The liability of non-executive directors
A non-executive director is also called an external director, outside director or independent director. While they serve on the same level as an executive director, they contribute to the board from the perspective of an objective, independent and unbiased stance.
Non-executive directors aren't directly involved in management issues, which allows them the opportunity to focus solely on board matters. The larger the company, the more likely they are to have non-executive directors. About 65% of board directors are non-executive directors.
While non-executive directors have a role that's uniquely different from that of their executive director peers, they essentially share the same types of liabilities.
What Makes a Non-Executive Director Different From an Executive Director?
Executive directors are employees of the company and are part of managing the daily duties of the company. Non-executive directors aren't employees of the company and they're typically chosen because they have valued experience, specialized or industry knowledge, and personal characteristics and dynamics that fit with the rest of the board.
What makes the non-executive director role so important is that they give constructive and objective criticism and advice to the management team. Ideally, they should be challenging and analyzing management's performance. They also have much wisdom to offer regarding the board's strategy, resources, key appointments and code of conduct.
Non-executive directors have the same access to sensitive information as all the other directors, so it's important that they maintain a high level of confidentiality in their work and their communications.
Nearly all the rest of the board director duties for executive directors and non-executive directors are identical. Fiduciary duties are the most important duties for both types of directors. To that end, executive directors and non-executive directors have essentially the same liabilities.
Liabilities of Non-Executive Directors
Companies act through the directors and officers of the company. Executive and non-executive directors don't have to worry too much about liability as long as they perform due diligence in all their board duties. If they should be lax and not fulfill their duties and responsibilities appropriately, they could be held liable for any loss. The consequences for board directors can include loss of their board seat, fines and under the worst-case scenarios, prison time. Companies also have much to lose in the way of reputational loss if board directors are lax in their board duties.
To demonstrate the rarity of board director liability lawsuits, between 1980 and 2005, board directors had to make payments out of their own pockets that weren't covered by insurance, including legal fees, in only 12 cases.
Serving as a board director comes with many responsibilities. It's important that all directors understand and fulfill their responsibilities to avoid putting themselves and the rest of the board at risk of liability issues. Following are some areas that executive and non-executive directors need to be aware of:
State corporate laws weigh heavily on fiduciary duties, including:
- Duty of care: requires directors to make decisions as any reasonable person would.
- Duty of loyalty: requires directors to act in the best interests of the corporation.
- Duty of candor: requires directors to communicate all information to the shareholders.
- Duty of obedience: requires directors to be in compliance with laws and regulations.
The courts enforce state corporate laws. They can do this by an injunction, which is a court order that requires the board to stop certain actions. If the courts find that board directors failed in their duties, they can award damages requiring directors to pay for losses sustained, either individually or collectively.
Under the business judgment rule, the court will usually not contradict the board's decision under the following circumstances:
- The board can demonstrate that they followed a reasonable process.
- The board took key relevant facts into account.
- The board acted in good faith, which requires boards not to turn a blind eye to issues and to act without conflicts of interest.
Non-executive directors also have liabilities under federal securities laws, including:
- Directors have a legal obligation to disclose information to the public.
- Directors of public companies must follow the disclosure requirements as established by the SEC.
- Directors are required to disclose all material information that an investor would consider important in evaluating their investment decisions.
- The board should rely on internal and external auditors to ensure that information is accurate.
Board directors are subject to federal securities laws, which are enforced through private lawsuits and SEC actions. Investors may bring lawsuits against board directors if they feel they've been harmed by a violation of the securities laws. Non-executive directors may be found liable in a violation of securities law if they made material misstatements or omissions of material information, and the misstatement or omission was the cause of a loss. The misstatement or omission must be intentional or the result of recklessness to be valid.
There are a few standard ways that board directors can reduce the potential for personal liability. First, there is an exculpatory provision. This means that the company charter protects board directors from unintentional or negligent acts. The second provision that protects board directors is a term called indemnification. This means that there is an agreement between the company and its board directors that the company will pay for costs associated with lawsuits. There is usually a condition placed on this provision that the director must have acted in good faith. Finally, the most common protection for board directors is directors and officers insurance (D&O insurance). D&O policies are common policies for corporations and nonprofits of all types and sizes. Essentially, D&O insurance policies cover litigation expenses, settlement payments and sometimes damages as well.
One of the best defenses against liability that non-executive directors can have is a board management software system like Diligent Boards and Governance Cloud. Diligent Boards provides evidence that board directors are giving all issues the proper due diligence, which includes demonstrating that they don't have conflicts of interest, they acted in good faith, and they took key information and relevant facts into account. A board portal system also stores important documents such as D&O insurance policies and copies of all disclosures.
Liability allegations against non-executive directors don't occur often, but when they do, they can have a serious impact on all board directors and the company. A D&O insurance policy is a good start to director protection. Boards can boost insurance policies by implementing software solutions like Governance Cloud to ensure they're performing due diligence in every area of their board duties.