Quintin Lindsmith
Partner, Bricker & Eckler LLP
January 2000

Barbarians. They will always be at the gates. Always. And there are two sets of gates that every company should be concerned about. The first are the gates to the courthouse. Barbarians commonly breach these gates by simply naming a corporation in a lawsuit.

The second and more important set of gates are those to the boardroom. If the litigation barbarians are able to enter the boardroom by naming individual directors, the plaintiff almost automatically has improved leverage. By crashing into the boardroom, the plaintiff can increase the nuisance factor for the board while gaining settlement leverage, even in a completely baseless lawsuit.

Litigation, after all, is simply a tool by which each party tries to create stronger leverage to secure a more favorable resolution. The fact that only about ten percent of all lawsuits actually go to trial is an indication that parties use litigation more as an advantage-building tool to settle and less often as a tool to conquer. If Clausowitz was right and war is only an extension of diplomacy by other means, then litigation is only an extension of settlement discussions by other means. Whoever performs better on the battlefield has greater power in discussions at the peace table. If, however, the battle invades the high command, the battle becomes more dangerous and the control shifts.

The focus of this article is not how to keep the litigation barbarians out of the courtroom, but how to keep them out of the boardroom.

In today’s litigation climate, any corporation that has been in operation for any material period of time will probably encounter a lawsuit. The lawsuit may come from any direction – from the work force, a competitor, a transaction gone bad, a shareholder, or even a class action purportedly representing a group of customers of the corporation. Yet, it is rare for a director to be named as a defendant in a lawsuit and even rarer for a director to face serious risk of personal exposure that could result in a loss of personal assets.

There are a number of reasons for this. In most jurisdictions, officers and directors of a corporation cannot be named as individual defendants in a lawsuit arising out of a contract dispute. Even when an officer or director might have personally orchestrated an egregious breach of contract, it is the corporation that is the party to the contract. Unless the corporation itself is deemed a sham, most jurisdictions do not allow officers and directors to be named in such lawsuits. Thus, directors are not exposed to a large class of business litigation.

In lawsuits where tort claims are brought against the corporation, such as negligence or fraud, it must be established that the officer or director actually participated in the tort at issue before most jurisdictions allow that officer or director to be named as the defendant. Such tort claims might enter the boardroom more easily in closely held corporations where the directors are often directly involved in the operations of the business. They are less likely to enter the boardroom of large, publicly held corporations where most directors are rarely involved in the day-to-day activities of the corporation.

Personal exposure of directors can further be limited by purchasing director and officer (D&O) liability insurance and through indemnification, which most directors are entitled to by statute, bylaw or contract.

In spite of the foregoing, significant risk to directors remains. Even if the barbarians are kept at bay dozens of times, one breach can change a director’s life. For example, a director who is trying to refinance a home will be negatively impacted by even a frivolous $1 million lawsuit. The director will have difficulty explaining to the loan officer that the lawsuit, which had to be disclosed on the loan application, is baseless. The loan officer will probably tell the director that the claim must be resolved before the bank will approve the loan. If the lawsuit drags on for even six months, rates could move up and the lawsuit could cost the director even if that director is completely covered by insurance and completely indemnified by the company.

A claim of breach of fiduciary duty, is, perhaps, the most common vehicle through which a litigation attack can crash into the boardroom. Directors have a fiduciary duty to the corporation and its shareholders. They must act in the best interests of the corporation and the shareholders and must avoid self-dealing. Many jurisdictions expand a director’s fiduciary duty to creditors of the corporation whenever a company becomes insolvent. That is, on the day the company’s balance sheet goes from a positive net worth to a negative net worth of even $1, directors suddenly have a new constituency to whom they owe a fiduciary duty.

The most common shield against such an attack is the Business Judgment Rule. In non-legal terms, the Business Judgment Rule provides that directors may not be held liable for a bad business decision as long as that decision was made in good faith and with disinterest. For example, if a clothing retailer has disastrous sales because the board made a strategic decision to go into polka dots when the fashion market was clearly going to stripes, the shareholders might vote differently in the next board election, but they do not have a claim for breach of fiduciary duty. The result might be very different, however, if members of the board majority who voted in favor of polka dots happened to own the vendor company which supplied the polka dots to the corporation.

Protecting a corporation from lawsuits is commonly referred to as risk management or loss prevention. Board members should consider whether enough is being done to assure loss prevention in the boardroom. Loss prevention does not mean simply winning lawsuits. The primary goal of loss prevention is keeping the boardroom doors closed to the barbarians.

The mere commencement of business litigation is akin to entering into a double-inverse, regressive tax bracket – the winner pays a huge tax on its earnings and the loser pays a huge tax on its losses. The tax, of course, is in the form of attorney fees, inordinate attention of management away from business operations, and even business disruption. The tax only gets higher when the litigation enters the boardroom. Like the Russian front in World War II, a loss prevention program for the boardroom must have several lines of defense, each one deeper within and stronger so the litigation barbarian never enters the boardroom.

To construct those lines of defense, a corporation should consult with either in-house or outside counsel. If you have an in-house counsel staff, do not look upon them simply as a cost center; use them. They could actually save you money. The same is true of outside counsel if you do not have an in-house staff.

It is often the case that law firms follow business trends, but almost never lead them. Yet, many large law firms have sophisticated loss prevention programs that include the designation of a loss prevention partner. Despite these programs, the use of loss prevention counsel in the boardroom is rare. What would a loss prevention counsel do for the board?

First, loss prevention counsel would examine the extent and adequacy of director and officer liability coverage. Counsel would look at exactly what types of claims the policy covers and, more important, the types of claims it would not cover, such as business slander or breach of fiduciary duty. Counsel would examine the nature and size of the business and its common transactions to determine if the policy limits are too low. Counsel would also study the exclusions of coverage to determine if they are acceptable; if they are unacceptable, counsel may conclude that it would be beneficial to obtain additional coverage.

Counsel should also review the company’s by-laws to ensure that the directors are adequately protected from the included indemnification provisions, which would fill the gaps in insurance coverage, including any deductible. Counsel would determine whether board members should be indemnified by contract. This provides additional protection to board members in the event a hostile change in ownership or control occurs. Although the new ownership may be able to change the bylaws, it cannot change the contract.

The most effective use of counsel is in the boardroom. Consider the attorney-client privilege. If the company is facing a sensitive strategic business issue that has some legal aspects, the discussion at the board level can be protected from disclosure by simply inviting counsel into the boardroom to participate in the discussion in the express context of the board consulting with counsel. The minutes would merely reflect in one sentence that "the board participated in a privileged discussion on the subject matter with counsel." Even if it turns out that 80 percent of the discussion focused on business issues, discussions between board members and counsel are privileged are not discoverable. This makes it more difficult to develop accusations of director misconduct.

In addition to counsel, directors can gain even more protection by using and relying on other professionals, including financial advisers, accountants, or even officers of the company. If a board takes action upon the advice of professionals, it is much more difficult to mount a breach-of-fiduciary-duty attack. If the director-meeting-minutes reflect that the board took action upon the advice of professionals, it is much more difficult to claim the directors breached a fiduciary duty. This is a form of risk-shifting designed for the benefit of directors under most states’ laws, which is amazingly underutilized by corporate boards.

Going into executive session is also an underutilized tool. This tool may be more beneficial to large non-profit corporations, such as health care corporations, where all members, including hostile ones, are permitted to attend all board meetings. In these cases, the board can retire to executive sessions with counsel. Although the board typically cannot take action while in executive session, anything can be discussed and the minutes would only reflect that the board went into executive session. The board can then emerge from executive session and take whatever action deemed necessary.

Another important aspect of board meetings are the minutes. When it comes to corporate minutes, less is more. Minutes should be sparse and should have virtually no detail of the nature of the discussion. An example of minutes recording the discussion of an item on the agenda should be as follows:

The board next considered the design department’s recommendation of polka dots over stripes. Following a presentation of the issue by Mr. Stripes, there followed a general discussion and the board voted unanimously to accept the proposal.

There should never be a detailed description of the dialogue because trial lawyers love to exploit board members’ statements. Even in the most complex commercial lawsuits involving hundreds of thousands of documents, the most damaging events often turn on one sentence from one document which the lawyers blow up in big letters and repeatedly show to the jury. In the recent Microsoft antitrust trial, it was only a handful of sentences from the few documents picked out of thousands which did serious damage to Microsoft.

Board members who want every detail of every discussion recorded in the minutes simply cannot anticipate every nuance of every subsequent legal battle. They also ignore another problem with detailed minutes – what they might not say. If minutes are so detailed that they record every thought expressed by every board member, they can be used to demonstrate what the board was not considering at the time. It is this failure to consider something which could be the Great Blank Blow-up in the courtroom.

While keeping the barbarians outside the boardroom gates is a main priority, the strategy does not end if the barbarians enter the boardroom. Depending upon the scenario presented, there are a number of actions which should be taken in the event one or more board members are named in a lawsuit. When a single member or a minority of board members are named in a lawsuit, a firewall should be erected as to the subject of the lawsuit. This allows the rest of the board to consider strategies in response to the lawsuit on behalf of the corporation while the defendant board members consult with their own counsel. Typically, counsel for the corporation and counsel for the defendant board members should communicate through a joint defense agreement so that the overall strategy remains coordinated.

When any board member is named in a lawsuit, counsel should be contacted first, followed by the claim’s representative of the D&O carrier. Even if the lawsuit does not assert claims that are covered under the D&O policy, the carrier may still provide defense counsel and may simply reserve its consideration of whether the policy applies to any liability.

In the rare case where all members of the board are named as defendants, a firewall is impractical. Yet, separate counsel should be retained for both the board and the corporation. The board’s counsel is typically paid for through the D&O carrier. If the D&O carrier insists on hiring counsel itself, the board may want to consider hiring its own counsel to oversee and work with the D&O carrier’s counsel. This would depend upon the nature of the action itself. If the lawsuit seeks to recover significant monies and is deemed something more than a frivolous lawsuit, second counsel should be considered.

When all board members are named as defendants, it may also be prudent for the board to delegate supervision of the lawsuit to one or a small handful of board members who can act as main contact with counsel. This would create an environment where counsel has one point person to report to and receive instructions from, which would assist in the development of a cohesive litigation strategy and diminish the possibility of leaks from the boardroom. Board members should never discuss the litigation among themselves outside of the presence and protection of counsel.

This last decade has seen a remarkable proliferation in both the quantity and quality of business litigation. Plaintiffs who sue corporations are becoming more sophisticated in their techniques and theories. What was a frivolous legal position ten years ago may have become meritorious today. Hundreds of courts across the country can repeatedly reject the same argument, but all it takes is one judge in one jurisdiction to finally agree with that argument to set a new precedent and change the legal landscape. With the legal landscape continually shifting, loss prevention in the boardroom is more important than ever.

There will always be barbarians at the gates. Good loss prevention techniques not only keep the barbarians outside the boardroom gates, but also provide that in the unfortunate event the barbarians enter the boardroom, there will be nothing for them to find.

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