KARLSRUHE, Germany-Directors of German companies are required to pursue damages if aware of criminal or negligence activity by company executives, or risk being sued themselves, following a recent decision from the German Supreme Court.

This and other court decisions in the past year are expected to boost demand for directors and officers liability insurance in Germany.

In last week's ruling, the Supreme Court, or Bundesgerichtshof, held that a board of directors was required to sue a top executive for damages when the directors knew about negligence by the executive in failing to stop an illegal activity.

The ruling overturns a state court decision in a case involving the board of directors and former chairman and chief executive of ARAG Rechtschutzversicherungs A.G., a leading German legal expense insurer in Dusseldorf.

The executive allegedly had knowledge of but did not stop illegal financial transactions made by a former chief financial officer, court papers show. The former CFO had invested in securities without authority and was eventually sentenced to 41/2 years in prison.

Initially, a majority of the ARAG board of directors had voted not to seek 55 million DM ($32 million) in damages-the amount lost that could not be recovered-from the chairman and CEO.

As CEO, the executive was responsible for the company's management and therefore allegedly was negligent for failing to halt the CFO's illegal transactions, according to court papers.

In 1995, though, dissenting board members brought the case before a state court. The dissenting members sued the board of directors for not taking action against the executive. The state court ruled the board's decision was an internal matter for the board to decide.

That court held that Germany's judicial system is responsible only for determining the legality of boards' actions, not reviewing the appropriateness of directors' business decisions.

On appeal, the German Supreme Court overturned that decision, saying the case involved allegations of illegal activity and therefore was not an internal matter to be settled by the board of directors. The Supreme Court's ruling means the board now will have to sue the CEO for damages, which it already has done. If it had not done sue, the board would be exposed to suits from shareholders or objecting board members alleging negligence on the board's part.

Legal experts say the ruling inevitably will have wide-reaching effects on German corporations.

"The liability of boards of directors was never really spelled out in the past," said Friedrich Graf von Westphalen, a corporate defense attorney based in Cologne. "Now it is clear" that boards of directors must seek to recover damages when aware of negligence by executives or else risk being liable for the damages themselves.

Because of this and other recent decisions increasing potential liability exposures for corporate actions, demand for D&O coverage in Germany has skyrocketed, says Ulrich Reinholdt, executive vp of European operations of American International Group Inc. in Frankfurt. "Demand is driven by serious, real concern" about the liability climate for directors and officers, he said.

The Supreme Court ruled earlier this year, for example, that employers in financial trouble could face criminal charges and fines if they do not pay social insurance premiums before other debts (BI, March 10).

Germany's changing business climate also is responsible for the increased demand, said Mr. Reinholdt. "There's a heightened awareness that errors are costly and errors are being made. More than ever, that is coming to light."

As an example, Mr. Reinholdt cited a recent failed hostile takeover effort by steelmaker Krupp A.G., which could increase its exposure to lawsuits by shareholders.

"When such steps become questionable, shareholders get nervous. It's the kind of situation that has radically changed the attitudes about D&O in Germany," he said.

Mr. Graf von Westphalen says a change in the German court system is also responsible.

"The attitude is that shareholders have certain rights that must be upheld. That is far-reaching. The freedom of directors and officers to act is more limited and the liability for actions increased."