7 Legal Questions to Ask about Serving on a Board

Here are seven key questions that people who are considering joining a board should ask their attorneys. Sitting directors can use the questions as a checklist to gauge what to demand from a company to stay on its board.

1. Are my assets covered? No question is likely to be more important than this one, regardless of how diligent and honorable a director, other board members, and company officers may be. The answer will determine how well a director is protected if sued. You don’t have to lose a case to need such coverage; it costs money to defend even the most frivolous lawsuit. “You have two protections between the plaintiffs’ bar and your house and the assets you want to leave for your children,” cautions R. Mark Keenan, co-chair of the financial services insurance coverage group at Anderson Kill & Olick in New York City. “One is the indemnification agreement from the company you work for, and the other is your D&O policy.” You should not rely on the in-house corporate legal staff to review them for you, he says: “If you’re an independent director, definitely get your own adviser. You want 100% of their loyalty to you.”
   
   An indemnification agreement is a contract between a company and a director. It specifies that the company will compensate the director for any costs incurred in defending against a lawsuit or similar complaint, or in settling such an action, provided the director has not committed fraud or been found grossly negligent. Of course, a company’s promise to indemnify its directors could be compromised if the company became insolvent, perhaps owing to the very activities that provoked the lawsuit. That’s one reason most outfits also carry directors’ and officers’ insurance; it passes the risk and responsibility for indemnification on to a third party.
   
   Unfortunately, merely knowing that a company provides D&O insurance isn’t enough. Directors should also want to know what exclusions are in the policy and whether the amount of D&O coverage is appropriate for the company’s size and the risks inherent in its line of business. If you’ve exercised all the diligence that you can as a board member and a plaintiffs’ attorney decides he’s going to sue you anyway, the clauses in your D&O policy had better not have loopholes that force you to finance your defense on your own. Uncomfortable with a company’s D&O coverage? Consider spending some of your own money on supplemental liability insurance.
2. Are the fuzz snooping around? Clearly, a company being probed for suspected wrongdoing poses an immediate risk to prospective directors. Your lawyer will have the staff, time, and resources to ferret out investigations that are under way but haven’t yet been announced or hit the media. “I use the term ‘investigation’ very broadly,” says Ira Raphaelson, a partner at O’Melveny & Myers. “It would include investigation by federal law enforcement and federal regulators—not just criminal, civil, or administrative investigations—as well as investigation by state attorneys general.”
   
   What if you’re already on a board and get wind of a pending investigation into the company? In that case, better consult your personal attorney. Rick Miller, an attorney at Powell Goldstein Frazer & Murphy in Atlanta, advises sitting directors not to walk away. “If you have liability, just bailing off the board isn’t going to get you unstuck,” he says. “The best thing you can do under those circumstances is stay the course and exercise your duties to the fullest extent.” Your attorney can help you decide what notes to take, what documents to save, what objections to raise, and what statements to put on record in the board-meeting minutes in order to best protect yourself.
3. Will I wake up in the morning and regret the company I’ve kept? The integrity of a company’s officers and board may be the most important factor in limiting risk for individual directors. To be sure, you could do background checks yourself. Most federal court records are accessible to the public at the PACER website run by the Administrative Office of the U.S. Courts, and news of criminal investigations by the Department of Justice and the SEC can be found at their respective websites. But you’re better off turning the task over to the pros. Your lawyer will know who they are. The investigators law firms use have sources and contacts that go beyond the public domain, and you can take what they turn up into account before deciding whether to join a board. If you’re already on a board and aren’t comfortable with the background data you’ve been given about a prospective director or company executive, you may want to ask your attorney to run an independent check. More than a hangover is at stake here, if you get mixed up with the wrong crowd.
4. Does the company give good governance? Again, this is something you can do yourself, but it’s wise to play safe and ask your lawyer to go over the company’s governance bylaws. Do they include guidelines specifying what qualifies a director as independent? Do they mandate that the board have a corporate governance committee? Does the company have a code of ethics, and if so, does it communicate that code in a meaningful way throughout the organization? Does the company spell out its whistleblower policy and the role of directors under that policy, as it should to comply with Sarbanes-Oxley? Any answers in the negative should give you pause if you’re considering getting on the board. If you’re a sitting director, “no” answers should make you demand reform.
5. Am I walking into another Enron? Enron’s downfall came largely from deals that didn’t show up on the balance sheet. “If there are a significant number of [such] related-party transactions, that’s a bit of a warning flag,” says Foley & Lardner’s Steven Barth.
   
   The challenge is to find out about such deals if the company or its top executives fail to disclose them. Attorney Martin Bring, chairman of the corporate group at Anderson Kill & Olick, says new disclosure requirements in Sarbanes-Oxley improve the odds that companies will spell out their off-balance-sheet activities. But directors or prospective board members who remain worried should quiz the company and its auditors directly, or have their attorneys do so. If you don’t get your questions addressed to your satisfaction, you should reconsider the matter of joining the board, says Bring. If you’re already a director and your questions aren’t satisfactorily answered, you should take your concerns to the full board. With your attorney’s help, you might want to put all your questions about related-party transactions in writing and request that the company respond in kind. Doing that, Bring says, would help you avoid being implicated in the event of an Enron-like fraud. “If a director documents the due diligence he’s done—and doesn’t find these things out because the company doesn’t tell him, even though he’s asked the right questions—his liability is going to be very limited,” says Bring.
6. What booby traps are waiting for me in the footnotes? You should read these as carefully as you read all other financial data the company puts out. “Just by reading the footnotes to the financial statements, you can learn a lot—if there’s been appropriate disclosure,” Barth says. Warning signs include references to significant amounts of off-balance-sheet debt or any litigation that puts the company at significant risk.
7. Are there any pending suits that can cost the company and me money? When HealthSouth Corp. was getting hit with a passel of shareholder lawsuits earlier this year, its name dominated business news headlines for weeks amid allegations that the health-care company had overstated profits by more than $1 billion since 1999. But most outfits don’t generate that much ink when they get sued—which is why it makes sense, before joining a board, to ask your attorney to check for and evaluate lawsuits against the company. Before re-upping as a director, you should also ask him or her to check out outstanding lawsuits against the company to see how damaging they might be. Top management could give you such information, but better play safe and use a lawyer.

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