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Directors & officers of private companies increasingly vulnerable

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Directors and officers of privately held companies consistently underestimate their personal exposure from lawsuits filed against the companies they serve. The inclusion of the personal assets of directors and officers in cases like Enron and WorldCom demonstrate the personal exposure of directors and officers serving public companies. However, private company officers, directors and board members may face even greater exposure because their companies often have more limited assets.


Increasingly, private company leaders are demanding comprehensive directors' and officers' liability insurance to cover claims arising from alleged wrongdoing as a condition of their participation -- and for good reason. Consider this:

* There are more D&O claims being filed today than in the history of U.S. litigation. The odds are greater than ever that an officer, director or board member of a privately held company will be sued personally.

* The amount of the average D&O claim award to shareholders has doubled since 2000, according to Tillinghast, a management consulting firm.

* On average, securities claims produce approximately $1.3 million in defense attorneys' fees and costs, according to R.R. Donnelly.

* Twenty-seven percent of all companies surveyed by Tillinghast were involved in merger, acquisition and divestiture activities, which triple the risk of being sued. But by no means does participation in the latter activities present the only or even the greatest risk of suit.

It should then come as no surprise that half of all public and private companies have received directors' and officers' liability insurance inquiries from their leaders, according to a 2005 D&O Liability Survey on Claims and Insurance Purchasing Trends. The same survey indicates that companies have experienced a 30 percent increase in claim frequency from 2004-2005. Merchandising, technology, transportation, communications, financial services, health services, education and durable goods companies all appear to be at particular risk.

From where does the potential exposure come? Any decision involving the investment of money is fair game for an investor lawsuit. In fact, few investors "lose" their money anymore. They now claim that the placement materials were misleading, management failed to perform, acted in self-interest and made financial or other decisions to their detriment.

Everything from raising capital, to decisions on how to spend it, to mergers and acquisitions has formed the basis for past claims. Other sources of D&O claims include competitors, customers, banks and other creditors, vendors and suppliers and governmental and other regulatory agencies.

It appears that employee-based lawsuits are by far the fastest growing area of dangerous exposure to business leaders. Many D&O policy providers can also package employment practices liability coverage when requested. Such claims can range from employment discrimination based upon a protected class (race, religion, age, gender, national origin, pregnancy and disability), to wrongful termination, harassment, retaliation (whistleblower), breach of employment contract and merger, acquisition and divestiture claims. More than 80,000 such claims are filed against companies and their officers annually.

It seems that the environment against company leaders is more hostile than ever. While the "good faith" defense remains strong for directors -- note the Disney case in Delaware-- the "business judgment rule" has experienced erosion in recent court decisions that increasingly second-guess the decisions of company leaders.

Although the Sarbanes-Oxley Act generally applies to only public companies, it is being used as the "standard of care" against private companies.

In fact, a recent New York decision held that the directors and officers of a privately held company had the same fiduciary duties as would those serving a public company. In that case, creditors targeted corporate officers and directors claiming breach of their fiduciary duties to keep the company, which had filed for bankruptcy, solvent. Even though the company leaders did not benefit from the bankruptcy filing in any way, they were held liable. When businesses enter the so-called "zone of insolvency," new rulings suggest that management has a duty to the creditors. This is an expanding area of liability.

More ominously, Stephen Cutler, in charge of enforcement at the Securities and Exchange Commission, recently declared a new initiative to increase scrutiny and pursuit of independent directors who fail to pursue misconduct.

Managers of privately held companies are particularly vulnerable to being sued because of their typical close involvement in the company's day-to-day operations and because such companies often lack the resources to comply with the myriad of compliance laws involving investment, employment and other claims, not to mention the financial wherewithal to fight them.

Private company insurance is typically much cheaper than similar insurance for public companies and the cost appears to be going down. These days, few respected business leaders will get involved with a company without the protection of such insurance. For more information about D&O insurance, contact your insurance company, broker or attorney.

Scully is a partner in the San Diego office of Gordon & Rees LLP

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