SURVIVING THE YEAR 2000 CRISIS

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Director and Officer Liability

By Daniel B. Hassett, Esq.

dhassett@wmcd.com

Williams, Mullen, Christian & Dobbins

Attorneys at Law

1. BACKGROUND - What is the Year 2000 Problem

The Year 2000 problem can be summarized as follows: many computer software programs and some hardware with embedded software were designed with only a two-digit date field to refer to any given year. Date fields are incorporated into software and hardware in order to permit automatic determinations and calculations for a multitude of purposes. On and even prior to January 1, 2000, many systems will read the date as "00" and interpret it as the year 1900, resulting in faulty operation or no operation at all.

As an example, for an employee who was hired in 1985, a computer will calculate years of employment, as of today, by subtracting 85 from 96 to reach the correct result of 11 years. However, in the year "00" the computer will subtract "85" from "00" and report a negative 85 years of employment, resulting in compounded miscalculations of pension, seniority and other time-based benefits or liabilities. Similarly, after the year 2000, a computer will perform a chronological sorting function without taking into account the fact that we will have entered the next century. Thus, the 1985, 1995, and 2005 dates will be sorted chronologically as '05, '85, '95 instead of '85, '95 and '05.

The potential for a system-wide crash can create catastrophic problems for an ongoing business. The problems range from data and reporting problems due to the inability to read or correctly calculate customer bills, amortization, annuity and other date sensitive schedules and reports, to problems with vault, security and sprinkler systems, elevators and other mechanical systems that rely on computerized timers. Additionally, rating agencies, shareholders, analysts, co-venturers, vendors and clients have begun to ask whether a company's systems are certified as Year 2000 "compliant." In response, many companies have adopted and are in the process of implementing their Year 2000 remediation plans.

This memorandum discusses some of the potential risks that a corporation's(1) directors and/or officers may encounter under state law due to a breach of their fiduciary duties owed to the corporation (and its shareholders) as a result of the Year 2000 remediation process, including the liability resulting from the failure of their corporation to adopt an adequate remediation plan.(2) Additionally, insurance and other alternatives available to directors and officers to manage their risk of personal liability are also discussed.

2 . THE FIDUCIARY DUTIES OF DIRECTORS AND OFFICERS

It is the legal obligation of directors of U.S. companies to act as the stewards of the corporation's assets and to plan and perform strategically. The Year 2000 crisis is a foreseeable issue (certain and material). Thus, the failure of a corporation's Board of Directors and/or senior management to develop and implement a remediation plan may be a breach of their fiduciary duty of due care to the corporation, its stockholders and, in some cases, creditors. Directors and officers who do not take appropriate procedural and substantive steps to remedy their corporation's Year 2000 problems may be personally liable to the corporation (or its shareholders) based on such a breach. Moreover, the possibility of further U.S. or international legislation requiring corporations and their directors and officers to "solve" their corporation's Year 2000 problems is also very likely.(3)

A. Legal and Statutory Framework

State corporation statutes (and interpretive case law) impose a fiduciary duty on directors and officers to act in the interest of the corporation. A director or officer may be held liable to the corporation (and its shareholders) for breach of such duties. (Note: directors and officers of parent and subsidiary corporations owe separate fiduciary duties to each entity.) A lawsuit against directors and officers may be brought by the corporation itself or by the shareholders of the corporation on behalf of themselves or on behalf of the corporation (derivative actions). There are, however, important substantive and procedural differences among the states as to the standards of care required of directors and officers, the imposition of liability, and the alternatives available to limit or indemnify directors and officers from liability. The discussion that follows is a general summary of the standards used by courts to find directors and officers personally liable, and alternatives available to directors and officers to limit such liability. We recommend that each individual director or officer review his or her relevant corporate charter documents, state law and any applicable insurance policies.

There are two distinct duties owed by directors and officers to a corporation: (i) the duty of due care, and (ii) the duty of loyalty. The duty of care is sometimes viewed as a procedural duty, and is most relevant to Year 2000 cases. Under the duty of care, a director or officer is required to exercise reasonable diligence and care in carrying out his duties to the corporation. The standard of care is determined by reference to similarly situated boards of directors. If the directors and officers follow (in good faith) an acceptable business process, they will be protected by the business judgment rule even if their decisions turn out to be wrong in hindsight.

Directors may escape or minimize liability for breach of their duty of care under the business judgment rule. Directors' "good faith" reliance on reports prepared by the corporation's officers, attorneys, accountants or other experts protect the directors for "honest" mistakes of business judgement. While directors are not required to be perfect in their decision making process, directors nevertheless should take care in hiring experts or consultants to remedy Year 2000 problems. However, directors cannot be passive in relying on experts and must conduct their own due diligence in informing themselves of the qualifications of experts and the merits of the business decisions. In sum, therefore, to cover all bases, directors both should educate themselves on the Year 2000 issue and engage qualified experts to develop a Year 2000 remediation plan. The biggest risk a director faces is failing to act, especially in light of the attention that the Year 2000 issue has been receiving in the national and trade press.

The duty of loyalty is more complex, and can be divided into three distinct areas in which directors and officers may be found liable: (i) self dealing, (ii) misappropriation of corporate or shareholder property, and (iii) approval of corporate action with mixed motives. At first glance, it seems hard to believe that a director or officer, absent a "bad" act, such as profiting from a remediation contract, could be found liable for a breach of loyalty claim as a result of his or her decisions on the Year 2000. Nevertheless, directors and officers are at risk because courts have interpreted the duty of loyalty in a broad manner and have found directors and officers liable for "not so bad acts" such as: (i) payment receipt of excessive compensation,(4) (ii) usurpation of corporate opportunity, and (iii) failure to approve or sufficiently analyze take-over bids.(5) Breach of duty of loyalty likely will be based on a director engaged in or approving a mixed motive transaction (director or officer benefits), or the misappropriation of confidential information regarding the corporation's progress on its Year 2000 plan. Since breach of loyalty cases are reviewed by courts substantively for fairness to the corporation, officers and directors may still be liable even if such transactions were approved by a disinterested board after full disclosure.

Possible problem areas involving a breach of a director's or officer's fiduciary duties that may arise as a result of the Year 2000 are summarized. These areas should be continually reviewed and monitored by directors and officers on an ongoing basis to minimize their risk of a shareholder suit:

Failure to Adopt a Remediation Plan - If a corporation's competitors are assessing and addressing the Year 2000 problem or if its competitors are already Year 2000 compliant, and the corporation is not, the corporation's directors and officers may have failed to meet the applicable standard of care. As result, they may be jointly and severally liable for breach of fiduciary duty.

Third Party Compliance - Directors and officers will need some insight into the financial and technical capabilities of "Mission Critical" third parties related to the Year 2000, including the following:

Key Suppliers - Directors and officers should determine whether the corporation's key suppliers are Year 2000 compliant, and whether their data interfaces are compatible with the corporation's so that a corporation's compliant systems will not be "reinfected" by a third party's failure to be Year 2000 compliant and/or to have compatible data.

Remediation Service Providers - The standard of care is also relevant in choosing Year 2000 remediation service providers, outsourcers and contractors. The number of Year 2000 vendors is increasing daily -- with many "fly-by-night" or inexperienced solution providers entering the market. Because the corporation has limited time to solve its Year 2000 problems, directors and officers should review the technical and financial capabilities of its Year 2000 vendors. The Information Technology Association of America ("ITAA") started a Year 2000 certification program in October 1996. The certification of a vendor by ITAA or some other credible entity will likely be some evidence of the vendor's capabilities (and director and officer satisfaction of their fiduciary duty).

Targets of Mergers and Acquisitions - The Year 2000 compliance of merger targets as well as joint venture partners should be reviewed to determine whether the corporation is receiving a "fair" deal. Suitable representation and warranties should be obtained from merger and joint venture candidates. Additional protections for the acquiring corporation may include performance bonds, exclusions of Year 2000 sensitive assets, or hold-backs on purchase price. Directors and officers of the acquiring and selling company are at risk for a breach of their duty of care (for not following an acceptable approval process), and a breach of their duty of loyalty (for receiving options, compensation, or profiting from the merger, etc.).

Profiting by Directors and Officers - There is some risk of lawsuits by shareholders and others in the event that directors and officers sell stock or receive excessive compensation. If a shareholder believes that he (or the corporation) suffered economically and a director or officer profited, a lawsuit or other claim is likely. Such a claim may be based on the belief that the director or officer used confidential information regarding Year 2000 problems.

2. Statutes of Limitations

The Delaware statute of limitations for bringing a derivative action is three years, unless the derivative action charges actionable self-dealing. Kahn v. Seaboard Corp., 625 A.2d 269, 274, 276 (Del. Ch. 1983). Under Delaware law, the statute of limitations begins to run when the action (or inaction) for the cause of action occurs. Nevertheless, the failure to take appropriate action to address Year 2000 problems may be viewed as an o0ngoing act. Additionally, bank directors and officers may be subject to a federal statutory look back by the FDIC under proposed amendments to the Financial Institution Reform, Recovery and Enforcement Act of 1989 ("FIRREA"). The proposed amendments are in response to Congressional disagreement with various recent court decisions holding that the FDIC and RTC were subject to state statute of limitations provisions. Under the proposed amendments, in the event of a bank failure, bank regula0tors are allowed to look back five years from the date that the financial institution fails in connection with a suite or claim against a director and officer for fraud, negligence or intentional misconduct.

FIRREA is directly relevant to bank directors and officers, but also should be viewed with concern by directors and officers of all other regulated industries. FIRREA was adopted in response to the last economic crisis: the savings and loan failures of the late 1980's. The pending Year 2000 crisis by all accounts will be larger; therefore, the cry for legislative action may be greater. On a final note, FIRREA also has lessened the level of misconduct necessary to impose director and officer liability from gross negligence under state law to simple negligence.(6) This substantive impact may create gaps in insurance and indemnity provisions, thereby leaving officers and directors exposed to personal liability.

3. Protection and Limitations on Liability

Generally, directors and officers are sheltered from liability for their acts under one of three alternatives: (i) indemnity by the corporation, (ii) state limitation of liability provisions or (iii) insurance. In response to the prevalence of shareholder suits against directors and officers in the late 1980's, many state legislatures expanded indemnification available to directors and officers and statutorily limited director and officer liability under certain circumstances. The following discussion focuses on Delaware's approach in limiting director and officer liability.

Many state corporation statutes either permit companies to elect to indemnify directors or require that corporations indemnify directors. Some state statutes do not cover officers at all. In some states, a corporation (by shareholder vote) must affirmatively elect to expand the indemnification of its directors and officers. A summary of Delaware's corporation statute follows:

i. Mandatory Indemnification - Delaware law mandates indemnification of a director or officer if such director or officer has been successful in an action brought against him either by a third party or the corporation. Thus, even if indemnification is not addressed in a corporation's certificate of incorporation or bylaws, the Delaware statute provides that the director or officer is entitled to be reimbursed for the cost of successfully defending an action, suit or proceeding on the merits. However, the director or officer must meet the following standards: he must have acted in good faith, and he must have acted in a manner he reasonably believed to be in, or not opposed to, the best interests of the corporation.

ii. Permissive Indemnification - Delaware broadly permits corporations to indemnify their directors and officers by a majority vote of the shareholders or as reflected in an agreement, or as provided for in the bylaws or the certificate of incorporation. Delaware law also makes a distinction between suits brought by third parties and suits brought "by or in the right of the corporation."

Third Party Suits - Delaware law allows the corporation to indemnify a director or officer for expenses (including attorneys' fees), judgments, fines and amounts paid in settlement, if incurred in connection with a suit or threatened third-party suit against him. In third-party suits, an adverse decision, a conviction, or a plea of nolo contendere will not alone create a presumption that the defendant failed to meet the statutory standards (due care). Thus, a corporation may still indemnify its directors or officers notwithstanding such dispositions if it determines that the directors or officers have met the required standards (due care).

Suits by Corporation - With regard to suits brought by the corporation, the Delaware statute only permits the corporation to indemnify directors and officers for expenses (including attorneys' fees) in connection with the defense or settlement of actions or threatened actions brought by the corporation. It does not provide for indemnification of directors or officers for judgments, fines, or amounts paid in settlement in connection with such actions. Moreover, Section 145(b) does not prohibit a court or corporation from finding that an adverse decision or plea of nolo contendere creates a presumption that the director or officer violated the statutory standards (due care). Therefore, the court or corporation may decide, based solely on such disposition, that such director or officer is not entitled to indemnification. Directors and officers adjudged liable to the corporation for a breach of duty may not be indemnified unless the court in which the suit is brought determines "in view of all the circumstances of the case, that such person is fairly and reasonably entitled to indemnity" for certain expenses.

4. Charter Provisions

The Delaware corporation statute limits the personal liability of directors only for monetary damages in suits alleging breach of fiduciary duty brought by the corporation and/or its stockholders. In order to avail themselves of this protection, the act or omission must not involve any of the following: (i) a breach of the director's duty of loyalty to the corporation or its stockholders; (ii) acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law; (iii) actions involving unlawful distributions; or (iv) any transaction from which the director derived an improper personal benefit.

5. Insurance

Generally, D&O insurance is effective when the corporation is sued, and the insurance protects directors and officers for negligent business decisions. Gross negligence is not protected. Thus, similar to the business judgement rule, directors' and officers' actions will be reviewed and compared with comparable actions of their peers. The failure of an entire industry to take remedial action does not, however, mean that all actions taken by the director or officer are covered.

D&O insurance policies generally carry a large deductible. Depending on an agreement with the corporation, the individual director and officer may be responsible for such a deductible. Although many directors and officers are covered by D&O insurance policies purchased by the corporation, there may be gaps in coverage that could expose the director or officer to personal liability. In addition, by the Year 2000, insurers may amend their standard form policy to exclude acts arising from the Year 2000 problem. Directors and officers should review the companies' policies carefully with a qualified insurance broker or attorney.

PRACTICAL STEPS

1. Adopt a Viable Remediation Plan

The Year 2000 plan, and any reports prepared by management or experts, should be specifically referenced in the corporations' minutes. A "clear paper trail" evidencing the analysis of the selection and hiring of vendors and consultants, and of merger and joint venture partners, should be maintained. Although a paper trail could contain embarrassing or damaging information that can be discovered in the event of litigation, this risk is outweighed by the risk of not being able to document or establish the diligence undertaken by directors and officers (and the corporation) to pursue a Year 2000 remedy.

2. Review Protection -- Review insurance, bylaws, and state-mandated and authorized protections to determine if there are any gaps in coverage.

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1. Although this memorandum discusses liability of directors and officers of corporations, similar standards are applicable to partnerships, limited liability companies and other entities with centralized management.

2. In addition to liability based on a breach of fiduciary duty under state law, directors and officers also may be liable under: (i) state and federal securities law for failure to report or disclose material financial conditions, and (ii) federal copyright law for contributory infringement in solving Year 2000 problems.

3. See FIRREA discussed in Section II(A)(3) herein. There is also proposed U.K. law requiring companies to develop a Year 2000 plan and requiring directors to disclose the details of their Year 2000 plan in an annual report. Under the U.K. proposal, directors are personally liable for failure to produce accurate reports.

4. Wilderman v. Wilderman, 315 A.2d 610, 615 (Del. Ch. 1974) (excessive compensation had to be reviewed procedurally and substantively; burden of showing reasonableness of compensation falls on director/recipient).

5. Revlon. Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A2,d 173 (Del. 1986); Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985).

6. Atherton v. Federal Deposit Insurance Corp., No. 95-928 argued 11/4/96 before the U.S. Supreme Court.

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