Directors and officers insurance

In a recent forum on financial risks, an executive of American International Group Inc., a multinational insurance company that operates in 130 countries, proposed that companies listed on the local stock market be required to buy liability insurance for their directors and officers.

Directors and officers liability insurance (also known as D&O) indemnifies losses incurred by or advances litigation expenses to business executives if they are sued for alleged wrongful acts in the performance of their duties and responsibilities.

The insurance usually covers all regulatory, administrative, civil and criminal actions that may be filed by stockholders, government agencies and other persons who may feel aggrieved by certain corporate decisions.

According to the AIG official, the coverage aims to give peace of mind to key officials and, in the process, encourage them to stay in their posts longer. He said D&O is compulsory for companies listed on the Hong Kong bourse. In Singapore, although coverage is not obligatory, almost 80 percent of the listed companies have D&O.

In the Philippines, of the 250 or so listed companies, only around 15 percent have D&O for their top honchos.

Coverage

The D&O concept started in the United States in the 1940s and became the corporate norm during the 1960s when its economy enjoyed a boom in mergers and acquisitions. Initially, the insurance coverage was limited to the personal financial protection of executives from suits filed against them by stockholders who either disagreed with certain corporate decisions or were unsatisfied with the returns they received on their investments.

When the financial sanctions imposed by courts and regulatory agencies directly hit the corporations’ coffers, the D&Os’ protective mantle was expanded to cover both the company and its executives. Since company funds are often used to pay for the insurance premium, D&O policies spell out in clear terms the extent of their coverage, the benefits payable and the parties entitled to receive the proceeds.

This is essential because vague or overextended D&O policies could invite complaints from stockholders who do not relish the idea that money that could have gone to their dividends are used to buy protection for already highly-paid company bigwigs. For good measure, coverage is limited to acts or omissions that relate to authorized company business or redound, directly or indirectly, to its benefit. Intentional illegal acts, unlawful profits and decisions based on a glaring misappreciation of facts are expressly excluded.

Management

D&Os rest on the principle that directors and officers will be better able to perform their duties and responsibilities if they are assured that their personal finances will not be adversely affected by suits that may be filed by third parties questioning the validity or soundness of their actions. In case such suits arise, the D&O will advance to them the money needed to pay for the services of lawyers and other litigation expenses from the date of the filing of the complaint until the case is resolved with finality.

And in the event they lose and damages are awarded, the D&O will answer for the payment of the monetary obligation and the costs of any other relief that may be granted to the winning party. The fear, for example, by the CEO of a public company that he can be sued for damages by disgruntled stockholders if no dividends are declared in a year may force him to postpone urgent capital expenditures to “save” funds to cover the expected dividends.

The apprehension of being held personally liable for investments that could adversely affect the company’s stock price may make the directors of a listed company averse to entering into business ventures that although untested have bright prospects. With financial security assured through D&O, there is reasonable expectation that the directors and officer will efficiently manage the affairs of the company or in accordance with what they believe are in its best interests.

Moral hazard

Some quarters, however, have expressed concern about the possible adverse effects of D&Os on the executives’ obligation and responsibility of accountability to the company’s stockholders and creditors. The confidence that they can escape personal financial liability from the negative consequences of their actions may create a “moral hazard” on the executives.

Knowing that their backs are covered, directors and officers may become less scrupulous in complying with their duty to exercise due diligence in the performance of their duties and responsibilities. At present, corporations enjoy a lot of leeway in their activities. Under the prevailing “business judgment” rule, unless clearly unlawful, courts are obliged to respect management decisions because they are presumed to have been done in good faith and in the best interests of the company.

With D&O in place, that wide latitude of discretion runs the risk of being abused or misused as the adverse consequences of wrongful acts are mitigated, if not totally set aside, by the protection provided by D&Os. Although D&Os have gained wide acceptance in developed economies, it is doubtful if the country’s major companies will embrace the same idea.

The conditions that may justify its adoption by our public or listed companies, whether at their own volition or upon orders of regulatory agencies, are not yet present.

For comments, please send your e-mail to [email protected].