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Best Practices in Legal and Insurance Departments of Organizations

Legal Intelligencer

Much has been written about good corporate governance practices for boards of directors, particularly of public companies and not-for profit organizations. The author has written a 276-page book titled Corporate Governance Best Practice (John Wiley & Sons Inc., 2006). However, very little has been written about best corporate governance practices of lower level executives in charge of different departments of the organization.

The purpose of this article is to examine best corporate governance practices within two important departments of the organization, namely the legal and insurance departments. If there is no internal legal department, these best practices apply to outside counsel who acts as general counsel for the organization.

Legal

  • Major legal risks of the organization should be prioritized and methods of preventing or mitigating such risks developed proactively.

Legal risks are some of the major risks facing any organization. The board of directors or its audit or compliance committee must obtain an understanding of the major legal risks, including their priority against one another. Such review and prioritization is essential to assisting management and the board of directors in performing an enterprise management risk analysis.

It is not sufficient to wait until the risk results in a major law suit or other legal catastrophe for the organization. The board of directors and management must authorize the legal department to proactively develop methods or prevent or mitigating such risks.

  • The board of directors or its audit or compliance committee must be immediately informed of any major new legal risks or significant law suits.

Mechanisms must be established to keep the board of directors or its audit or compliance committee informed of new legal risks or significant law suits. Such information will assist them in making business judgments concerning issues facing the organization and will help them fulfill their duty of monitoring management.

  • The legal department should maintain an ongoing program to protect the organization’s property, as well as to obtain and enforce patents, trademarks, servicemarks and copyrights.

The intellectual property of an organization adds value to the organization and helps to protect it from competitors.

  • The legal department must review, on a periodic basis, the standard terms and conditions of purchases and sales, as well as how the purchasing and sales department forms contracts.

Laws and court decisions relating to purchasing and selling activities are constantly changing and may require changes in the standard terms and conditions of purchase and sales.

  • The legal department must be kept informed of all new marketing efforts so it can determine the legal risks and methods of mitigating those risks.

It is not unusual for an organization to undertake a marketing effort without fully understanding the legal risks involved. Open and frequent communication with the legal department will permit the organization to identify and ameliorate such risks.

  • The legal department should develop a record retention policy customized to the business of the organization, which should include a requirement to consult with the legal department prior to any document destruction.

All organizations should have a document retention policy, with specific times at which  documents should be destroyed. However, to avoid any possible charge of obstruction of justice, no document should be destroyed without a prior legal review to determine if there are any outstanding or threatening investigations that would require production of documents intended for destruction.

Under the Sarbanes-Oxley Act of 2002, any person who alters, destroys, mutilates, conceals, covers up, falsifies or makes a false entry in any record, document or tangible object with the intent to impede, obstruct or influence the investigation or proper administration of any matter within the jurisdiction of any department or agency of the United States or any Chapter 11 bankruptcy case shall be fined, imprisoned for up to 20 years, or both. This provisions applies to all organizations, whether public, private or not-for-profit.

  • Intellectual property assets of the organization (trade secrets, patents, trademarks, servicemarks, copyrights, logos, licenses, etc.) should be identified, classified and protected.

Intellectual property assets are financial assets of the organization and in many cases represent very valuable assets of the organization. Many companies identify, classify and protect their plant, property and equipment, but completely neglect their intellectual property. Public companies may have an obligation to also value such intellectual property.

Insurance

The following is a summary of the major best practices within the insurance department:

  • Only deal with insurance agents who maintain an errors and omission (E&O) insurance policy for the agency with sufficient coverage, and require the E&O carrier to give the organization notice of any changes in the E&O policy.

Insurance is typically purchased through an insurance agent. The insurance agent also provides significant advice to the organization on what policy to purchase, a summary of the terms of the policy, and recommends coverage. If a significant mistake is made by the insurance agent and the agent does not carry an adequate E&O policy, the organization will have no coverage for the losses caused by the agent’s error or bad advice. If the corporation deals only with large international insurance brokerage firms that have substantial net worth, an E&O policy is of less importance.

  • The amount of business interruption insurance to be covered by the organization and the risk covered should be carefully reviewed by the board of directors.

Insurance is the first line of protection against risk and must be considered when performing an enterprise risk management analysis. Business interruption policies are particularly important in hedging risk and must be carefully reviewed by counsel with experience on insurance coverage issues.

Inadequate coverage on a business interruption policy can be devastating to an organization. Disasters such as fires, floods or explosions can cause major problems to the continuation of a business, including loss of customers and key suppliers as well as loss of intellectual property. This coverage deserves careful review of the highest levels of an organization. Off-site storage is necessary to avoid destruction of records necessary to support a claim in case of a disaster.

  • In order to attract independent directors, the organization should maintain a director and officer liability policy with adequate coverage that should not be disclaimable by the insurer, at least as to innocent independent directors.

Competent independent directors may be unwilling to serve on the board of an organization that does not provide adequate insurance coverage. Some insurance companies have been attempting to rescind coverage after a claim has been made on the ground that the insurance application contained false financial information about the organization. Director and officer liability policies that prohibit disclaimer of coverage for innocent independent are available and should be purchased even though the premium cost is generally higher than disclaimable policies.

A D&O insurance policy typically consists of three parts: Side A coverage for directors and officers personally; Side B coverage for the corporation to the extent the organization is required to indemnify directors and officers under its bylaws; and Side C coverage for the organization’s own liability.

Board members should insist on Side A coverage, with coverage limits that are not tied to the limits of Side B or Side C. If a bankruptcy petition is filed with respect to the organization and there is no Side A coverage, a question arises as to whether the board members may still draw down on the policy to fund legal defense cost or to pay claims.

Several bankruptcy courts have raised the issue that director drawdowns on a D&O policy may be depleting an asset of the bankrupt estate of the corporation and, therefore, the bankruptcy court could enjoin the director drawdowns. Even the existence of a single combined coverage limit for both Side A and Side B (corporate reimbursement coverage) may result in delays in obtaining coverage for legal fees and expenses incurred by the director until bankruptcy court approval is obtained.

  • Directors should review with the insurance department what insurance coverages are available which the organization has elected not to purchase, including any endorsements that broaden coverage and those the organization elected not to purchase.

The cost of insurance must be weighed by the directors against the benefit of covering specific organizational risks. In order to keep the directors informed as to what cost benefit decisions have been made, the insurance department should advise the directors as to what coverages are available that the organization elected not to acquire.

Likewise, the insurance department should advise the directors as to what endorsements to existing policies are available which broaden coverage. The decision not to broaden coverage with such endorsements should also be discussed at the board level.

  • An attorney and insurance consultant should periodically review the adequacy of the organization’s insurance coverage and the adequacy of the documentation needed to support a plan.

The person within the organization in charge of purchase insurance coverage is usually under significant pressure to lower insurance costs. This cost pressure may lead to purchasing inadequate insurance coverage or utilizing insurance companies which do not have the financial strength to respond to claims. A good example of this phenomenon was the insolvency of Reliance Insurance Company, which issued a significant amount of director and officer insurance policies at low prices in order to obtain market penetration, and subsequently defaulted.

One should view an insurance policy as the right to sue the insurance company and not necessarily a guarantee of coverage. Since major organizational risks are insured, it is extremely important that, as part of enterprise risk management analysis, there be a review by an insurance coverage attorney and an insurance consultant as to the adequacy of coverage.

Of particular importance are endorsements that are available to the organization but that have not been purchased as part of the policy, as well as the insurance company’s financial strength.

Conclusion

The legal and insurance departments of corporations perform vital functions within the organization and must themselves use best corporate governance practices. These departments play key roles in enterprise risk management analysis that must be performed by the board of directors of all organizations.

Reprinted with permission from the November 17, 2008 edition of the Legal Intelligencer © 2008 ALM Properties, Inc. All rights reserved. Further duplication without permission is prohibited.