article for a finance audience)
http://ssrn.com/abstract=800604 (German language version of Germany-paper)
http://ssrn.com/abstract=590913 (summary for practitioner audience)
Number of Pages in PDF File: 107
Keywords: outside directors, corporate law, securities law, indemnification, D&O insurance
JEL Classification: G38, K22
Date posted: April 4, 2006 ; Last revised: November 3, 2010