The D & O Diary : Directors and Officers Liability and Insurance : The D & O Diary : Kevin LaCroix : Securities Laws, Corporate Fraud, D & O Litigation

Lee Farkas, the criminally convicted former Chairman and majority shareholder of  the defunct Taylor Bean and Whitaker Mortgage Corporation, must repay the nearly $1 million in defense fees the company’s D&O insurer had advanced on his behalf, according to an April 11, 2013 Fourth Circuit opinion. The terse three-page appellate opinion adopts the ruling of the lower court, holding that Farkas’s criminal conviction triggered the D&O insurance policy’s “in fact” conduct exclusions which in turn triggered the insurer’s right to recoup the defense fees it had previously paid. The Fourth Circuit’s opinion can be found here, and the March 21, 2012 district court opinion, which the appellate court affirmed, can be found here.

Background

In June 2010, Farkas was indicted on multiple counts of committing and conspiring to commit bank, wire and securities fraud. On April 19, 2011, a jury found Farkas guilty of all 16 counts of fraud and conspiracy to commit fraud. As detailed here, Farkas was, among other things, alleged to have conspired with employees of the failed Colonial Bank to sell the bank approximately $400 million of mortgage assets that had no value. Taylor Bean was also alleged to have engaged in numerous other transactions with the bank that had no value. The bank’s collapse followed after the fraudulent scheme unraveled.

After he was indicted, Farkas sought to have his criminal defense fees paid by the company’s D&O insurer. With bankruptcy court approval, the D&O insurer advanced $928,977 toward Farkas’s defense. Farkas incurred significant additional defense expenses, and the carrier’s request for the bankruptcy court’s leave to pay those additional amounts was pending when the jury returned the guilty verdict. Following the verdict, the carrier informed Farkas that, as a result of the verdict and in reliance on the policy’s conduct exclusions, it would no longer fund Farkas’s defense costs, and it reserved its right to seek recoupment from Farkas of the amounts it had previously advanced.

Farkas filed an action in the Eastern District of Virginia seeking a judicial declaration that the jury verdict did not terminate the insurer’s defense obligation, and that in any event all of the fees he had incurred prior to the jury verdict must be paid. The D&O insurer filed a counterclaim seeking a judicial declaration that Farkas was not entitled to coverage under the policy and that Farkas was obligated to repay the amounts the insurer had previously advanced. The parties cross-moved for summary judgment. In her March 21, 2012 opinion, Eastern District of Virginia Judge Leonie Brinkema granted the insurer’s motion for summary judgment. Farkas appealed.

In arguing that as a result of the jury verdict coverage for Farkas’s criminal defense fees was precluded under the policy, the insurer relied on the policy exclusion specifying that “The Insurer shall not be liable to make any payment for Loss in connection with a Claim against an insured …arising out of, based upon or attributable to the committing in fact of any criminal, fraudulent or dishonest act, or any willful violation of any statute, rule or law.”

In seeking to have Farkas repay the amounts that it had advanced, the insurer relied on the language in the policy specifying that “advanced payments by the Insurer shall be repaid to the Insurer by the Insureds or the Company, severally according to their respective interests, in the event and to the extent that the Insureds or the Company shall not be entitled under the terms and conditions of this policy to payment of such Loss.”

The Fourth Circuit’s Opinion and the Ruling Below

On April 11, 2013, in a terse three-page per curium opinion, a three-judge panel of the Fourth Circuit affirmed the district court’s ruling. The appellate court said that “having carefully reviewed the briefs, record and appellate law, we affirm for the reasons stated by the district court in its thorough opinion.”

In her March 2012 opinion, Judge Brinkema had granted summary judgment for the D&O insurer, finding that the jury verdict in the criminal case represented an “in fact” finding that triggered the conduct exclusion; rejected Farkas’s argument that he was entitled to the payment of the defense costs incurred by not yet paid before the verdict was returned; ruled that the insurer was entitled to recoup from Farkas the defense cost amounts it has advanced prior to the verdict; and rejected Farkas’s argument that the district court should stay its ruling while Farkas’s criminal appeal was pending. (Farkas’s criminal conviction was in any event subsequently affirmed.)

In ruling that the jury verdict triggered the policy’s conduct exclusion, Judge Brinkema stated that “there can be no reasonable dispute that the jury verdict here is an objectively verified and pertinent factual finding.” She added that none of the courts that have held that an “in fact” wording in a policy exclusion requires a final adjudication had defined a final adjudication as an appeal. She concluded that “there is simply no support in the case law for plaintiff’s position that a jury verdict does not trigger the ‘in fact’ requirement in the exclusion.”

With respect to Farkas’s contention that the insurer should at least pay the defense costs he had incurred but that the insurer had not yet paid when the verdict was returned, Judge Brinkema said that Farkas’s argument “ignores the consequence of a particular claim being excluded.” Farkas’s conduct “was never actually covered under the Policy, and he was therefore never entitled to the monies advanced to him.” Pursuant to the policy language, the insurer, she found, “has the right to seek recoupment of any costs that it advanced before it determined that an exclusion applied.”

Discussion

The question of an insurer’s right to seek recoupment of advanced defense expenses is a recurring topic. As I have previously noted (here), although D&O insurers frequently assert their right to seek recoupment, it is still relatively rare for the insurers to actually do so. Among other reasons why the insurers rarely seek reimbursement is that it is relatively unusual for a D&O claim to proceed to the point that there has actually been a factual determination triggering an exclusion. Indeed, one of the many reasons why civil claims triggering D&O coverage frequently settle is that an insured defendant would risk a factual determination that might preclude policy coverage if the defendant were to press the case forward rather than settle.

This case’s criminal context obviously presents a different set of circumstances than does a civil case. A criminal defendant does not have the option of a pre-trial settlement that avoids a potentially coverage precluding outcome.

Just the same, the coverage outcome here is also due in part to an unusual feature of the policy at issue According to the court record, the D&O insurance policy at issue here was first issued to the Taylor Bean firm in 2008 and subsequently extended by endorsement. Even in 2008 it was standard for most D&O insurance policies to be issued with the “final adjudication” wording, rather than the “in fact” wording. With the final adjudication wording, the preclusive effect of the conduct exclusion does not apply under there has been a final judicial determination that the precluded conduct has occurred. The presence of the “in fact” exclusion language in the Taylor Bean policy is an anachronism that is unexpected and frankly a little bit surprising.

Because the policy had the “in fact” exclusionary language, Judge Brinkema had little trouble concluding that the jury verdict precluded coverage. Had the policy had the now-standard “final adjudication” language, the parties would then have had to argue about whether or not the criminal judgment against Farkas was “final” while his appeal was pending. I am well aware that there is extensive case law on the question whether or not a district court judgment if final and enforceable while an appeal is pending. But if the policy had contained the “final adjudication” language rather than the “in fact” language, Farkas might have had a better argument that the insurer was obligated to continue to advance his defense fees unless and until the conviction was affirmed.

It is worth noting that these circumstances demonstrate why the preferred exclusionary trigger is not just the “final adjudication” wording but rather the “final non-appealable adjudication” formulation. If the policy had the “non-appealable adjudication” wording, the insurer here would have been obligated not only to advance the amounts Farkas had incurred prior to the verdict but that the insurer had not yet paid, but also to continue to advance his defense expenses for his appeal. Farkas would have been able to continue to use his preferred counsel through his appeal (rather than, as Judge Brinkema noted, counsel appointed for him under the Criminal Justice Act). Farkas may well feel that the appeal might have turned out differently if he had been able to rely on his preferred counsel. I know for sure that if it were me, I would certainly want to be able to use my preferred counsel while appealing a criminal conviction.

The fact that Farkas had to rely on appointed counsel for his appeal suggests that he did not have resources of his own to rely on -- which begs the question of why the carrier went to the trouble to obtain an order requiring Farkas to repay the advanced amounts. I mentioned at the outset of this discussion that it is relatively rare for carriers to seek recoupment of advanced amounts, and among other reasons why it is rare is that often there is no point for the carrier to seek recoupment because usually by the time a serious D&O claim has concluded, the defendant is usually broke – which seems to be the case here, which in turn begs the question why the carrier even bothered to pursue a recoupment order.  It probably is worth noting in that regard that the D&O insurer did not initiate the coverage lawsuit here, Farkas did. The carrier only sought recoupment in its counterclaim, after Farkas had sued the insurer. Whether the carrier ultimately will recover anything under the recoupment order is a different question.

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The modern public company D&O insurance policy provides coverage not only for the directors and officers of the company but also for the company itself – however, in the public company D&O insurance policy, the entity coverage applies only to securities claims, a limitation that sometimes leads to disputes whether or not a particular matter constitutes a securities claim.

A recent decision from the Central District of California took a look at whether the claims against a mortgage originator and securitizer involving the company’s issuance of mortgage-backed securities constituted a “Securities Claim” within the meaning of the company’s D&O insurance policy. In her February 26, 2013 order (here), Judge Josephine Tucker held that the claims were not “Securities Claims” within the meaning of the D&O policy and therefore that the insurer did not have a duty to advance defense costs.

Background

Until 2007, Impac Mortgage Holdings funded, sold and securitized residential mortgages. A unit of the company acquired mortgages that another company unit originated. The acquired mortgages were placed in a trust, which in turn issued certificates that were issued to an underwriter which then sold them to investors.

The coverage dispute relates to three separate claims that were asserted against Impac and its related entities. First, in April 2011, the Federal Home Loan Bank filed a state court complaint against Impac alleging unfair and deceptive acts as well as false and misleading statement in connection with the sale of the certificates. Second, in May 2011, Citigroup filed an action in the Central District of California against Impac, alleging violations of Sections 18 and 20 of the Securities Act of 1934, as well as negligent misrepresentation in connection with the Citigroup’ s purchase of certain other certificates. Finally, in April 2010, the Federal Reserve Bank of New York sent a letter to Impac referencing a dispute concerning priority of payments under four Impac securities offerings.

Impac submitted all three of these matters to its D&O insurer, seeking to have the insurer advance defense costs for all three matters and contending that all three arose out of Impac’s mortgage-backed securities business. The insurer denied coverage for all three claims and Impac filed an action against the D&O insurer, seeking a judicial declaration that the insurers ha a duty to advance defense costs. The parties cross-moved for summary judgment.

In pertinent part, the D&O insurance policy defined the term “Securities Claim” to mean a claim made against an insured:

(1) alleging a violation of any federal, state, local or foreign regulation, rule, or statute regulating securities …which is

(a) brought by any person or entity alleging, arising out of, based upon or attributable to the purchase or sale of or offer or solicitation of an offer to purchase or sell any securities of an Organization;

The February 26 Ruling

In her February 26, 2012 order, Judge Tucker denied Impac’s motion for summary judgment and granted the D&O insurer’s summary judgment motion.

The D&O insurer had argued that the phrase “securities of the Organization” in the policy’s definition of the term “Securities Claim” referred to Impac’s own securities. Impac urged that the phrase had an additional meaning extending it to the mortgage-backed securities at issue in the underlying disputes. Impac argues that the term securities “of” the company encompasses securities that were possessed, connected or associated with the company.

With respect to Impac’s interpretation of the definition, Judge Tucker said:

The fact that it would be “semantically permissible” to interpret the Policies’ language as extending coverage to securities Impac bought, sold or was involved in the creation of is not sufficient to create coverage where none would otherwise exist. Rather the court must interpret the disputed language in context, w with regard to its intended function in the policy. Here, Impac has provided no admissible evidence that such an interpretation gives effect to the mutual intention of the parties. (Citations omitted)

Judge Tucker went on to note that Impac’s proposed interpretation “would require the phrase ‘securities of’ to carry multiple meaning within one policy definition.” She added that in the context of the full definition and policy, “the phrase ‘securities of’ makes sense only in reference to the securities of Impac itself.” She added that by ascribing multiple meaning so the phrase, “Impac’s construction would result in the provision of vastly broader coverage when the insured happens to engage in the business of securitizing mortgages and would cause a traditional D&O Policy for those particular companies to become a defacto E&O policy, i.e., a professional liability policy for entities.”

Judge Tucker also concluded that coverage was precluded by the D&O policy’s Error and Omissions Exclusion, precluding coverage for the company’s “performance of (or failure to perform) any professional services.” She noted in that regard that Impac had asserted against the co-defendant in the action – that is, Impac’s E&O insurer – that the underlying claims do arise out of the provision of professional services.

While she concluded that coverage was precluded under the D&O policy’s Errors and Omissions exclusion, Judge Tucker did rule in Impac’s favor ruling in a separate February 26, 2013 order (here) in Impac’s separate action against its E&O insurer. She held that that Impac’s securities transactions constituted professional services under the E&O policy. The parties had disputed whether the underlying claims, which related to Impac’s securitization of mortgages, arose out of Impac’s “performance of or failure to perform professional services for others.” The E&O policy defined Impac’s profession as “mortgage banker/mortgage broker.” Judge Tucker concluded that “the undisputed facts support the conclusion that the securitization was a central element in Impac’s mortgage banking/brokerage business.”

She also found that an exclusion cited by Lloyd’s was too ambiguous to warrant a denial of coverage. (The exclusion on which the E&O insurer had sought to rely excluded coverage for (1) “the depreciation (or the failure to appreciate) in value of any investment transaction” or (2) “any actual or alleged representation, advice, guarantee or warranty provided by or on behalf of an Insured with regard to the performance of any such investment.”)

Discussion

Like many coverage disputes, the dispute here over whether or not the claims at issue were or were not “Securities Claims” came down to an interpretation of the specific policy language at issue. But even without reference to the specific provisions in the policy, it would have represented an unexpected result for a company’s D&O insurance policy to pick up coverage for claims brought against it for its activities as a mortgage securitizer. As Judge Tucker correctly concluded, to do so would require the D&O insurance policy to provide coverage for the company’s delivery of professional services and would thereby convert the policy into an E&O insurance policy – when in fact the D&O policy carried an express exclusion of coverage for claims arising from the delivery of or the failure to deliver professional services.

In a Monday morning quarterbacking kind of a way, I find it irresistible to note that the extent of the policy’s coverage would have been clearer if the policy had not only generally excluded coverage for claims arising from the delivery of professional services but also expressly precluded from the definition of securities claim the company’s issuance of securities as part of its business as a mortgage securitizer.

While I don’t have a problem with Judge Tucker’s interpretation of the policy here, there are other gray areas that arise from time to time with respect to the extent of D&O insurance coverage for securities claims. There are claims that can arise when a company is hauled into a lawsuit alleging violations of the securities laws when the specific securities at issue may not be those of the insured company.

A couple of examples come to mind: say, for example, when the insured company has spun out one of its divisions as a stand alone, publicly traded entity, and the separate entities file claims not only against the new company but out of the predecessor firm as well. (For an example of this kind of claim, refer here). Another example is an aiding and abetting type lawsuit; say, for example, an insured company is alleged to have violated the securities laws by aiding another company misrepresent its financial condition (sure, private claimants can’t assert these kinds of claims under the federal securities laws, but the SEC can, and private claimants could assert their claims in reliance on state law liability theories). A D&O insurance policy limiting “Securities Claims” solely to claims relating to securities “of” the company arguably might preclude coverage for these claims. For that reason, I have preferred definitions of the term “Securities Claim” that extends coverage to any claim alleging a violation of the federal securities laws or state or local equivalents.

From the factual allegations in the Impac case, I can now see (from the carrier’s perspective), at least one flaw with a definition of the term “Securities Claim” that would extend coverage to any alleged violation of the securities laws. If Impac’s D&O policy had included this “any violation of the securities laws” formulation, the policy might well have picked up coverage for the claims against Impac arising from its mortgage securitization activities, which is a result I am certain that the D&O insurer did not intend here.

Recognition of this potential shortcoming to the “any violation of the securities laws” formulation suggests a need to devise a new formulation, one that would not hazard the kind of unintended result I noted in the preceding paragraph. My current thought is that perhaps the “any violation of the securities laws” formulation could include a provision expressly precluding coverage for the company’s issuance of securities other than its own securities.

This is the kind of topic that I think would benefit from a more thorough discussion. I welcome readers thoughts on this topic, under the heading – “toward a more perfect definition of the term ‘Securities Claim’.”

One final note for practitioners. In her analysis of the D&O policy, Judge Tucker correctly determines that traditional “duty to defend” case law and policy interpretation principles do not apply to a “duty to advance” D&O insurance policy. Those involved in litigating defense expense issues in the context of a D&O insurance policy may find her discussion of these issues useful.

A Stray Thought about Current Events: Pope Benedict has now moved on to his new life as Pope Emeritus. He undoubtedly hopes he can look forward to a life of quiet contemplation. Everyone here at The D&O Diary wishes him well. Whatever may lie ahead for him and for the Catholic Church, we can all be sure that Benedict will avoid the fate of one of his predecessors, Pope Formosus, who died in April 896 at the age of eighty-one after a five year papacy.

As described in Paul Collins’s recent book, The Birth of the West, a one-volume history of the nascent beginnings of modern Europe in the Tenth Century, following the death of Pope Formosus, his successor, Pope Stephen, convened what has become known as the “Cadaver Synod.” Ten months after Pope Formosus died, and under pressure from local magnates, Pope Stephen had his predecessor’s corpse exhumed, dressed in pontifical robes, and placed in a bishop’s chair to be tried for heresy. With troops surrounding the city, the terrified bishops called to pass judgment quickly found Formosus guilty of violating church law. All of his papal acts were declared void and his dead body, stripped of the papal robes, was reinterred as a layman in unconsecrated ground.

If Pope Stephen hoped this macabre ceremony would preserve peace, he was mistaken. Collins notes that “the Cadaver Synod marked the beginning of some of the worst internecine civil strife in the history of papal Rome.” All of this took place at a time when Europe was beset with recurring invasions from Vikings, Magyars and Saracens.

For those who are worried that the current Catholic Church faces challenges, well, things have been worse. Yet it was from this chaos that the rudiments of modern Europe slowly emerged. In any event, here’s hoping that the upcoming papal transition be smoother than some of those in the past have been.

Speaker’s Corner: On March 19, 2013, I will be speaking at a panel at the C5 Forum on D&O Liability Insurance in London. I will be participating on a panel entitled “The Impact of Increased Regulatory Oversight and Regulatory Investigations.” The panel will include my good friends Helga Munger of Munich Re, Cristiana Baez-Safa of XL and Ralf Rebetge of Chubb. The C5 Forum, which is excellent every year, includes a number of interesting sessions and an outstanding line up of speakers. Conference information, including registration instructions, can be found here. If you are planning on attending, I hope you will make a point of greeting me at the conference particularly if we have not previously met.

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In addition to indemnification, corporate directors and officers also may have the right under applicable law and corporate by-laws to have their costs of defense advanced before the ultimate right to indemnification has been determined. A question that often arises is whether a corporation may withhold advancement. A recent decision from the Ontario Superior Court of Justice determined that a corporation did not have to advance the costs certain former directors and officers had incurred in defending claims the corporation had filed against them. The decision is clearly significant for directors and officers of companies in Canada, but it also provides an interesting context within which to consider the limits of advancement rights here in the U.S. as well. A copy of the September 28, 2012 decision can be found here.

Background

Look Communications is a technology company organized under the Canadian Business Corporations Act (CBCA). Its business fortunes faltered and its board ultimately approved a sale of its assets through a court-supervised process. Following the sale, the board authorized the payment of bonuses to certain officers and directors and also allowed corporate officials to receive compensation for the cancellation of certain stock option and other equity rights. Altogether the company paid over $20 million in bonus compensation and in compensation for the options and equity rights, representing about 32% of the asset sale proceeds.

After the award of the bonuses and other compensation was disclosed, shareholders filed significant objections. The board authorized the payment of $1.5 million in retainers to law firms acting on behalf of the directors and officers, who then resigned once the retainers had been paid.

In July 2011, after an investigation by Look’s new management, Look commenced an action against the former directors and officers alleging that the individuals had breached their fiduciary duties and seeking repayment of the bonuses and equity cancellation payments. The individual defendants, in reliance on the company’s by-laws as well as a written indemnification agreement, demanded that the company advance their expenses incurred in defending against the company’s lawsuit. The company refused and the individuals filed separate actions seeking judicial declarations of their advancement and indemnification rights.

Under Section 124 of the CBCA, a company may indemnify its directors and officers for legal proceedings in which the individuals become involved as a result of their association with the company, as long as the individual seeking indemnification “acted in good faith and with a view of the best interests of the corporation.” Look’s by-laws made these permissive indemnification rights mandatory. A separate indemnification agreement required Look to advance legal costs in any proceeding, including one brought by Luck itself, subject only to an obligation to repay if a court determined that the individual was not entitled to indemnification.

The former directors and officers argued in reliance on the by-laws and indemnification agreement that they were entitled to automatic advancement of their defense fees; that they were also entitled to a presumption that they had acted in good faith; and that their ultimate entitlement to indemnification could only be determined after a full evidentiary trial.

Look argued in reliance on Section 124(4) that a corporation is permitted to advance defense fees only “with the approval of the court,” which, Look argued, required the court to assess the parties’ conduct to determine whether the persons seeking advancement had acted in good faith. Look further argued that the individuals had not acted in good faith and were not entitled to advancement and submitted affidavits and other materials in support of this position.

The Court’s Ruling

In his September 28, 2012 opinion, Justice Laurence A. Pattillo noted the court’s critical supervisory role in the statutory indemnification scheme, observing that “in my view, requiring the court to scrutinize indemnification and advances in circumstances where a corporation has sued its former directors and officers ensures corporations cannot arbitrarily avoid indemnity and advancement obligations to former directors and officers who have acted in good faith and in the best interests of the corporation, while at the same time ensuring that directors and officers who have not so acted cannot further harm the corporation.”

Justice Pattillo further observed that the court’s supervisory role still obtained notwithstanding the fact that the parties had a written indemnification agreement that made the rights to advancement automatic. He said that just as a corporation cannot indemnify a director or officer if the statutory requirement of good faith conduct has not been met, “neither ... can they contract to exclude the court’s discretion to approve advancement.”

Justice Pattillo further concluded that the court approval specified under Section 124(4) requires the consideration of evidence. Because the directors and officers are entitled to a presumption that they acted in good faith, the burden is on the corporation seeking to avoid advancement to establish a “strong prima facie case” that the statutory standard has been met.

Based on the affidavits and other material Look submitted, Judge Pattillo concluded that Look had presented sufficient evidence that all but one of the individuals seeking advancement had acted in bad faith, in their own self interest and not in the best interest of the company, and therefore were not entitled to advancement.

Discussion

This case represents an unusual circumstance where a corporation was able to avoid its obligation to advance defense expenses of its directors and officers. It is, however, a reflection of both the unusual factual circumstances and the particular features of the applicable Canadian statutory provisions. The indemnification provisions in the Delaware Corporations Code (which governs the many U.S. corporations incorporated in Delaware) do not contemplate the same level of judicial supervision that the court exercised here. Indeed, Justice Pattillo specifically declined to consider Delaware case law, notwithstanding the fact that Delaware courts are “well regarded in this area of the law,” noting that the Delaware statutory provisions “contain no statutorily imposed conduct requirement.”

The outcome is also a reflection of the unusual facts involved. As the Osler law firm noted in its October 11, 2012 memorandum about the decision (here), the facts in this case (at least as found on an interim basis) “appear to have been exceptional” and that in many other cases, courts would be unable to make the kind of determination made here solely on the basis of a “paper record,” without live witnesses and credibility determinations.

While the outcome here may be the result of the uncommon factors, what is not uncommon is for these types of advancement disputes to arise, particularly where, as here, the claims have been brought against former management by their successors and the claims is asserted on behalf of the corporation. The successor management often contends that the corporation should not have to fund the defenses of the persons whose conduct they are claiming to have harmed the corporation.

As I noted in a recent post discussing an advancement decision under Ohio law (here), the general pattern and practice is that corporate directors and officers are entitled to have their defense fees advanced, subject only to an undertaking to repay in the event of an ultimate determination that the individual is not entitled to indemnification.

The Ontario court’s decision is noteworthy not only because of the critical supervisory role the court played in the determination of the individual’s advancement rights, but also because of the court’s determination that it was obligated under the statute to play the supervisory role notwithstanding the parties’ agreement to make the right of advancement automatic.

For corporations frustrated by their advancement obligations, the level of court supervision exercised here may represent an attractive model. I will say though that there is also something to be said for the rights of corporations and their directors and officers to arrange their indemnification and advancement obligations contractually, at a time when there are no claims pending, and for those arrangements to be respected when the claims do arise. I also note a concern about substantive legal rights being decided on less than a full evidentiary record. Here, because these individual defendants will now not have their defense fees advanced, they may be forced to settle simply to avoid financial ruin, whether or not that outcome is actually warranted by the merits of the dispute.

The Story of the Year?: Two recent guest posts on this site have discussed the question of fiduciary liability insurance coverage for settler liability claims. First, on September 19, 2012, Kim Melvin and John Howell of the Wiley Rein law firm posted a guest post (here) commenting on the New York Court of Appeals decision in Federal Ins. Co. v. IBM (2012), which was followed by an October 11, 2012 commentary by Rhonda Prussack and Larry Fine of AIG (here).

Now in a October 15, 2012 post on his blog, The D&O E&O Monitor (here) , Joe Monteleone has added his observations about the exchange of views in the two guest posts on this site. Among other things, Joe refers to the questions that the New York case has raised as “the story of the year.” Joe provides some interesting additional insight on the issues as well.

Homeowners File Latest Libor-Related Antitrust Case: On October 4, 2012, a group of homeowners filed the latest class action lawsuit against the banks that participated in setting the Libor rates. In their complaint, which can be found here, the homeowners, who had adjustable rate mortgages tied to the Libor benchmark, allege that they were harmed by the rate-setting banks’ alleged manipulation of the rates. The homeowners assert claims based on the Sherman Act, the New York antitrust laws and RICO. Although there have been numerous antitrust actions previously filed against the Libor rate setting banks, this lawsuit, according to press reports, is the first to be filed on behalf of homeowners.

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In the August 2012 issue of Business Law Today, the ABA Business Law Section published an article entitled “Training for Tomorrow: Corporate Counsel Checklist for Supervising Creation/Renewal of D&O Protection Program” (here). The article describes the critical components of a comprehensive executive protection program. A detailed description of the article and an explanation of the process by which the ABA Business Section created and published the checklist can be found in a September 11, 2012 post by Kevin Brady on the Delaware Corporate and Commercial Litigation Blog

The ABA checklist and accompanying commentary emphasizes that there are multiple components of a comprehensive program to protect corporate directors and officers from potential financial and criminal liability. The first element, statutory exculpation, should be incorporated into the company’s certificate or articles of incorporation.

Three additional elements of the program described in the ABA article are:  the right to advancement of defense costs; relief from the duty to repay advances; and indemnity against settlement and judgments. All three of these elements should be address in the company’s corporate by-laws. As the article notes, the changing legal environment poses “significant hurdles” to “making sure that the entity’s by-laws actually provide the maximum rights to advancement and indemnity that the law permits. The article provides a short, useful checklist to be used in reviewing corporate by-laws in order to ensure that the provisions provide the recommended components of executive protection program. Readers of this blog will find this portion of the ABA article particularly useful.

The article also notes that D&O insurance is a critical component of a comprehensive executive protection program. The article also contains a D&O insurance checklist. The list contains many useful items. D&Oinsurance professionals will want to be familiar with the list, as it is possible that their clients, armed with checklist, might expect the insurance professionals to respond to each of the checklist items.

One item that should be added to the list is the critical importance of associating in the D&O insurance placement process an experienced and knowledgeable insurance professional that is qualified to negotiate policy terms and conditions and that is able to make informed recommendations about policy limits and structure. Corporate counsel that want to ensure that their company’s D&O insurance program is state of the marketplace will want to enlist the assistance of a D&O insurance professional that is out in the marketplace every day and that is fully informed about what is available in general and from each of the carriers.

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One of the most important sources of director protection is corporate  indemnification. But as significant as indemnification is for the protection of directors, the directors’ first line of defense, literally, is their right to advancement of their costs of defense. All too often, these two terms – advancement and indemnification – are used interchangeably, but they are in fact separate and distinct. Of critical importance, directors are entitled to the payment of their attorneys fees in advance of any determination that the directors are entitled to indemnification.

An interesting July 3, 2012 Ohio Supreme Court opinion (here) highlights the critical distinction between advancement and indemnification and examines the circumstances under which directors are entitled to advancement.

Background

Samuel M. Miller (Sam M.) is a 25% shareholder and director of Trumbull Industries, a plumbing supply company. Sam M. is also Trumbull’s Vice President of Sales. Murray Miller (Murray) and Samuel H. Miller (Sam H.) are also Trumbull shareholders and directors. 

In 2002, a dispute arose in which Murray and Sam H. alleged that Sam M. had usurped a corporate opportunity for his personal advantage. In February 2003, Murray and Sam H. filed a complaint against Sam M. (among others) seeking injunctive relief and damages.

In September 2005, Sam M. sent Murray and Sam H. a memo informing them that he had reimbursed himself out of the Trumbull corporate treasury for the costs of defending himself against their complaint, after executing an “undertaking” under Ohio Code Section 1701.13 (E)(5)(a) to repay the amounts if it is determined he is not entitled to indemnification. The undertaking incorporated the specified statutory undertaking language.

In December 2006, both sides sought a judicial declaration regarding Sam M.’s rights to indemnification for his legal fees. Following an almost impossibly complicated procedural odyssey, the indemnification case made its way to the Ohio Supreme Court.

The July 3 Opinion

In a 6-1  majority opinion dated July 3, 2012 and written by Chief Justice Maureen O’Conner, the Ohio Supreme Court overturned the intermediate appellate court’s holding that the trial court had improperly ordered Trumbull to pay Sam M.’s attorneys’ fees and reinstated the trial court’s finding that Trumbull was in contempt for refusing to pay Sam M.’s attorneys’ fees.

In determining Sam M.’s rights, the “Court interpreted Ohio law, but looked to judicial decisions interpreting Delaware law for “insight,” as advancement is a “Delaware specialty.”

At outset, the Court made an important distinction, highlighting the fact that Sam M. sought “advancement,” not “indemnification.” Though the parties and the lower courts had used the terms “interchangeably,” the terms, “though related” are “not the same and should not be used as synonymous.”

Murray and Sam H. (hereafter, the appellees) argued, in reliance on the Ohio statutory provisions specifying when a director is entitled to indemnification, that Sam H. was not entitled to have his attorneys’ fees paid because he was not being sued for any “act or omission” he committed on behalf of the corporation. The appellees also argued that he was not entitled to indemnification of his fees because his acts were not within the protection of the business judgment rule.

The Supreme Court rejected these arguments, based as they were on the statutory standards for the entitlement to indemnification, on the grounds that “the advancement of fees is neither determined by nor dependent on whether a director is entitled to indemnification.” The only issue, the Court said, is “whether Sam M. is entitled to advancement of his expenses,” not whether he will ultimately be entitled to indemnification based on the adjudication of the allegations against him.

The Court said that Trumbull could not avoid its statutory advancement obligation because Sam M.’s conduct, if proven, “would foreclose indemnification due to an alleged breach of his fiduciary duties.” Allowing a corporation to “avoid advancement by asserting that a director breached his fiduciary duty would make the advancement statutory provisions pointless.”

The only prerequisite for advancement is the execution of the statutorily required undertaking to repay, which Sam M. had done. When the director seeking advancement has executed the undertaking, “the corporation is required to advance.”

The Ohio statutes provide, the Court noted, that a corporation may opt-out of these mandatory advancement provisions by adding a provision to its articles of incorporation specifying that the advancement provisions do not apply. However, Trumbull had not adopted an opt-out provision in its articles, and therefore, given that Sam M. had executed the required undertaking, there was no basis for Trumbull to withhold advancement.

Justice Terrence O’Donnell dissented, arguing that Sam M. was not entitled to advancement because the wrongful acts of which he was accused had allegedly been undertaken in his personal capacity or in his capacity as an officer (rather than as a director) of Trumbull. Either way, the acts had not been undertaken in the sole capacity (i.e., as a director) for which he was entitled to advancement under the relevant statutory provisions.

Discussion

In my factual recitation above, I omitted the lengthy procedural history of the indemnification case. If nothing else, the tortured procedural history shows how contentious these kinds of disputes can become. Indeed, the original claim underlying the indemnification fight is now in its tenth year. The contentiousness in turn illustrates another point, which is the importance of working out the details of advancement and indemnification arrangements when all is calm and skies are clear. It is a terrible time to try to sort these issues out after the storm has hit.

The majority opinion did emphasize that under the relevant statutory provisions, Ohio corporations can amend their articles of incorporation to opt-out of the mandatory advancement provisions. However, I suspect that companies addressing these issues when all is calm are unlikely to include such an opt-out provision in the articles of incorporation. At that point, none of the directors have any way of knowing whether or not they might be the ones that would want to have their defense fees advanced, and so they would be unlikely to adopt such an opt-out provision.

After a dispute has arisen, a corporation or some of its board members may well want to withhold advancement from one or more directors. However, that simply underscores how important it is that the right to advancement is automatic. If it were any other way, after a falling out or during an intra-board dispute, a group of directors could act together to deprive another director of his or her rights and ability to defend themselves.

The automatic operation of the advancement requirement ensures that directors are able to defend themselves, even when (or perhaps particularly when) the allegations against them are serious. From time to time, controversies can arise when corporations are obliged to provide funds for directors’ defense when the directors are the subject of high-profile allegations. For example, as I discussed here, there were questions when BofA funded the defense for former Countrywide CEO Angelo Mozillo. Because the advancement rights are automatic (subject to only to the undertaking requirement), directors cannot be deprived of their defense protection even if they have become involved in controversy or they are the target of intra-corporate vindictiveness.

The advancement right is also very durable. In a July 30, 2008 Delaware Chancery Court opinion (here) in which then-Vice Chancellor Leo Strine held that the Sun-Times Media Group had to continue to advance the defense expenses of four former officers, including Lord Conrad Black, even though: 1) the four had been convicted of various criminal offenses; 2) the four had already been sentenced; 3) the convictions had been upheld on appeal; and 4) the company had already advanced $77 million in defense expenses for the four. Strine held that under Delaware statutory law and the applicable by-law provisions requiring advancement until "final disposition," the obligation to advance expenses continued until the "final, non-appealable conclusion" of the criminal action, which had not yet been reached.

Perhaps the most important aspect of the majority opinion is its insistence on the distinct difference between advancement and indemnification. All too often, observers and commentators, like the parties to this dispute and like the lower courts here, blur the distinction between the two. The two, though related, represent distinct statutory rights available for the protection of directors. Moreover, as the Court here emphasized, if mere allegations which if proven might provide a basis for withholding indemnification from a director were sufficient to deprive the director of his or her right to advancement, the statutory provisions relating to advancement would be meaningless. Advancement is available so that directors can defend themselves, without which the right of indemnification itself might also be rendered meaningless.

It should not be lost here that a critical prerequisite to the right of advancement is the provision of the undertaking to repay. This requirement is not a meaningless procedural step. Directors taking advantage of the right to advancement may in fact be required to repay amounts advanced in the event of a judicial determination establishing they are not entitled to indemnification. In many instances, when the time comes for repayment, the individuals lack resources out of which the might make the repayment. However, from time to time, corporations do successfully assert and establish their right of repayment. 

These issues surrounding the obligation to repay have recently been in the limelight, following the insider trading conviction of Rajat Gupta. Peter Lattman’s June 18, 2012 New York Times article discussing Goldman Sachs’ payment of Gupta’s legal fees and of its rights or repayment for the fees in the wake of Gupta’s conviction can be found here.

A potentially important issue that the majority opinion sidestepped but that the dissenting opinion stressed is the question of whether or not Sam M. was acting in capacity for which he is entitled to advancement when he engaged in the alleged misconduct of which he is accused. The majority opinion essentially said that it did not have to address the question because it had not been properly preserved on appeal. Had the majority addressed the question, the outcome of this appeal could well have been quite different.

For a basic overview of indemnification rights and the relationship of indemnification to D&O insurance, refer to my earlier post on the topic, here. I published the earlier post as part of my series on the “Nuts and Bolts” of D&O insurance; the complete series can be accessed here.

A July 2012 memorandum from the Squire Sanders law firm discussing the Ohio Supreme Court’s opinion can be found here.

Criminal Charges Against Former Officers of Failed Bank: It has been weeks since the FDIC has filed a civil suit against the former directors and officers of a failed bank; as reflected here, the FDIC’s last civil suit was filed in May, and that was the only civil lawsuit the FDIC has filed since April. But the FDIC has not been idle. A grand jury has returned a July 11, 2012 indictment (here) against four former officers of the failed Bank of the Commonwealth, or Norfolk, Virginia, as well as two of the bank’s customers. According to the FBI’s July 12, 2012 press release regarding the indictment (here), the investigation of the bank had been undertaking in collaboration and cooperation with the FDIC’s Office of Inspector General.

The Bank of the Commonwealth failed on September 23, 2011. The indictment alleges that the bank had grown rapidly between 2005 and 2009, largely based on the bank’s reliance on brokered deposits. In 2008, the volume of the bank’s troubled loans soared. The indictment alleges that from 2008 to 2011, the criminal defendants allegedly masked the bank’s true financial condition out of fear that the bank’s declining health would negatively impact investor and customer confidence and affect the bank’s ability to accept and renew brokered deposits.

To hide the bank’s deteriorating loan portfolio and condition, the defendants  allegedly overdrew demand deposit accounts to make loan payments, used funds from related entities—at times without authorization from the borrower—to make loan payments, used change-in-terms agreements to make loans appear current, and extended new loans or additional principal on existing loans to cover payment shortfalls.

The indictment also alleges that bank insiders also provided preferential financing to troubled borrowers to purchase bank-owned properties. These troubled borrowers were already having difficulty making payments on their existing loans; however, the financing allowed the bank to convert a non-earning asset into an earning asset, and the troubled borrowers obtained cash at closing to make payments on their other loans at the bank or for their own personal purposes. The indictment also alleges that troubled borrowers purchased or attempted to purchase property owned by bank insiders These real estate loans were fraudulently funded by the bank.

The bank’s former CEO, Edward Woodard, is charged with conspiracy to commit bank fraud, bank fraud, false entry in a bank record, multiple counts of unlawful participation in a loan, multiple counts of false statement to a financial institution, and multiple counts of misapplication of bank funds. The other defendants are charged with a variety of related charges.

These charges are far from the first criminal charges the enforcement authorities have filed as part of the current wave of bank failures. As discussed here (scroll down), the federal authorities are also pursuing criminal charges against certain former officers of the failed United Commercial Bank. The FDIC has also filed criminal charges against two former officers of Integrity Bank, as discussed here. There undoubtedly have been other criminal charges as well.

It is hard to tell from the outside, but it sure would be interesting to talk to somebody on the inside about when the FDIC upgrades its investigation of the circumstances surrounding a bank’s failure to a criminal investigation. The allegations in the indictment alone do not sound all that dissimilar from the kinds of things that the FDIC and that investors have alleged in connection with many other bank failures that have not involved criminal charges.

In any event, there undoubtedly will be other criminal charges to come in connection with other banks. At the same it is interesting that the pace of the FDIC’s filing of civil litigation in connection with the failed banks clearly has tailed off. Again, it is hard to tell from the outside what is going on, but it sure would be interesting to talk to somebody on the inside.

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In a June 17, 2009 opinion (here), the Eleventh Circuit upheld the district court’s entry, in connection with the $445 million partial settlement of the HealthSouth securities action, of a bar order that extinguished Richard Scrushy’s contractual claims both for indemnification of any settlement he may enter in the case as well as for advancement of his legal defense costs. The opinion raises interesting and important issues and arguably includes some troublesome analysis, particularly with respect to the advancement issues.

Background

In 1994, Scrushy and HealthSouth had entered an agreement requiring HealthSouth to indemnify Scrushy to the fullest extent permitted by law. The agreement also entitles Scrushy to receive advancement of attorneys’ fees as they become due, provided he agrees to repay the amount advanced if it is later determined that he is not entitled to be indemnified.

In 2003, HealthSouth, Scrushy and several other HealthSouth officials were sued in a series of securities class action lawsuits that were later consolidated. Refer here for background regarding the case. In 2006, HealthSouth and several of the officials reached a partial settlement agreement in which HealthSouth and its insurers agreed to pay the plaintiffs $445 million. (The insurance carriers paid $230 million of this settlement amount.) Scrushy was not a party to this settlement, and he has still not settled.

The parties’ stipulation of settlement proposed several bar orders for the court’s approval. Among other things, the proposed bar order extinguished any non-settling party’s claim for contribution against settling parties. The contribution bar order is reciprocal (that is, HealthSouth’s contribution claim against Scrushy is also barred), and is also balanced by a judgment credit, under which a future judgment against non-settling party is to be credited by the amount of the settlement.

The district court entered the bar order over Scrushy’s objections that the order extinguished his contractual indemnification and advancement rights. Scrushy appealed to the Eleventh Circuit.

The Opinion

Scrushy raised several arguments against the bar order, contending first that the mandatory contribution bar in the PSLRA was exclusive, and therefore the bar could extend only to his rights to contribution, but not to his separate contractual rights of indemnification and advancement. The Eleventh Circuit held that the PSLRA’s contribution bar was not exclusive, and in fact was enacted against a background of established case law which had approved bar orders precluding indemnification claims.

Scrushy also argued that under case law and the PSLRA if he were to be deprived of valuable rights in a contribution bar order, he is entitled to compensation. The Eleventh Circuit held that the judgment credit represented very valuable compensation, since if Scrushy were to take the case to trial, the plaintiffs "will recover nothing at all from Scrushy and other non-settling defendants unless the verdict exceeds $445 million." The court also noted that Scrushy should be able to use that fact as "a very significant bargaining chip" in settlement negotiations with plaintiffs.

Scrushy argued further that depriving him of his indemnification rights would be contrary to public policy under Delaware law designed "to encourage qualified individuals to serve as corporate officers." The court said that these considerations must be "balanced against countervailing policies in favor of settlement." The court also referenced extensive case law that indemnification of securities violations is inconsistent with policies underlying the securities laws. The court concluded that the bar order’s elimination of Scrushy’s indemnification right was not against public policy.

The court then turned to Scrushy’s argument that the bar order’s elimination of his advancement rights was inappropriate. Scrushy argued that his rights of advancement were independent of any liability he might have to plaintiffs, and therefore it inappropriate in a settlement involving plaintiffs’ liability claims to strip him of his independent contractual rights.

The court conceded that "no circuit court… has addressed this issue" and acknowledged that the injury to Scrushy with respect to his advancement rights is not measured with respect to amounts Scrushy might have to pay to the plaintiffs. However, the court said that "the attorneys’ fees are nonetheless paid on account of liability to the underlying plaintiffs or risk thereof." The court found that the claim for attorneys’ fees "clearly cannot be considered to be independent of his liability to the underlying plaintiffs" because it is "so close in nature of the claims which established case law holds are appropriately barred" that so holding is "a minimal and reasonable extension thereof."

Scrushy raised a separate public policy argument with respect to his advancement rights, arguing that Delaware law "supports advancement of litigation fees for officers and directors to ensure that they will resist unjustified claims, and to encourage qualified individuals to serve."

The court recognized that in the absence of fee advancement "an innocent officer might have difficulty proving his innocence, and thus might have difficulty realizing a prevailing status." But the court said these considerations have to be balanced by policies in favor of settlement. It noted that HealthSouth might well have been reluctant to settle if "it would continue to be liable for endless legal fees to fund Scrushy’s individual defense" as that would constitute "limited peace." The Eleventh Circuit also said (and I want to take care to quote this carefully here) "advancement of legal fees might be inconsistent with the policies underlying the securities laws."

The court rejected Scrushy’s argument that he was not compensated in the bar order for the elimination of his advancement rights; the court said the "overall compensation was adequate" given the judgment credit.

Accordingly the Eleventh Circuit held that the district court to not abuse its discretion in entering the bar order.

Discussion

At one level, the outcome of this dispute is hardly surprising, as it is particularly difficult to meet the "abuse of discretion" standard applicable to the Eleventh Circuit’s review of the district court’s entry of the bar order.

On the other hand, the Eleventh Circuit’s apparent commitment to upholding the settlement and to rejecting Scrushy’s claims seems to have driven their consideration of these issues, and whether or not the outcome ultimately is appropriate, there are parts of the court’s analysis that I find less than comfortable.

Although I also have issues with respect to the court’s analysis of indemnification issues, my real concerns relate to the court’s holding regarding Scrushy’s advancement rights.

In particular, the court gave very short shrift to Scrushy’s public policy arguments regarding advancement. True, the court did concede that an innocent officer "might" have difficulty proving his innocence if his advancement rights are eliminated, and (the court delicately added) "might have difficulty realizing a prevailing status."

A fair assessment of these points would not be written in the conditional sense -- there is no "might" about it. The reality is that company official whose advancement rights are cut off is pretty much screwed unless he or she has individual resources to defend him or herself. (I am setting insurance issues to the side here, in order to concentrate on the advancement issues).

I also think the court strained very hard but not very convincingly to substantiate its conclusion that Scrushy’s advancement rights are not independent of the plaintiffs’ liability claims against him.

My overwhelming impression of this opinion is that the outcome was dictated by the identity of the appellant. The fact that it was the notorious and reviled Richard Scrushy before the court clearly seems to have had an impact, and in particular a presumption of Scrushy’s liability for the violation of which he is accused pervades the Eleventh Circuit’s opinion. For example, the Eleventh Circuit said that "Scrushy made no showing in the district court that he was merely an innocent bystander with respect to the violations at issue here."

The court also noted, approvingly, that "a party in HealthSouth’s shoes might well have been more willing to leave extant the contractual claims for advancement of fees on the part of an outside director who could adduce evidence of excusable ignorance of the violations."

The unmistakable message seems to be that it is OK for the bar order to extinguish Scrushy’s advancement rights because we all know that he is a bad guy. Indeed, the popular consensus is that Scrushy is a bad guy and even that he did all the stuff that plaintiffs allege. But in our system, we generally require these kinds of things to be proven before they can serve as the basis for depriving someone of their contractual rights. Scrushy was in fact acquitted in the criminal trial relating to these allegations, though later convicted on unrelated bribery and racketeering charges. The entry of the bar order did not follow a trial, it followed only a fairness hearing. (Readers who feel I am disregarding some important findings of fact in connection with these proceedings are invited to let me know if I am overlooking something.)

Several days ago I defended Bank of America’s advancement of Angelo Mozilo’s defense fees (see my prior post here), and many of the things I said there seem applicable here. In reflecting on these issues, I find myself wondering about the Eleventh Circuit’s consideration of public policy under Delaware law. I can’t help but find the contrast overwhelming between the outcome of the Eleventh Circuit’s analysis on the advancement issue here, and the ruling of the Delaware Chancery Court in the Sun-Times case (linked in my earlier post about Mozilo) that the company had to continue to advance defense costs even though the former officers had been convicted of crimes, had been sentenced and were in jail.

It seems to me that the right way to think about the advancement issue is to forget that the appellant here was Richard Scrushy and imagine instead that we are talking about some poor anonymous sucker that got cut out of a settlement and now faces a panoply of securities law allegations by himself. Imagine further that unlike Scrushy the poor sucker has no independent resources with which to defend himself. Perhaps the outcome on the question of the appropriateness of a bar order extinguishing advancement rights might be the same for the poor sucker as it was here. But I find the impression overwhelming that the outcome of this case had to do with the fact that it was about Scrushy and not some anonymous poor sucker.

My final concern about this opinion is that in its zeal to uphold the settlement against Scrushy’s challenge the court managed to say some things that simply don’t stand up. The worst example is the court’s statement (which I quoted carefully above) that "the advancement of legal fees might be inconsistent with the policies underlying the securities laws." I really cannot explain or understand this statement, but it seems to be a very radical suggestion to even pose the possibility that it is against public policy for companies to advance defense fees on behalf of corporate officials who have merely been accused of securities laws violations.

I feel confident that this is a proposition that would elicit no assent in any quarter, but if it were an accurate statement of the law, I think we would see a wave of mass resignations as no one would voluntarily undertake the kind of risks that this proposition implies.

I have said some strong things here. I hope readers who disagree with my view of this case will take the time to add their comments to this post.

Many thanks to a loyal reader for providing me with a copy of the Eleventh Circuit opinion.

UPDATE: On June 18, 2008, a Jefferson County (Alabama) Circuit Court judge entered a $2.8 billion judgment against Richard Scrushy following a bench trial in a derivative lawsuit filed against him. Although there are no findings of fact in the Final Judgment (copy here), the order clearly represent a finding that Scrushy engaged in the alleged misconduct. This ruling obviously puts the Eleventh Circuit's decision in a different light. However, this ruling had not yet been issued at the time the Eleventh Circuit issued its decision, so I think many if not all of my questions raised above remain valid given the record before the Eleventh Circuit at the time it ruled.

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A variety of news articles and blogs have expressed surprise and even outrage that Bank of America is advancing the legal expense that former Countrywide CEO Angelo Mozilo is incurring in defending against the various claims that have been raised against him, including the recent SEC enforcement action.

There is no particular reason for me to bestir myself to justify BofA’s action, particularly since Mozilo has done such an effective job making himself look like a cartoon villain (as I discussed here). But under Delaware law and under the legal understandings that BofA reached when it acquired Countrywide, BofA has a legal obligation to advance Mozilo’s expenses. The only outrage would be if BofA refused to do so.

Countrywide was a Delaware Corporation. BofA is a Delaware Corporation. Under Section 145(e) of the Delaware General Corporation Law, companies are permitted to advance expenses directors and officers incur in defending claims brought against them for actions undertaking in their capacities as directors and officers. Most companies’ by-laws make these advancement requirements mandatory, which I presume would have been the case for Countrywide. Mozilo may even have had a separate advancement and indemnification agreement; many senior executives do. In addition, as reflected in a June 9, 2009 Bloomberg article (here), the two companies’ July 1, 2008 merger agreement specified that Bank of America would maintain Countrywide’s existing indemnification rights for six years.

There is a very good reason for the legal formality surrounding advancement and indemnification; that is, the question of entitlement to these rights usually comes up only after serious allegations have arisen. Accordingly, it is important to lock down rights and obligations at a calmer time, so that duties and expectations are clear if questions later do arise. Having entered these agreements, companies are not at liberty to dispense with the commitments simply because they later find it distasteful or repugnant to honor the commitments.

Mozilo may well be one of the most unpopular figures in the United States right now, and a lot of people want to make him the poster child for everything that went wrong with our financial system. But as reviled as some might perceive him to be, that does not deprive him of his legal rights nor does it relieve BofA, as Countywide’s successor-in-interest, of its legal obligations.

Keep in mind that Mozilo has not been convicted of anything (yet?) – indeed, though he is one of the subjects of an SEC civil enforcement action, no criminal charges have been brought against him. Nor has he yet been found liable in any of the many civil actions against him.

Indeed, even if criminal charges had been brought, Mozilo would nonetheless retain the right to advancement of his defense expenses. In considering the extent of Mozilo’s rights, it is important to recall the July 30, 2008 Delaware Chancery Court opinion (here) in which Vice Chancellor Leo Strine held that the Sun-Times Media Group had to continue to advance the defense expenses of four former officers, including Lord Conrad Black, even though: 1) the four had been convicted of various criminal offenses; 2) the four had already been sentenced; 3) the convictions had been upheld on appeal; and 4) the company had already advanced $77 million in defense expenses for the four. Vice Chancellor Strine held that under Delaware statutory law and the applicable by-law provisions, requiring advancement until "final disposition," the obligation to advance expenses continued until the "final, non-appealable conclusion" of the criminal action, which had not yet been reached.

Whatever else may be said, advancement rights are enforceable and durable. (I will leave aside the problem created by the Schoon v. Troy case, about which refer here, which did seemingly permit the retroactive elimination of advancement rights, the Delaware legislature recently created a statutory remedy for that bobble.)

BofA is of course entitled to obtain from Mozilo an undertaking to repay the expenses advanced if it is later determined that he did not act in "good faith and in a manner the person reasonably believed to be in or not opposed to the best interests of the corporation." Mozilo is a very wealthy man, wealthy enough that if the statutory standard for repayment is triggered, BofA can try to recover the amount advanced – that is if there’s anything left at that point.

I understand that the main objection to BofA’s advancement of Mozilo’s defense expenses is that BofA has accepted $45 billion in bailout money. The objection is that taxpayers are effectively paying Mozilo’s legal fees, or something like that.

One might try to argue that, because taxpayers shouldn’t have to foot the bill, companies accepting bailout funds ought to be required to terminate advancement or indemnification rights of former officers and directors, but as far as I know there were no such requirements imposed in connection with the bailout money provided to BofA. Moreover, even though Congress has a pretty impressive record of trying to impose retroactive conditions on bailout recipients -- without the slightest regard for the requirements of binding contracts -- there are still some very good policy reasons why even Congress would have to hesitate to retroactively superimpose a bailout condition like that.

In any event, the objection about Mozilo’s defense expenses is not to advancement of defense expenses as a general matter, but to advancement for Mozilo in particular. There is no principled basis on which to isolate one individual, no matter how unpopular he may be, and single him out as the one person retroactively disentitled to his otherwise enforceable rights. To put it another way, if Mozilo is not entitled to advancement, then no current or former director or officer from an entity receiving bailout funds should be entitled to advancement. I suspect that even the most thick-skulled, grandstanding member of Congress would see the policy concerns with taking that position.

There is an added component to this question – that is, the extent to which Countrywide’s D&O insurance may be reimbursing BofA for its advancement of Mozilo’s defense expense. Countrywide undoubtedly carried D&O insurance, likely with limits of liability in the tens and perhaps in the hundreds of millions of dollars. The Countrywide insurance program may have had a significant self-insured retention, but that has likely been satisfied even if it is many millions of dollars.

The problem with D&O insurance as a source of reimbursement for defense expenses is that there are so many lawsuits against Countrywide and its directors and officers in so many different courts that the insurance limits could quickly be depleted or even exhausted, assuming for the sake of discussion that the carriers have not asserted defenses to coverage.

To the extent not reimbursed by insurance, BofA will have to advance Mozilo’s defense expenses. For those who still just find this too much to swallow, here’s one final thought – even if BofA is obliged to pay Mozilo’s defense expense due to an undertaking the merger documents, BofA appears to be making money from the Countrywide acquisition. According to Bloomberg (here), BofA reported mortgage-banking income in the first quarter of $3.71 billion, compared to $1.52 billion in the first quarter of 2008, "because of surging demand for home loan refinancings." This is a significant form of consolation for the fact that BofA is on the hook for Mozillo’s defense expenses.

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On June 26, 2008, Judge Gerard Lynch of the Southern District of New York issued another opinion (here) in the D&O insurance coverage litigation arising out of the Refco debacle (My recent post discussing Judge Lynch’s prior opinion in the case discussing insurance application issues can be found here.)

In yet another judicial decision that resonates with significance for excess D&O insurance issues, Judge Lynch, hearing an appeal from a bankruptcy court ruling, addressed the question whether an excess insurer may withhold advancement of defense costs based on its determination that an exclusion in its policy precluded coverage. Judge Lynch held that even if the excess policy has the distinct exclusions, the policy's terms do not  affect the operation of the applicable defense cost advancement provisions, and the advancement provisions should be enforced according to their terms.

The background of the case can be found in my prior post. Of significance here, the primary insurer’s $10 million limit and the first level excess insurer’s $7.5 million were exhausted in payment of defense expense. As also discussed in the prior post, the second level excess insurer disputes coverage on a number of grounds. The second level excess insurer also disputes that it has any obligation to advance defense costs pending a determination of coverage.

The parties agree that the advancement provisions in the primary policy control the advancement issue; they dispute how the provisions apply in the context of the second level excess carrier’s policy.

The primary policy specifies that:

The Insurer will pay covered Defense Costs on an as-incurred basis. If it is finally determined that any Defense Costs paid by the Insurer are not covered under this Policy, the Insureds agree to repay such non-covered Defense Costs to the Insurer.

The second level excess insurer [hereafter in this post, simply “the insurer”] contended that notwithstanding this language, it has no obligation to advance defense costs. In making this argument, the insurer relied on the word “covered” in the first sentence of the advancement provision, qualifying the type of defense costs that the provision requires to be paid on an as-incurred basis.

The insurer’s argument is based on its contention that its policy’s conduct exclusions, unlike the primary and first level excess policies’ exclusions, do not have an adjudication requirement. The insurer argued, according to the court, that because the conduct exclusions in its policy have no adjudication requirement, “prior to a court determination, [the insurer] has the unilateral right to determine whether defense costs are ‘covered,’” and that it has made a “good faith determination” that the insureds’ claims are precluded under its policy.

As the court paraphrased the insurer’s position, the insurer contended that the terms of its contract “authorize it to apply its exclusions to deny coverage unilaterally – and thus to refuse to advance defense costs – unless and until a court determines that the costs are ‘covered’” under its policy.

The insureds contend in their counterclaim in the coverage litigation that the exclusions on which the insurer relies to deny coverage “are not, in fact, part of the policy.” With respect to the advancement issue, the insureds argued that the advancement provisions require the insurer to advance defense expense, contending that as long as the claim “falls within the policy’s insuring agreement, it is covered unless and until there is a final determination that an exclusion applies.”

The insureds also argued that nowhere in the insurer’s policy does it state that the insurer can unilaterally withhold defense expense absent a court determination, and nothing in the insurer’s policy states that its exclusions are not subject to the “final determination” language in the second sentence of the advancement provisions.

In his June 26 opinion, Judge Lynch observed that “in essence, the central dispute among the parties centers on who bears the burden regarding whether defense costs are ultimately covered.” Judge Lynch, while noting that the insurer’s position regarding advancement “is not unreasonable on its face,” also noted that the insurer’s interpretation “places enormous emphasis on the word ‘covered.’” Judge Lynch said that the word’s inclusion in the advancement provisions “can hardly be said to make an unambiguous change in the provision’s literal meaning,” and “seems, at best, an unusual way to effectuate a fundamental change in the parties’ expectations.”

Because the court found the wordings to be ambiguous, it interpreted the provision in favor of the insureds – a result that the court noted “makes eminent sense, as adopting [the insurer’s] interpretation … would effectively render the advancement obligation worthless.” Judge Lynch concluded by saying that if the insurer “wants the unilateral right to refuse a payment called for in the policy, the policy should clearly state that right.” (citations omitted)

Whatever else might be said about the court’s opinion, it is certainly a sharp reminder of the importance of inclusion of adjudication requirements in the D&O policy’s conduct exclusions. If, in the absence of an adjudication requirement, the insurer may contend (as did the insurer in the Refco coverage litigation) that it has the unilateral right to determine coverage and withhold policy benefits, then the omission of adjudication requirements is perilous indeed for insureds.

But the crux of the dispute is whether the second level excess insurer’s policy contains exclusions not found in the primary or first level excess policies. The insureds apparently dispute that the exclusions are part of the second level excess policy (although the precise nature of that dispute is not clear from the face of the opinion). Assuming that the distinct exclusions are in fact part of the second level excess insurer’s policy, it does suggest that the insurance program is something less than pure “follow form” insurance. Indeed, many insurance programs that are characterized as “follow form” in fact have characteristics that may make them something less than follow form, a consideration that may sometimes be overlooked in the insurance transaction process.

It is of course true that each policy in a tower of insurance represents a separate contract. Excess insurers have every right to insist on terms differing from the underlying layers. The Refco coverage dispute highlights the pitfalls that can arise when (or perhaps if) an excess policy has terms that differ from the underlying policies. Indeed, the arguments raised by the second level excess insurer in the Refco coverage litigation show that differences in wording between the layers potentially can cause the different layers to operate quite differently, potentially in ways that may not necessarily be apparent or anticipated.

One final note has to do with the parties’ apparent dispute whether the exclusions are in fact part of the second level excess policy. It is hard to tell from the face of the opinion, but this dispute may be due to the process issues discussed briefly in my prior post. At least until the merits are sorted out, it may be premature to try to draw any conclusions. But as I noted in my prior post, and to the extent the dispute is due to process issues, this case may be a reminder of the opportunities for and the dangers of ambiguities in insurance placement process communications. From the perspective of every process participant, after a serious claim has arisen is a very difficult time to have to try to sort out, for example, whether or not exclusions are part of a policy.

Special thanks to Kelly Reyher for providing me with a copy of Judge Lynch's June 26 opinion.

And Finally: For those of us laboring in the salt mines of the blogosphere, it is always exciting when a fellow blogger steps out in some dramatic way. And so I was delighted to see in the July 16, 2008 Wall Street Journal that Mark Herrmann of the Drug and Device Law Blog published a book review critically analyzing the recent book "Side Effects" by Alison Bass. Kudos to Mark for his excellent and well written review.

May all new media practitioners continue to prosper and succeed. Gradus ad Parnassus.

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It is generally understood that under Delaware law, directors enjoy broad rights of indemnification and advancement. The Delaware statutory regime does allow corporations a great deal of flexibility in how they adapt these provisions to their own circumstances. But while these principles are generally understood, it may nevertheless come as a surprise to many that a corporation’s flexibility to adjust the provisions includes the ability to eliminate former directors' advancement  rights, at least according to a recent Delaware Chancery Court opinion.

A March 28, 2008 opinion in Schoon v. Troy Corporation (here) by Vice Chancellor Stephen P. Lamb held that as a result of a board approved by-law amendment eliminating advancement rights for former directors, a former company director did not have the right to advancement of attorneys’ fees.

The company’s by-law had originally provided that “the Corporation shall pay the expenses incurred by any present or former director.” After one of the company’s directors left the board but before the director became involved in litigation relating to his prior board service, the company’s board deleted the by-law’s reference to former directors.

The former director argued to the court that his right to advancement had vested when he commenced his board service. The former director also sought to rely on a prior Delaware court decision which had held that a board cannot terminate a former director’s advancement rights while litigation is pending. Vice Chancellor Lamb rejected the former director’s arguments, holding that the director’s advancement rights do not become “vested” until litigation is actually commenced.

As Steven M. Haas of the Hunton & Williams law firm noted on the Harvard Law School Corporate Governance Blog (here), “[t]his holding may surprise some practitioners, given that the purpose of indemnification and advancement is to encourage board service and assure directors that their expenses relating to their official actions will be repaid – even if litigation arises after they resign from the board.”

The possibility that directors could lose their rights to indemnification or advancement after they leave the board may not only “surprise some practitioners,” but it would shock many directors, whom I believe rightly would be appalled to learn that they could be stripped of these rights after they leave the board. At a minimum, this holding strongly reinforces the need for each director to have their own separate indemnification agreement with the company, to reduce the possibility for a later board to eliminate these rights after the director has left board service. Without a separate contractual undertaking, directors may have no assurance that after they leave the board their rights to advancement and indemnification will be preserved.

At the same time, however, it should be emphasized that most directors and officers liability insurance policies include former directors within their definition of insured persons, and that under most circumstances a former director for whom corporate advancement and indemnification has been withheld would still have right to seek defense expense protection and indemnification under the company’s D&O liability policy. There might be some question about which retention would apply under the policy, but that issue aside, the insurance coverage should be available to protect the former director (subject to all of its terms and conditions).

Accordingly, In most circumstances, the company’s D&O insurance program should provide adequate protection even for former directors – assuming that the company has procured and continued to maintain insurance protection, and assuming further that the limits available under the insurance program are not otherwise consumed by other insured persons’ defense expense and indemnity requirements.

For directors who have left board service and who are concerned that events could conspire (whether through by-law revision, or as a result of discontinuance or exhaustion of the D&O insurance) to leave them unprotected, there is another insurance solution available. That is, a director concerned about these circumstances may want to consider a so-called former director and officer liability insurance policy. This kind of coverage, which was described at greater length in a recent CFO.com article (here) is buyer-specific; that is, it belong exclusively to the individual director or officer, and would not be subject to termination or discontinuance by the action or inaction of others. It is also noncancelable, nonrescindable, and provides coverage for up to 6 years after the director resigns, retires or is fired.

The point that should not be lost here is that the director in the case cited above lost his anticipated rights after he left the board. Directors concerned about their rights following board service will want to fully consider the available insurance alternatives.

The Ropes & Gray law firm has a May 5, 2008 memorandum (here) discussing the ways in which by-laws and indemnification agreements might be modified to protect against retroactive elimination of directors' rights.

The Delaware Corporate and Commercial Litigation Blog has a post (here) discussing other aspects of the Schoon v. Troy decision.

Speakers’ Corner: On May 6, 2008, I will be in Montreal, Quebec, participating in a panel sponsored by the Canadian Chapter of the Professional Liability Underwriting Society (PLUS). The panel (more information about which can be found here) is entitled “The Subprime Meltdown and its Impact on the Canadian Insurance Landscape” and includes a number of distinguished speakers, included Dr. Faten Sabry of NERA Economic Consulting, David Williams of Chubb, and Denis Durand of Jarislowsky Fraser Limited.

In addition, on May 8, 2008, I will be moderating a panel at a American Bar Association Tort Trial and Insurance Practice Section conference in New York. The title of the conference is "Beyond Legal: A Business Approach to Corporate Governance" and the panel is entitled "Identifying, Predicting and Minimizing Securities Litigation Risk." Joining me on the panel will be Nell Minow of the Corporate Library, Professor Eric Talley of the Boalt Hall School of Law at UC Berkeley, and Patrick McGurn of RiskMetrics. A copy of the conference brochure can be found here.

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