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

Mutual fund directors have been attacked before. For example, in his 2002 letter to shareholders of Berkshire Hathaway, Berkshire chairman Warren Buffett took a detour in an essay about corporate governance to express concerns about mutual fund directors. He noted that mutual fund directors effectively have only two “important duties”; to pick the fund manager and to negotiate the manager’s fee. The record of mutual fund managers pursuing either goal has been “absolutely pathetic.” The manager selection process for far too many funds has become a “zombie-like process that makes a mockery of stewardship.”

Within months of Buffett’s stinging criticisms, many participants in the mutual fund industry were ensnared in the so-called “market timing” scandal, in which it was alleged, among other things, that mutual funds were permitting trading in their fund shares after market close. In the wake of the market timing scandal, the mutual fund industry faced not only a great deal of scrutiny but also a wave of enforcement actions.

At least according to a March 25, 2013 Wall Street Journal article entitled “Fund Directors Are Feeling the Heat” (here), mutual fund directors are attracting attention once again. The Journal article was focused on the administrative proceedings that the SEC has filed against eight former members of the board of directors overseeing several Morgan Keegan mutual funds. The agency filed the administrative action, a copy of which can be found here, in December 2012. In its December 10, 2012 press release accompanying the filing, the agency said that the directors had “abdicated” their asset –pricing responsibilities.

The administrative proceeding relates to five Morgan Keegan mutual funds whose portfolios contained below-investment grade debt securities, some of which were backed with subprime mortgages. In its press release about the proceeding, the agency claims that the funds “fraudulently overstated the valuation of their securities as the housing market was on the brink of financial crisis in 2007.” The agency has previously charged the funds’ managers with fraud, and the Morgan Keegan itself agreed to pay $200 million to settle related charges.

The agency alleges that the directors delegated their fair valuation responsibility to a valuation committee without providing meaningful substantive guidance and made “no meaningful effort to learn how fair values were being determined.”

The Journal article reports that the parties to the administrative proceeding are in settlement negotiations, but in the meantime the proceeding is going forward. The Journal article notes that the directors met 30 times in 2007, including 14 times in three months, and received daily updates on the value of the five mutual funds they oversaw.

Regardless of how the administrative proceeding against the former Morgan Keegan mutual fund directors ultimately plays out, the proceeding is, according to the Journal article,  “making waves” across the mutual fund industry. According to a December 14, 2012 memorandum from the Debevoise & Plimpton law firm, the administrative proceeding against the Morgan Keegan directors represents “a stark warning to fund directors and all fund personnel charged with management or oversight duties that they need to take their responsibilities for overseeing fund management seriously, even with respect to the complex and technical area of asset valuation.” The action signals “the SEC’s willingness to charge senior officials for failing to ensure the fair valuation of hard-to-value securities.”

The SEC’s decision to pursue an administrative action against the fund directorsseems clearly calculated to send a message. The fact that the agency filed the administrative proceeding against the directors after it had concluded an enforcement action against the fund management company itself does seem, as the Debevoise law firm said in its memo, that the administrative proceeding was intended to serve as a “stark warning.”

The SEC’s action against the Morgan Keegan directors unquestionably is noteworthy, but it is far from the first instance where allegations have been raised against mutual fund directors in the wake of the financial crisis. There were in fact a number of private securities class action lawsuits filed against mutual funds after the subprime meltdown, and a number of these suits included the funds’ outside directors as named defendants.

For example, March 2008, investors in the Charles Schwab YieldPlus Funds initiated a securities suit alleging violations of the federal securities laws and seeking damages; the defendants in that action included the funds’ trustees. The federal litigation ultimately settled for $200 million (with an additional $35 million to settle separate but related state litigation). The consolidated subprime-related securities class action litigation involving several Oppenheimer mutual funds, and which also included the funds’ trustees as named defendants, ultimately settled for a total of $100 million, as discussed here.

Indeed, as discussed here, the Morgan Keegan funds themselves were also involved in separate securities class action litigation that included as named defendants the same individual outside directors as were named in the SEC administrative proceeding. The separate Morgan Keegan fund securities class action litigation ultimately was settled for $62 million (refer here). 

The SEC’s administrative action against the Morgan Keegan funds’ outside directors not only has important implications in general about mutual funds outside directors’ accountability. It also has important implications about the scope of their potential liability exposure. Together with the possibility of private securities litigation, the possibility of an aggressive SEC pursuing administrative actions or even enforcement proceedings against the outside directors of mutual funds underscores the fact that serving as a mutual fund director entails significant liability exposures.

The extent of the liability exposures in turn highlights the importance for the outside directors to confirm that the mutual funds maintain D&O liability insurance sufficient to ensure that the directors can defend themselves against all claims that might arise against them. As the circumstances surrounding the Morgan Keegan funds demonstrate, when adverse developments lead to claims, numerous claims involving numerous parties can be involved. This fact underscores the need to ensure that the mutual funds maintain insurance limits of liability that are sufficient to respond in the complex claims situations. Finally, the need to ensure that the sufficient funds remain to protect the outside directors when multiple claims arise underscores the need to makes sure that the insurance program is structured to provide that a portion of the D&O insurance is dedicated solely to the outside directors’ protection.

Securities Suit Against U.S.-Listed Chinese Company Settles: In 2010 and 2011, plaintiffs’ lawyers rushed to file securities suits in U.S. courts against Chinese companies with shares listed on the U.S. securities exchanges. However, the suits have not proven to be as remunerative as the plaintiffs’ lawyers might have hoped. As I noted in an earlier post, many of the cases that have settled have involved only very modest settlements.

A recent settlement in one of these suits might provide modest grounds for encouragement for the plaintiffs’ lawyers. On March 25, 2013, the parties to the securities class action lawsuit pending in the Southern District of New York against Sinotech Energy Limited filed a stipulation of settlement indicating that they had agreed to settle the case for a total of $20 million. (The settlement does not include the company’s auditor, Ernst & Young Hua Ming LLP). The settlement is subject to court approval. The parties’ settlement stipulation can be found here.

Though this settlement is more substantial than the prior settlements, it should be noted that Sinotech Energy’s contribution to the settlement is only $2 million. The remaining $18 million is coming from several offering underwriter defendants who were also named as defendants in the litigation. This outcome is in fact consistent with what many plaintiffs’ lawyers have told me about these cases, which is that while they hope to recover from the company defendants, their real hope for recovery is based on the attempt to try to recover from the outside professionals who helped the companies to go public. (I am guessing that the reason that Ernst & Young Hua Ming was not a party to this settlement may have something to do with the $117 million that Ernst & Young agreed to pay in the Ontario securities suit relating to Sino Forest; the plaintiffs may be hoping they can use that prior settlement as a “price of poker” indicator.)

Whether or not the plaintiffs can succeed in recovering from the outside advisors, they likely will have to set their expectations of recoveries from the Chinese companies themselves at modest levels. It isn’t just that the Chinese companies have not contributed significantly to the settlements so far; it is that apparently in many instances, the Chinese companies are not even paying their own defense lawyers. As reflected in a March 14, 2013 Reuters article entitled “Defense Attorneys in China Securities Cases Look for an Exit” (here), defense counsel in several of these cases involving U.S.-listed Chinese companies are seeking to withdraw from the cases because their Chinese clients are not paying them. It doesn’t bode well for any eventual recovery for the plaintiffs if the defendant company isn’t bothering to pay its own lawyers.

Special thanks to a loyal reader for sending me a copy of the Reuters article.

The M&A Litigation Problem: As anyone following recent litigation trends knows, litigation relating to M&A transaction has become a serious problem. If it is any consolation, the courts are working on it, at least in Delaware, according to Vice Chancellor Donald Parsons of the Delaware Chancery Court. In a forthcoming article entitled “Docket Dividends: Growth in Shareholder Litigation Leads to Refinements in Chancery Procedure” (here, Hat Tip to the Delaware Corporate and Commercial Litigation Blog), Parsons contends that the Delaware Chancery Court is developing tools to address the concerns associate with the M&A litigation.

According to Parsons, Delaware’s courts are best positioned to respond to this litigation, although, owing to the phenomenon of multi-jurisdictions litigation, it is can’t resolve all of the concerns. Those who are interested in Parsons’ views may want to review Alison Frankel’s tidy summary of the article in a March 26, 2013 post on her On the Case blog (here).

You Think Your Job is Tough?: Next time you are feeling that your job is too demanding or stressful, spend a little time considering this guy’s job.

• Print
• Comments
• Trackbacks
• Share Link

Most states have adopted statutes providing individuals who serve as directors on nonprofit boards with limited immunity from liability. Among other issues that frequently arise is the scope of the protection provided under this statutory immunity. A recent decision from the Connecticut Appellate Court in a case involving a liability claim against the volunteer President of the nonprofit interpreted the statutory immunity expansively to encompass a broad range of activities. The decision provides interesting insight into the extent of immunity available to nonprofit board members. The Connecticut Appellate Court’s decision, released on January 1, 2013, can be found here.

Background

The Friends of Hammonasset is nonprofit volunteer organization organized under Section 501(c)(3) of the Internal Revenue Code. The organization works with the Hammonasset Beach State Park (a Connecticut State Park). Deanna Becker serves as the volunteer President of Friends. Becker is not compensated for her services.

In January 2010, the park held its annual “Owl Prowl” event. The Friends organization was invited to participate in the event and handled all of the publicity for it. One the evening of the event, one of the attendees slipped and fell on roadway and broke his wrist.

The injured individual filed a personal injury lawsuit against Friends and against Becker. The trial court entered summary judgment for both defendants, holding that the plaintiff had not alleged sufficient facts to support a claim for premises liability against Friends and also that Becker has immunity from plaintiff’s claims brought against her in her capacity as President of Friends. The plaintiff appealed.

The Appellate Court’s decision

On appeal the plaintiff argued that the trial court erred in entering summary judgment in Becker’s favor because his claims against Becker did not relate to duties or activities within the scope of the statutory immunity.

The statutory immunity provisions, which are contained in Connecticut General Statutes Section 52-557m, provide that the officer or director of tax-exempt organization who is “not compensated” for their services “shall be immune from civil liability for damage or injury … resulting from any act, error or omission made in the exercise of such person’s policy or decision-making responsibilities if such person was acting in good faith and within the scope of such person’s official function and duties, unless such damage or injury was caused by the reckless, willful or wanton misconduct of such person.”

In his appeal, the plaintiff argued that this section does not apply because he did not allege that Becker was negligent in her “policy or decision-making responsibilities.” Rather, he alleged that she was negligent in her supervising, training and oversight activities as the President of Friends, in that she allegedly failed to suet up a walk through of the path to determine if safety hazards existed; failed to assign a member of Friends to do a walk through; and failed to notify or assign a volunteer to notify the state to plow or sand the area.

The Appellate Court determined that these alleged activities of Becker were within her “policy or decision-making responsibilities,” noting that:

When the phrase “decision-making responsibility” is examined in conjunction with the dictionary definitions of supervise, oversee and train, the allegations in the complaint describe conduct falling squarely within Becker’s decision-making responsibilities. The allegations imply that Becker had the authority to make decisions that included ordering a walk through of the park before the event, directing that a Friends volunteer perform the walk through, and informing the state of dangerous conditions that the volunteer might find. Accordingly, the plaintiff cannot prevail on his claim that decision-making responsibilities do not encompass supervising, training and overseeing.

The Appellate Court also rejected the plaintiff’s contention that the state statutory immunity provision was preempted by the federal Volunteer Protection Act. The Act contains a provision preempting any state law to the extent that it is inconsistent with the Act, but exempting from preemption any state statue that provides “additional protection” to volunteers. The Appellate Court interpreted the Connecticut statutory provisions to provide “greater protections” than the Act, and accordingly the Appellate Court concluded that the Act did not preempt the Connecticut statutory provisions.

Discussion

In a January 21, 2013 Hartford Business Journal article discussing this decision (here), Dylan Kletter, an attorney with the Brown Rudnick law firm, notes that the Appellate Court’s decision confirms that the statutory immunity provisions “provide broad protection” for volunteer nonprofit board members and officers, adding that

Although the scope of an officer or directors’ “policy or decision-making responsibilities” will vary based on the unique facts of each tax-exempt organization’s mission and activities, the court’s decision gives comfort to such volunteer officers and directors and reinforces the concept that unless such an individual acts with “reckless, willful or wanton misconduct” in the exercise of their duties, they may similarly qualify for total immunity from legal liability and damages.

Most other states statutory immunity provisions are similar to those of Connecticut, so the “comfort” that volunteer directors and officers can take from this decision is not limited just to those in Connecticut. The decision provides reassurance that courts will broadly interpret the scope of responsibilities for which the immunity protection is available. (It should be noted that some statues require that the nonprofit organization’s by-laws must expressly grant the immunity in order for an individual to be entitled to the immunity.)

But though this decision is reassuring for volunteer directors and officers, it nevertheless must be kept in mind that the immunity available under these statutory provisions is limited – and limited in a number of ways.

First, the protection is only available to nonprofit directors and officers who are not compensated. So if for example a nonprofit organization were to bring on their board a specialist of some kind who provides the organization with some indispensable exercise and if that individual were compensated for their board service, that individual likely would not qualify for the statutory immunity. 

Second, the scope of the statutory protection is limited. It not only is restricted to “policy and decision-making responsibilities” but only to those within “the scope of such person’s official function and duties.” At a minimum, these limitations present potentially fruitful grounds for dispute over the questions whether the individual’s alleged misconduct was with the scope of protected activities, as this case shows.

Third, the statutory provisions restrict not only the breadth of activities that are protected but also the kind of activities that are protected. Thus the immunity is not available when the individual officer or director was not “acting in good faith” or was engaging in “reckless, willful or wanton misconduct.” Plaintiff’s lawyers interested in averting the statutory immunity defense will likely keep these limitations in mind when drafting the complaint and will shape their allegations accordingly.

Finally, although it is kind of obvious, it is worth noting that even at its greatest extent, the statutory immunity provisions protects only individuals. It does not protect the nonprofit organization itself.

The volunteer directors and officers of nonprofit organizations can be reassured that they have immunity from liability for claims of negligence against them in connection with their actions undertaken within the scope of their duties. But because there are numerous limitations to the protection availably under the immunity statutes, it remains important for these organizations and their representatives to ensure that the organizations have and maintain a comprehensive program of liability insurance, including in particular broad, state-of-the- market D&O insurance. Because of the extent of the scope of protection afforded under these insurance programs is so important for nonprofit organization directors and officers, they will want to ensure that a knowledgeable and experienced insurance professional designed and placed their program.

The FDIC Ramps Up the Lawsuits: Earlier last week, I noted that the FDIC had filed the first of failed bank D&O lawsuit in 2013. I speculated at the time that there would be many more cases to come this year. As if to prove my point, late last week, the FDIC filed two more failed bank lawsuits, including the latest the agency has filed involving a failed Georgia bank. Both of the new lawsuits were filed on January 25, 2013. Both of the banks involved failed on January 29, 2010, so that agency filed its lawsuits just before the third anniversary of the banks’ failures and just ahead of the end of the statute of limitations period.

First, the agency filed an action in the Western District of Washington in its capacity as receiver for the failed American Marine Bank of Bainbridge Island, Washington against four officer defendants (one of whom was also a director) and six director defendants. The FDIC’s complaint (a copy of which can be found here) alleges claims for breach of fiduciary duty, gross negligence and negligence. Among other things, the FDIC alleges that the defendants “took unreasonable risks with the Bank’s loan portfolio; allowed irresponsible and unattainable rapid asset growth concentrated in high-risk and speculative” construction and commercial real estate loans; and “disregarded regulator advice and criticisms regarding lending activities. The complaint alleges that the defendants’ actions caused damages to the bank of “no less than $18 million.”

Second, in the latest lawsuit the agency has filed involving a failed Georgia bank, the FDIC filed an action in the Northern District of Georgia against eleven former directors and officers of the failed First National Bank of Georgia, of Carrollton, Georgia. In its complaint, which the FDIC filed in its capacity as receiver for the failed bank, the FDIC asserts claims for negligence, gross negligence and for breach of fiduciary duties. The complaint, which can be found here, alleges that the defendants failed to properly oversee the bank’s lending function, improperly approved millions of dollars in loans, allowed excessive concentration in certain lending areas and knowingly permitted poor loan underwriting. The FDIC alleges that these actions cause damages to the bank in excess of $29.97 million.

These latest lawsuit are the 46^th and 47^th that the agency has filed as part of the current failed bank wave and the second and third so far in 2013. For whatever reason, the FDIC’s suits have been disproportionately concentrated in Georgia. This latest suit is the 15^th in Georgia so far, meaning that just under third of all of the FDIC’s lawsuits have involved failed Georgia banks. Though more banks have failed in Georgia than any other state as part of the current bank failure wave, Georgia’s bank failures represent far less than a third of all bank failures. There may be some timing issues here as many Georgia banks were among the first to fail but it still remarkable how many suits the agency has filed in the state.

Scott Trubey’s January 25, 2013 Atlanta Journal Constitution article about the latest Georgia lawsuit can be found here. Special thanks to a loyal reader for sending me a link to the article and alerting me to the new lawsuit. Special thanks to yet another reader for sending me a copy of the Western District of Washington complaint.

Advisen Claims Trend Seminar: On Tuesday January 29, 2013 at 11 am EST, I will be participating in a Quarterly D&O Claims Update Webinar hosted by Advisen. The webinar will provide a quarterly review of securities and other litigation impacting D&O coverage and will identify and analyze the trends of greatest significance to Risk Managers and Management Liability professionals. The participants in this free webinar will include AIG’s Tom McCormack, and Advisen’s David Bradford and Jim Blinn. Further information about the seminar, including registration instructions, can be found here.

A Spectacle Too Many Are Missing: One of the world’s great sporting events is taking place, yet very few are paying any attention. The 2013 African Cup of Nations soccer tournament is being played now (actually, between January 19, 2013 and February 10, 2013) in South Africa. Though the tournament features many of the world’s best soccer players as well as a host of upstarts, the tournament undeservedly is receiving little attention, particularly in the United States.

Among the many incredibly talented players participating are the tournament are reigning African Footballer of the Year, Yaya Touré of the Côte d’Ivoire (who plays his club football for Manchester City in the English Premiere Leagu); Emmanuel Adebayor, the Togolese football player and striker for Tottenham Hotspur in the English Premier league; Michael Essien, the Ghanian player who is currently playing for Real Madrid in La Liga, the Spanish football league, on a season loan from Chelsea in the English league; and Gervinho, who plays for Côte d’Ivoire and for Arsenal in the English Premier League. There are many others great players as well.

Even more exciting than these marquee players are the upstarts, like the team from Niger that has qualified for the tournament for only the second time, or the team from tiny Cape Verde Islands, which has never previously qualified for the tournament, yet, after a stunning 2-1 victory on Sunday against Angola, is sitting in second place in its tournament bracket and has already qualified for the tournament’s next round.

The tournament has featured some brilliant games, including in particular the game in which Burkina Faso, which had hung on throughout the game, scored in the fourth minute on stoppage time on the absolute final play of the game to pull off a tie against a much more talented Nigerian team, or the game in which an inexperienced Niger side played with sheer determination to scrap out a nil-nil draw against the much more experienced team from the Democratic Republic of Congo.

A soccer aficionado friend of mine regards the world’s seeming inattention to these games with a shrug, noting that it may be that international soccer competitions, like Opera or Single-Malt Scotches, are an acquired taste that can be appreciated only by the cognoscenti. I disagree. This tournament features the highest level of athleticism and games that flow with an incredible beauty. I think many sports fans would be drawn into these games on first glimpse of they only saw the games.

The games are actually a lot easier to see this year than during prior tournaments, because ESPN 3 is showing at least some of the games live – but because of the time difference, they are being broadcast during the morning in the U.S., which is not a time when most people are watching sports. For those who are interested in the games or who think they might be interested, but aren’t interested in sitting down to watch soccer at 10 am in the morning, the best way to watch these games is through the Watch ESPN app. On the ESPN 3 Channel on the App, under the Replay tab, all of the games are listed by date. (You can also find all of the games by clicking on the Sports tab along the top of the user interface and clicking on “Soccer” in the drop down menu).

To get a sense of the sheer athleticism this tournament involves, as well as the incredible enthusiasm of the teams’ supporters, watch this video of the 22 year-old Tunisian forward, Yousef Msakni, scoring the game winning goal in stoppage time in a first-round game against Algeria:

• Print
• Comments (2)
• Trackbacks
• Share Link

Under the Responsible Corporate Officer Doctrine, corporate officials can be held liable for misconduct in which they did not participate and of which they have been entirely unaware, based on their responsibility for the corporation itself. As shown in a July 27, 2012 opinion from the District of Columbia Court of Appeals (here), a misdemeanor conviction based on the Responsible Corporate Officer doctrine can not only result in criminal penalties  but can also include  “career-ending” consequences, in the form of a lengthy ban from participating in governmental programs. Although the appellate court struck down the specific disbarment at issue in the case, it upheld the government’s right to impose the ban.

As discussed below, this case serves as a reminder of the significant exposures corporate executives face under the Responsible Corporate Officer Doctrine.

Background

Purdue Frederick Company was accused of fraudulent misbranding of the painkiller OxyContin. Among other things prosecutors alleged that unnamed employees of the company marketed OxyContin as less addictive and less harmful than other painkillers. The company ultimately pled guilty to felony misbranding. Among other things, monetary sanctions of about $600 million were imposed on the company.

Under the Responsible Corporate Officer Doctrine, three Purdue executives – Purdue CEO Michael Friedman, general counsel Howard Udell, and medical director Paul Goldenheim—were accused of the misdemeanor of misbranding of a drug. The individuals pleaded guilty to misdemeanor misbranding, for (as the appellate court put it) “their admitted failure to prevent Purdue’s fraudulent marketing of OxyContin.” The individuals were sentenced to extensive community service, fined $5,000, and ordered to disgorge compensation totaling about $34.5 million.

Several months after the individuals’ conviction, the Department of Health and Human Services determined that the individuals should be excluded from participating in Federal health care programs for 20 years. During the individuals’ ensuing administrative appeals, the individuals managed to get the length of the disbarment reduced to 12 years. The 12 year disbarment ultimately was affirmed by a U.S. District Court, and the individuals appealed, arguing that the agency did not have the authority to impose the disbarment and also arguing that because the agency lacked a substantial basis for the length of the disbarment, its imposition was arbitrary and capricious and therefore invalid.

The July 27 Opinion

In a July 27, 2012 opinion written for a divided three-judge panel, D.C. Circuit Administrative Judge Douglas Ginsberg affirmed the agency’s authority to impose the disbarment, but agreed with the individuals that in this case the imposition of the 12-year disbarment “was arbitrary and capricious for want of a reasoned explanation for the length of their exclusions,” and the court remanded the case to the District Court for further proceedings. Chief Judge David Sentelle concurred in part and dissented in part, noting that he would have affirmed the length of the disbarment.

None of the three judges questioned the agency’s authority to impose disbarment. Judge Ginsberg’s opinion expressly rejected the individuals’ argument that the agency’s imposition of the disbarment for an offense lacking a mens rea element (that is, lacking a culpable state of mind) violated their constitutional rights to due process. Among other things, the individuals noted that the imposition of criminal penalties under the Responsible Corporate Officer Doctrine had been upheld in the past only because the “associated penalties commonly are relatively small, and conviction does no grave damage to an offender’s reputation.”

The appellate court rejected this constitutional argument, saying that “we do not think excluding an individual … on the basis of his conviction for a strict liability offense raises any significant concern with due process,” adding that “surely the Government constitutionally may refuse to deal further with senior corporate officers who could have but failed to prevent a fraud against the Government on their watch.”

The court did hold that the agency had failed to justify its imposition of a 12-year disbarment, noted that “we do not suggest that the appellants’ exclusion for 12 years based upon a conviction for misdemeanor misbranding might not be justifiable; we express no opinion on that question. Our concern here is that the [agency’s administrative review board] did not justify it in the decision under review.” Noting that no prior disbarment had exceeded ten years, the court concluded that the agency’s decision was “arbitrary and capricious with respect to the length of their exclusion because it failed to explain its departure from the agency’s own precedents.”

Discussion

If nothing else, this case serves as a reminder of the power that the Responsible Corporate Officer Doctrine gives prosecutors to pursue criminal charges against corporate officials based on the misconduct of the officials’ subordinates in which the officials were not involved and of which the officials may have been entirely unaware. And even though the appellate court reversed the “career ending” disbarment that the agency had imposed on the corporate officials here, the appellate court emphasized that there was nothing inherently wrong with the length of the disbarment; the appellate court’s reversal was strictly based on the agency’s failure to explain the length of the disbarment.

Indeed, the appellate court expressly affirmed the agency’s authority to impose disbarment even in the case of strict liability offense that lacked any culpable state of mind. The court seemed entirely untroubled by concerns surrounding convictions under the Responsible Corporate Officer doctrine that these convictions involve the imposition of liability without culpability in the form of a guilty state of mind. (For more about concerns with imposing liability about culpability, refer to my prior post here).

To be sure, in connection with their pleas of guilty to misdemeanor misbranding, the individuals had expressly admitted that they had “responsibility and authority either to prevent in the first instance or to promptly correct” the misbranding activity. Their convictions and their admissions, as well as the seriousness of the underlying misconduct, may cast this case in a different light.

Nevertheless, I continue to find the willingness of courts and regulatory authorities to impose criminal convictions and “career restricting” penalties on officials who had no involvement in or even awareness of the misconduct to be troubling. The court itself noted that the justification for the strict liability imposition of criminal liability based on the Responsible Corporate Officer Doctrine was premised in part on the supposition that that the penalties involved were relatively small. There is nothing small about the type of career-ending disbarment the government sought to impose here. To the contrary, this case shows that the consequences for individuals convicted under the responsible corporate officer doctrine can be significant.

A July 2012 memo from Eric Reed of the Fox Rothschild law firm entitled “Even Without Knowledge or Participation, Corporate Officers Can Be Criminally Liable for Subordinates’ Misdeeds” (here) points out that this case “stands as a reminder” of several concerns about the Responsible Officer Doctrine, including that “ignorance of misconduct by subordinates is not always a defense for corporate officers.” This case also shows that “when violations occur, resolving regulatory or criminal charges may not conclude all liabilities for a particular occurrence” and in parallel administrative or agency proceedings “facts admitted or proved in an initial proceeding may bind in the later matters.”

One of the bedrock principles of our criminal justice system is that a prerequisite of liability should be a finding of culpability. Even if, as courts now seem comfortable in assuming, there are circumstances where the kind of strict liability imposed under the Responsible Corporate Officer Doctrine is appropriate, that type of liability should be rare and imposed sparingly. My concern, as I have noted elsewhere, is that the imposition of this type of liability is becoming increasingly common and is imposed far too often. As this case shows, the consequences for individuals on whom this type of liability is imposed can not only be substantial, but it can be career-ending. This deeply troublesome trend deserves far greater attention, and the constitutional concerns raised here deserve much closer consideration than they were given by this court.

Susan Beck’s July 30, 2012 article on the Am Law Litigation Daily about the D.C. Circuit’s opinion can be found here.

Goldman Sachs Settles Mortgage-Pass Through Securities Suit: The parties to the Goldman Sachs/ GS Mortgage Pass Through Certificates securities suit have reached an agreement to settle the case for $26.6125 million. The settlement is subject to court approval. In addition, as reflected on the parties’ July 31, 2012 motion for preliminary court approval of the settlement (here), the settlement is subject to a $1.3125 reduction if Stichting APB (which filed a separate action relating to the mortgage-pass through certificates) elects not to participate in the class settlement. The settlement fund is inclusive of $5.3 million for attorneys’ fees and expenses. The parties’ stipulation of settlement can be found here.

As noted in detail here, the case had in January 2011 survived in principal part the defendants’ motion to dismiss. The court had subsequently certified a plaintiff class. The defendants had sought leave to appeal the class certification to the Second Circuit. The defendants’ petition to the Second Circuit, which remained pending at the time the settlement was reached, has now been stayed pending approval of the settlement.

Alison Frankel has an interesting August 1, 2012 post on her On The Case blog about the GS Mortgage Pass-Through Certificates Settlement, in which she asks, among other things, whether the MBS cases are turning out to be a "bust" for the plaintiffs' lawyers. As always, Frankel has interesting thoughts and observations on the topic. Her post can be found here. I should add that if your not reading all of Alison's posts every single day,  you are making a very serious mistake.

I have in any event added the Goldman mortgage pass-through certificate settlement to my list of subprime and credit crisis-related case resolutions, which can be accessed here.

Corrected Link: Yesterday, I wrote about the latest antitrust lawsuit to be filed in the wake of the emerging Libor scandal. Unfortunately, it appears that the link I originally put up on the site to the new case complaint was faulty. I have corrected the link. Readers who may have wanted to see the complaint but were unable to do so owing to the faulty link can see the complaint here. I apologize for the faulty link as well as any confusion the faulty link may have caused.

• Print
• Comments (2)
• Trackbacks
• Share Link

In a ruling that has gained a great deal of attention and scrutiny, Southern District of New York Judge Jed Rakoff rejected the “neither admit nor deny” settlement in the SEC’s enforcement action against Citigroup, a ruling that is now on appeal in the Second Circuit (about which refer here). Among other things, Judge Rakoff’s ruling raises the question of whether or not settlements of SEC enforcement actions should be permitted without some type of admission of guilt or wrongdoing.

In a May 29, 2012 Dealbook blog post entitled “Why S.E.C. Settlements Should Hold Senior Executives Liable” (here), two University of Minnesota law professors, Claire Hill and Richard Painter, suggest that in order to increase the effectiveness of SEC enforcement actions, rather than requiring an admission of guilt, “a more effective approach would be to make senior, highly compensated officers of the bank pay some portion of the fine.”

The authors suggest that officers making more than $1 million a year “should be personally and collectively liable for paying a significant portion (perhaps 50 percent) of S.E.C. fines levied against the bank.” The authors add that independent directors should supervise negotiations with the S.E.C., and if the case is litigated rather than settled, the officers should be personally responsible for a portion of the bank’s legal fees. Banks should be prohibited from reimbursing the officers for the amounts the officers pay. The authors propose that the officers should be personally liable for fines whether or not the bank admits to liability.

In support of this proposal, the professors point out that under current practice, fines effectively are paid by shareholders, who “neither caused the behavior that led to the fine nor were they responsible for preventing it.” The authors also point out that many of the investment banks formerly did business in partnership form, which ensured that when there was a loss, the most highly paid partners suffered the most.

I have a number of concerns about the authors’ proposal. In commenting on their proposal, I do not in any way mean to minimize their observation about how the costs settlements are now imposed on shareholders. I agree that there are very serious questions that need to be addressed. However, I disagree that forcing corporate officers to bear personal liability for corporate fines is an appropriate solution. I want to stress at the outset that in offering my views here, I mean no disrespect to the Professors or their article. I mean only to present a contrasting point of view.

First, it appears that, though not expressly stated in their article, the authors proposal is directed specifically and exclusively toward companies in the financial sector. Indeed, it appears that in proposing their solution the authors were thinking only about investment banks, perhaps because they made their proposal in the context of the Citigroup settlement controversy. However, the authors do not provide any principle whereby their proposed solution would (or could) be limited just to the investment banking sector. If this proposal is fair for officers of investment banks, then it ought to be fair if applied to any publicly traded company. And if it would not be fair for other companies, it would not be fair for investment banks – it not enough simply to say it is fair because investment bankers make a lot of money.

Second, it is also not expressly stated in their article, but it appears to me that the authors intended that the officers should be held personally liable for corporate fines regardless of whether the officers had any involvement in or even awareness of the alleged wrongdoing – and indeed whether or not the bank itself has admitted to any wrongdoing.   In other words, the authors seem to be suggesting that the officers should have to pay a portion of the fines not because of any actual or even alleged culpability, but simply as a matter of their status. Indeed, the officers have to be prepared to pay out of their own pockets if they want to fight the charges even if they themselves are not charged with any wrongdoing.

As I have stated before on this blog (most recently here), I think there is an increasing and unfortunate tendency to try to impose personal liability in corporate officers without regard to culpability. Among other things, an increasing and indiscriminate use of the “responsible corporate officer” doctrine has been used to impose personal liability on corporate officers for fines involving healthcare and environmental violations. Statutory provisions such as the Sarbanes Oxley compensation clawback provisions similarly have been used to impose liability on corporate officials whose companies restate prior financials, regardless of whether the officers themselves had any actual or even alleged involvement in the circumstances that required the restatement. 

I am concerned that a generalized presumption that corporate executives as a group or class are somehow blameworthy and deserving of liability is behind this trend toward imposing liability on corporate executives without actual culpability. There is an unfortunate trend in our society to assume that when something has gone wrong that somebody has to be punished. This general proclivity to look for someone to blame is exacerbated by a general willingness to demonize corporate “fat cats,” which in turn leads some to conclude that corporate executives deserve liability because of their position, without regard of whether they actually did anything culpable.

The authors’ proposal to impose personal liability on investment bankers simply because of their pay grade embodies all of these concerns. It overlooks any notion that liability in our legal system ought to be premised on culpability. Moreover, there seems to be a suggestion that because investment bankers are highly compensated, liability can fairly be imposed on them even if it might not be fairly imposed on comparable officials at other types of firms or under other similar circumstances.  

It is not an answer or justification for this approach that investment banks formerly did business as partnerships, in which partners bore losses personally. These firms long ago stopped doing business in that form, and chose to do business as corporations precisely because there are advantages to doing business in corporate form. There is absolutely no reason why investment banks doing business in corporate form are any less entitled to the protection of the corporate form than any other type of business doing business as a corporation. There is no reason to overlook the corporate form and impose corporate liability on individual officers simply because officers at the investment bank are highly compensated.

Let me come at this from a completely different direction. Many recent law school grads and many commentators have noted that recent law school graduates have had trouble getting legal employment. There are many causes to this problem. One might suggest that the law schools would be quicker to find solutions to this problem if law professors had to give back a portion of their compensation paid to them during the period when the unemployed law students were enrolled at the school. I suspect that law professors would see many problems to this kind of “solution” – it isn’t their fault that the students can’t get employment; their compensation has no relation to the students’ employability; they themselves never promised that the students would get employment, and so on.

Many of the same obvious objections to the modest solution about law professor compensation clawbacks are equally applicable to the authors’ proposal about the investment bankers’ personal liability for corporate activity. The point is that the imposition of penalties without culpability is fundamentally unfair, and this fairness is not eliminated simply because the persons on whom the fines would be imposed are highly compensated. When investment bankers are viewed as mere abstractions, as corporate fat cats lighting cigars with hundred dollar bills, it is easy to propose penalties and impositions on them that would not be considered fair in any other context. It is easy to ignore basic constraints such as the notion in our society that there should be no liability without culpability, or that corporations are legally separate from the persons who run them.

If there are problems with the way investment bankers are compensated, well, fine, let’s discuss that issue. But even if investment bankers’ compensation needs to be addressed, that is no reason to deprive them of the same protections of fair play that to which everyone else is entitled.

I appreciate that many believe corporate executives need to be held more accountable. Nevertheless, I am concerned that as a result of the increased tendency to try to impose liability on corporate executives without culpability, there is a contrary danger that corporate executives could be held liable too frequently, or at least in instances when they have done nothing themselves to deserve it. Scapegoating any individual – even a highly paid investment banker – for circumstances in which they were not involved and of which they were not even aware is inconsistent with some of the most basic assumptions of a well-ordered society governed by law.

Lady Justice carries a sword. But she also carries scales that are evenly balanced. And she is blindfolded. It should not matter who stands before the law. .

Tiananmen Square Remembered: Yesterday, June 4, 2012 was the 23^rd anniversary of the date in 1989 when the Chinese authorities violently cleared Tiananmen Square after six weeks of protests and demonstrations there. In recognition of the anniversary, the Atlantic Magazine online published a gallery of photos from Tiananmen Square, then and now. The pictures, which are fascinating and moving, can be found here. 

Given the violence of the suppression, it is hardly surprising that no one in China wants to talk about those events now. But it is remarkable observing in the photos how many people were involved in the demonstrations. A lot of the people who (understandably) won’t talk about it now were marching in the streets then.

I know from my April visit to Beijing that the Square itself is now full of tourists and aspiring capitalists trying to sell genuine Rolex watches to foreigners, and that the street between the Square and the Forbidden City is now full of tour busses, SUVs, and taxi cabs. And also government officials speeding past in Audi A6s with tinted windows.

`

About the Title of This Post: The title of this post is a reference to a line from Voltaire’s Candide. At that time, England had notoriously executed Admiral John Byng for “failing to do his utmost” during England’s naval defeat at the Battle of Minorca, at the outset of the Seven Year’s War. In Voltaire’s book, the main character, Candide, witnesses the execution in Plymouth, and is told that "in this country, it is good to kill an admiral from time to time, in order to encourage the others." (Dans ce pays-ci, il est bon de tuer de temps en temps un amiral pour encourager les autres).

• Print
• Comments (4)
• Trackbacks
• Share Link

Among the important questions that will need to be answered in connection with the current wave of failed bank litigation is the question of extent to which the non-director officers will be able to defend themselves in reliance on the business judgment rule.

In the following guest post, Jonathan Joseph (pictured to the left) takes a look at the extent to officers may defend themselves in reliance on the business judgment rule in cases to which California law applies. These questions go to the heart of the

officers’ potential liabilities and the legal standards that will be applied to address those questions.

Jonathan Joseph is a member of the California State Bar and has focused for over 33 years on regulatory, corporate, securities and transactional matters for banks and bank holding companies and officers and directors of distressed and failed institutions.  He currently serves as the Co-Vice Chair and Secretary of the Financial Institutions Committee of the Business Law Section of the California State Bar (2008 – present). He is the founder and managing partner of Joseph & Cohen, Professional Corporation in San Francisco, CA. Mr. Joseph is also a member of the Washington D.C. Bar and the State Bar of New York. He may be contacted at Jon@josephandcohen.com. A substantially similar version of this article was initially published in Issue No. 1 2012 of the Business Law News of the California State Bar. The original article on which this revised version is based was originally written before the initial decisio in FDIC v Perry was reported (about which decision, refer here).

Many thanks to Jon for his willingness to publish his article here. I welcome guest posts from responsible commentators on topics relevant to this blog. Any readers who are interested in publishing a guest post on this site are encouraged to contact me directly. Jon's article follows. Footnotes appear below following the article text.

The exact nature of the duties and liabilities of corporate officers who are not directors is a subject that has received little attention from courts and commentators. [1]  Many cases which relate to the duties and liabilities of corporate fiduciaries explore whether negligence and breach of care claims are protected by the business judgment rule and the courts that have spoken have done so mostly in terms of its application to decisions or judgments of corporate directors. [2] While the standard of liability for non-director officers remains relatively unexplored, there is widespread consensus among the courts on the policy justifications for the deferential treatment of directors under the business judgment rule.[3]

Recently, two Federal banking agencies have brought civil damage actions in California against corporate officers of failed federally-insured depository institutions in which they assert that the widely recognized deference accorded by courts to decisions by directors does not apply to corporate officers. These cases seek damages for the alleged negligence of non-director officers as well as officers who were also directors for huge losses suffered when regulators closed the institutions based largely on pre-closure decisions made in good faith that didn’t turn out well. Three of these cases, which are all triangulating on the same issues, are discussed below. [4] 

While none of these cases has proceeded to trial, rulings at the motion to dismiss and judgment on the pleadings stage in two of these matters, all within the Central District of California, have emerged with contradictory results -- including one ruling in August to the effect that the business judgment rule doesn’t apply to non-director officers. This is troubling to some California practitioners as the great weight of authority by courts and commentators has favored application of the business judgment rule to officers acting in their capacity as officers within the scope of their delegated authority.[5] 

In most states, including California, Delaware and New York, despite the case law being sparse, there has been little dispute that the business judgment rule or BJR applies equally to corporate officers and directors. Consequently, these pending Central District cases are worthy of focus since any final rulings upholding the position asserted by the Federal banking agencies could have far flung effects. If the BJR is ultimately held not to protect good faith decisions by officers of California based banks, that holding would extend to officers of any California corporation.

These cases touch upon significant underlying themes being widely debated in American society today (e.g., Occupy Wall Street) as to who should be held responsible for the tremendous costs of bailing out the largest American banks in 2008, why more executives and directors of such institutions haven’t been held accountable and whether corporate executives and directors could have anticipated the acute global financial meltdown in 2008 and thereafter.[6]

The Standard of Conduct and Business Judgment Rule

The general standard of conduct applicable directors and officers of California corporations in the performance of their functions as they relate to matters in which they are disinterested is a corporate governance principle widely recognized throughout the United States. The standard is well summarized by the American Law Institute’s Principles of Corporate Governance [7]:

“A director or officer has a duty to the corporation to perform the director’s or officer’s functions in good faith, in a manner that he or she reasonably believes to be in the best interests of the corporation, and with the care that an ordinary prudent person would reasonably be expected to exercise in a like position and under similar circumstances.”

In California, as elsewhere, when it is applicable, the business judgment rule.[8] precludes judicial second-guessing of decisions made by corporate fiduciaries in good faith or where the decision can be attributed to any rationale business purpose.[9]  The rule is procedural and process oriented. It sets up a presumption that decisions are based on sound business judgment and the “presumption can only be rebutted by a factual showing of fraud, bad-faith or gross-overreaching" [10]  based on a widespread “judicial policy of deference to the business judgment of corporate directors in the exercise of their broad discretion in making corporate decisions." [11] The relevant consideration is whether the process employed was either rational or employed in a good faith effort to advance corporate interests even if a judge or jury considering the matter after the fact, believes a decision to have been “substantively wrong, or degrees of wrong extending through stupid to egregious." [12]

Two Federal Banking Agencies Seek Damages for Breach of the Duty of Care

Since the global financial crisis began in 2008, four hundred twelve banks have been closed across the United States through December 15, 2011 including thirty-eight banks in California. [13] As of December 8, 2011, the FDIC has authorized suits in connection with 41 failed institutions against 373 individuals for director and officer liability with damage claims of at least $7.6 billion. [14]  Credit unions also failed during this period, although the actual number of failures is lower. {15]  Federal banking regulators are required to investigate insured depository institution failures and bring lawsuits to recover damages. Enforcement authority under Federal law was strengthened in 1989 after Congress concluded that a large number of saving and loan failures during the 1980’s were due to outright fraud and other egregious conduct. [16]

Thus, it isn’t surprising that the banking agencies have instituted damage suits in connection with some of the most recent failures and more will undoubtedly be authorized in the coming months. [17] As stated above, both the Federal Deposit Insurance Corporation (“FDIC”), in Van Dellen and Perry, and the National Credit Union Administration (‘NCUA”), in Siravo, have asserted that corporate officers in California are not protected by the business judgment rule. [18] Their basic argument is that section 309 of the Corporations Code applies on its face to directors, not officers and that there is no common law business judgment rule in California case law that applies to limit the liability of officers.

The Aftermath of the Failure of IndyMac Bank

Van Dellen and Perry involve two different actions by the FDIC as receiver arising out of the failure of IndyMac Bank, FSB in 2008. On July 11, 2008, IndyMac Bank, Pasadena, CA was closed by the Office of Thrift Supervision and the FDIC was named Conservator. With about $32 billion in assets when it was closed, the failure is the second largest since 2008 and the FDIC has estimated that the loss was $8 billion. Van Dellen was filed in July 2010 against former officers of the homebuilder division of IndyMac Bank alleging breach of fiduciary duty and negligence in approving loans made by the division. 

The FDIC’s other companion IndyMac case is more recent. It was filed against former Chairman of the Board and CEO Michael Perry in July 2011 seeking $600 million in damages, alleging in a single count that Perry, solely in his capacity as an officer (i.e., CEO), had been negligent. [19]  The complaint in Perry is noteworthy for several reasons including that i) the allegations artfully bypass his actions as a director, ii) the complaint is comprised of a single claim for ordinary negligence, and iii) no outside directors were named. The latter is presumably due to the FDIC’s conclusion that the BJR would immunize the outside directors’ conduct. [20]  Alternatively, it is possible that the outside directors settled or are negotiating to settle the FDIC’s claims against them.

In addition to anticipating the weakness of claims for ordinary negligence against the bank’s directors when it filed the Perry action solely against Michael Perry, the FDIC may also have concluded that it couldn’t support gross negligence theories against directors (including Perry). In Siravo, the NCUA had originally named the former outside directors of WesCorp and alleged they had been negligent, but lost this argument on a motion to dismiss based on the courts assessment that the BJR was applicable. On August 1, 2011, after earlier allowing the FDIC to amend its complaint several times, Judge George Wu issued his Siravo Order in which he dismissed all claims against the directors on business judgment rule grounds – without leave to amend. [21].

The Failure of WesCorp Federal Credit Union - NCUA v. Siravo

Siravo involves losses arising out of the failure of Western Corporate Federal Credit Union (“WesCorp”), which was the largest corporate credit union in the United States when it was placed into conservatorship by the NCUA on March 19, 2009. On October 1, 2010, the NCUA placed WesCorp into involuntary liquidation. WesCorp was originally seized after the NCUA concluded that its liquidity was imperiled by $6.8 billion in anticipated losses stemming from investments in private-label mortgage-backed securities (“MBS”). The NCUA originally brought suit against former officers and directors of WesCorp alleging they breached their duty of due care and were grossly negligent when they approved investments in MBS. Due to Judge Wu’s decision to dismiss the NCUA claims against WesCorp’s outside directors, the only remaining defendants in Siravo, as of the date this article went to print, were five officers.

The Siravo Order was issued pursuant to a motion to dismiss brought by the officer and director defendants pursuant to Rule 12(b)(6). The standard for such a motion required the court to 1) construe the NCUA’s complaint in the light most favorable to the plaintiff, and 2) accept all well-pleaded factual allegations as true, as well as all reasonable inferences to be drawn from them. [22]  The court was not required to accept as true “legal conclusions merely because they were cast in the form of factual allegations." [23] and the complaint against the defendants will not be upheld if it “tenders ‘naked assertion[s]’ devoid of ‘further factual enhancement.'" [24] Rather, the court concluded that to survive a motion to dismiss, the plaintiff must allege facts that, if accepted as true, are sufficient to “raise a right to relief above the speculative level,” and to “state a claim to relief that is plausible on its face." [25]

The director defendants in Siravo argued that the facts as pled in the amended complaint made clear that they had operated far above the standard of culpability necessary for a claim to survive application of the business judgment rule. The director defendants further argued that the complaint failed to focus, as required, on the “process” in which they made their decisions, but rather attacked simply the content and results of their decision.

In considering director defendants’ motion to dismiss, Judge Wu held that the plaintiff would effectively have to plead “fraud, breach of trust, conflict of interest, bad faith, oppression, corruption, complete abdication of responsibility, willful ignorance or gross overreaching” in order to overcome the business judgment rule as applied to the directors. [26]  In the final analysis, Judge Wu concluded that the directors “may have made choices – or not made choices – with which the NCUA disagrees, but that does not mean they failed in their responsibilities so severely that they lose the protection of the business judgment rule." [27]

The director defendants also argued that the business judgment rule extends to officer defendants such as a WesCorp executive who had been the Chief Investment Officer. The NCUA argued that a 1989 California decision, Gaillard v. Natomas Co. [28]  held that only directors are protected in California by the business judgment rule. In denying the motion to dismiss the officer defendants from the breach of duty claim, the court focused on the plain language of section 309 of the Corporations Code (which is applicable only to directors) and refused to recognize the common law application of the BJR to an officer in California. The Judge noted that some California decisions had included officers within the scope of the BJR’s protection, but found nevertheless that Gaillard v Natomashad considered the issue and concluded that the WesCorp officer defendants did not enjoy the rules protection. The court may have been swayed by an inference that executives had received increased compensation as a result of a shift in WesCorp’s investment emphasis which increased the compensation paid to top executives. [29]

Judge Fischer Rules that the BJR May Be Raised by Corporate Officers

Just one month after Judge Wu’s ruling in Siravo, Judge Dale S. Fischer issued the Van Dellen Order which also considered the issue of whether the common law business judgment rule extends to good faith conduct by corporate officers in California. The procedural posture in Van Dellen was slightly different than in Siravo. In Van Dellen the officer defendants had filed an Answer raising affirmative defenses. The FDIC moved for partial judgment on the pleadings pursuant to Federal Rule of Procedure 12(c) as to some of the affirmative defenses including the business judgment rule. However, because a motion for judgment on the pleadings is functionally identical to a motion to dismiss, the applicable standard is essentially the same as for a Rule 12(b)(6) motion. [30]  Judge Fischer rejected the reasoning employed by Judge Wu and reached the opposite conclusion. The Judge distinguished Gaillard v. Natomas and held that as a matter of law the FDIC had failed to demonstrate that the business judgment rule is inapplicable to officers in Californa. [31]

The Van Dellen officer defendants had argued that the common law component of the BJR applies even if Section 309 does not apply to officers and that Gaillard v. Natomas was a duty of loyalty case inapplicable to whether the BJR is a defense to breach of care claims. Presumably, the Judge was aware of Professor Melvin Eisenberg’s criticism of Gaillardin his 1995 study for the California Law Revision Commission [32]  since her ruling closely tracked the Eisenberg Law Revision Commission Analysis. She held that “California has recognized that ‘[t]he common law business judgment rule has two components’ and ‘[o]nly the first component is embodied in Corporations Code section 309’… most California cases discussing § 309 involve directors and not officers, … the common law component of the business judgment rule may apply to officers even if § 309 does not." [33]

Motion to Dismiss Ruling in FDIC v. Perry Could Be Tie Breaker

The Perry case is also being considered in the Central District of California before Judge Otis Wright. Perry has filed a motion to dismiss pursuant to Rule 12(b)(6). The motion was considered on November 7, 2011 following briefing by the FDIC and Perry. Perry’s motion points the court to the Van Dellen Order and notes that the FDIC’s position that section 309 applies to directors only is beside the point since the second, uncodified component of the BJR, applies to directors and to officers. [34]

Perry also attacked the FDIC’s reliance on Gaillard. Perry pointed out that Gaillard related to golden parachutes provided to a corporation’s officers and involved self-dealing. Perry argues that Gaillard correctly held that the BJR was inapplicable because the officers therein had a personal interest in golden parachutes, but the second aspect of the court’s holding was incorrect because the officers were not entitled to the protection of the BJR only because they had engaged in self-dealing. [35] Perry does not involve any self-dealing or duty of loyalty allegations.

The officer defendants in Siravo intend to raise the Van Dellen Order at a hearing in early 2012. It is possible, therefore, that Judge Wu might modify his prior BJR ruling as it relates to officers. In Perry, the courtis expected to rule on Perry’s motion to dismiss in the next few months. While the issue may seem narrow, the implications in California could be far-reaching if the FDIC’s position prevails. The FDIC argues that good reasons exist as to why the BJR should not apply to corporate officers. In contrast to outside directors, they state that because officers receive higher absolute pay levels, they stand to reap substantial rewards for serving and taking risks and for this reason, the FDIC reasons they should face greater risks. [36]  Perry’s reply is that FDIC’s assertion that policy reasons support limiting the BJR protection only to directors is entirely off base. Perry asserts that not a single state has implemented such a policy. [37]

The BJR represents sound public policy that, as a general rule, should continue to be applied by the courts as a presumption that good faith judgments by officers and directors of California corporations can only be rebutted by a factual showing of fraud, bad faith or gross overreaching. To employ a different rule as advocated by the banking agencies – one that permits judging the content of decisions by corporate fiduciaries with the benefit of hindsight – would, in the long run, be injurious to shareholder interests. [38]  Such a holding would tend to chill the ability of corporate executives, including bankers, to take legitimate and reasonable business risks that could benefit their corporations and shareholders.

Professor Melvin Eisenberg has noted that the BJR is premised on the idea that business judgments are necessarily made on the basis of incomplete information and in the face of obvious risks, so that typically a range of decisions is reasonable. Fact finders are ill-equipped to distinguish between bad decisions and proper decisions that turn out badly based on 20-20 hindsight. If courts too often erroneously treat decisions that turned out badly as bad decisions, and unfairly hold directors and officers liable for such decisions, corporate decision makers might tend to be unduly risk-averse. The business judgment rule protects directors and officers from such unfair liability and encourages risk taking. [39]

The Van Dellen Order, dated September 27, 2011, and the Siravo Order, dated August 1, 2011, both considered the business judgment rule as it relates to tort claims against corporate officers under California law and reached conflicting results. The Perry cased involves the same issue. A motion to dismiss the single claim for negligence in Perry was heard on November 7, 2011. No ruling had been delivered as of early December 2011. The ruling, when issued by the Perry court, could be viewed as a tie-breaker. Alternatively, since the issue presents an unsettled question of an important legal principle in California, if the Court in FDIC v. Perry follows the Siravo result (i.e., ruling against Perry), it could pave the way for an appeal by Perry to the Ninth Circuit.

These decisions and future rulings in other FDIC civil damage actions against bank executive officers that have also been brought by the FDIC recently in California and appeals of District Court decisions could shape California law as it applies to officers of California corporations and federally-insured depository institutions headquartered in California for years. Consequently, California business leaders and corporate practitioners should follow these cases closely. 

Given the justifications and importance of the business-judgment rule and the uncertainty of its status and formulation in California, particularly as it applies to officers of corporations in the exercise of judgment when making business decisions, it may be desirable to codify the rule legislatively unless the Ninth Circuit or the California Supreme Court act first and find that the business judgment rule applies to officers.

Postscript

On December 13, 2011, the District Court in Perry denied Michael Perry’s motion to dismiss, holding that the business judgment rule does not apply to officers under California law. The Court’s order was based on the Judge’s conclusion that no authority exists for the proposition that the common law BJR applies to officers and he further inferred that when the legislature adopted section 309 it must have meant to eliminate the common law business judgment rule. His finding is surprising because the legislative history doesn’t explicitly state the legislature intended to override the common law business judgment rule when it enacted section 309 in 1977.   Consequently, the Court’s reasoning isn’t particularly persuasive.

In an amended order issued on February 21, 2012, Judge Otis Wright approved Perry’s request for an immediate interlocutory appeal of his order. Judge Wright found that his order involved “a controlling question of law as to which there is substantial ground for differences of opinion” and that the immediate appeal “may materially advance the ultimate termination of the litigation.”

This author’s view is that the Ninth Circuit should overrule the District Court’s decision in Perry. This can be accomplished by holding that Gaillard v. Natomas was misapplied by the District Court since Gaillard is only applicable to cases involving breach of the duty of loyalty. The Appellate Court should also correct the District Court’s unfounded conclusion regarding the legislative intent underlying section 309 by finding that in 1977 when section 309 was enacted the common law business judgment rule as applied to officers was not eliminated. Consequently, the BJR would continue as a valid defense for officers of California corporations and federally chartered institutions headquartered in the State.   Common sense and public policy call out for such a result.

*End*

• Print
• Comments
• Trackbacks
• Share Link

One of the most basic notions in our legal system is that liability attaches only to those who act with intent or knowledge. But as detailed in a front-page September 27, 2011 Wall Street Journal article (here), Congress has in recent decades enacted numerous provisions imposing criminal liability regardless of intent. Among the many troubling aspects of this trend are the implications for corporate directors and officers, who often are the target of these strict liability provisions and who increasingly have liability imposed on them for matters in which they were not involved and of which they were not even aware.

As the Journal article explains, a “bedrock principle” of our legal system is that criminal liability cannot be imposed without “mens rea,” or a guilty mind. But as the article details, Congress has “repeatedly crafted laws that weaken or disregard the notion of criminal intent.” As a result, things that “once might have been considered simply a mistake” are “now sometimes punishable by jail time.”

The article cites a number of recently enacted criminal provisions, particularly certain enactments regarding wildlife issues and firearms violations. One example cited refers to the imposition of a 15-year criminal sentence for possession of a single bullet (in violation of firearms restrictions for convicted felons).

Among the areas the article references that have seen the enactment of these types of provisions is white collar crime. The article specifically cites the provisions of the Sarbanes Oxley Act that make it “easier for prosecutors to bring obstruction of justice cases related to the destruction of evidence.” The article explains how these provisions passed as part of the larger bill without full or appropriate consideration of the implications.

The Sarbanes Oxley Act provision cited is far from the only recent statutory enactment or judicial development that potentially imposes liability on corporate officials without culpability. Indeed, just a few days ago, on September 13, 2011, another Wall Street Journal article entitled “U.S. Targets Drug Executives” (here) described how federal regulators have increasingly been using the judicially developed “responsible corporate officer doctrine” to pursue criminal prosecutions against corporate executives for federal food and drug law violations.

As I discussed in my own earlier look at the “responsible corporate officer doctrine” (here), courts have the doctrine to impose criminal liability on corporate officials who were not involved in or even aware of the violations. (The word “responsible” in the name of the doctrine references responsibility for the corporation not for the conduct.) As the September 13 Journal article details, the use of this doctrine can not only result in the imposition of criminal fines and penalties, but the convictions obtained in reliance on the doctrine can then be used to exclude convicted executives from Medicare and Medicaid, in effect turning their conviction into “career-ending punishment.”

As discussed here, the doctrine’s application has not been limited just to food and drug violations but has also been extended to violations of environmental law as well, and also has been used as the basis for the imposition of civil liability as well as criminal liability.

Nor do these instances represent the only examples of imposition of liability without culpability – to the contrary, they are consistent with a growing willingness of government regulators and prosecutors to try to impose liability without regard to involvement in or awareness of the alleged wrongdoing. For example, there have been multiple instances recently where the SEC has pursued enforcement actions against corporate officials without regard to their lack of knowledge of the alleged wrongdoing.

First, as described here, the SEC has now on several occasions used its authority under Section 304 of the Sarbanes-Oxley Act to “clawback” compensation corporate executives earned a time when their companies were committing accounting fraud. For example, most recently former Beazer Homes CFO James O’Leary was compelled to return $1.4 million in bonus compensation even though he was himself not charged with any wrongdoing in connection with the company’s accounting fraud. As I noted in my prior post, though the SEC’s implementation of the compensation clawback is statutorily authorized, the imposition of a forfeiture without culpability or fault raises troubling questions, including basic questions of fairness.

In a separate development discussed here, the SEC recently filed an enforcement action seeking to impose control person liability on two officers of Nature’s Sunshine Products for the company’s Foreign Corrupt Practices Act violations – even though the two officials were not alleged to have any involvement in or awareness of the wrongful conduct.

Unfortunately, this trend toward the expansion of liability without culpability seems to be growing. Indeed, the Dodd-Frank Act greatly expands the compensation clawback ,  by requiring the major exchanges to adopt requirements for all listed companies to adopt provisions for the recovery in the event of a restatement of bonus compensation from any current or former executive officer who earned bonus compensation during the three years preceding the restatement.

The September 27 Journal article suggests that Congress is creating these types of exposures simply because it is neglecting to consider traditional intent requirements. I am not so sure, particularly when it comes to liability for corporate officials, as there seems to be this pervasive notion that corporate officials deserve liability and are getting off “scot free” and this in turn is leading to an increasing willingness to impose liability because of the position rather than because of their culpability.  

In recent months, I have taken on several commentators who have tried to argue that corporate officials need to be held liable more often (here), or that there is something wrong with our legal system when corporate officials cannot be held liable more frequently (here). I am concerned that general presumption that corporate executives are somehow blameworthy and deserving of liability are behind this trend toward imposing liability on corporate executives without actual culpability.

There is an unfortunate trend in our society to assume that when something has gone wrong that somebody has to be punished. This general proclivity to look for someone to blame is exacerbated by a general willingness to demonize corporate “fat cats,” which in turn leads some to conclude that corporate executives deserve liability because of their position, without regard of whether they actually did anything culpable.

I appreciate that many believe corporate executives need to be held accountable. Nevertheless, I am concerned that as a result of the increased tendency to impost liability on corporate executives without culpability, there is a contrary danger that corporate executives could be held liable too frequently, or at least in instances when they have done nothing themselves to deserve it. Scapegoating any individual – even a corporate executive – for circumstances in which they were not involved and of which they were not even aware is inconsistent with some of the most basic assumptions of a well-ordered society governed by law.

Along with all the other concerns, these types of proceedings may also raise D&O insurance coverage issues. Corporate officials in most instances would not have insurance coverage for the various fines and penalties imposed in these actions or for disgorged compensation. But the executives might well seek insurance coverage of their legal fees incurred in defending themselves in these actions. One question that might be asked in many of these types of cases is whether or not the proceedings involve an alleged “Wrongful Act” as is required to trigger coverage. Should these questions arise, these executives will want to be able to argue that the applicable D&O policy in any event covers them for allegations against them in their capacities as directors and officers “and in their status as such.”

Bank Director and Officer Defenses: As I have noted in prior posts (most recently here), there are now a growing number of actions against the directors and officers of failed banks brought by the FDIC as the failed bank’s receiver. The defenses available for these individuals and related considerations (including indemnification and insurance) are discussed in a brief, useful (date) memo from the Dechert law firm, entitled “Bank D&O Defense Manual” (here). The memo provides background on the FDIC’s approach to director and officer liability, the well as on the legal theories on which the FDIC will proceed and the defenses available to the directors and officers.

Speakers’ Corner: On October 5 and 6, 2011, I will be in Cologne, Germany participating in C5’s Sixth European Forum on D&O Liability Insurance. I will be participating in a panel on the first day discussing the evolution of class actions in the U.S. and Europe. Joining me on the panel will be Rick Bortnick of the Cozen O’Connor law firm; Guillaume Deschamps of Marsh, S.A. (France) and Prof. Dr. Roderich Thümmel of the Thümmel Schültze law firm.  Background regarding the event, including the complete agenda and registration information, can be found here.

If you will be attending the conference, I hope you will take time to greet me, particularly if we have not previously met.

• Print
• Comments
• Trackbacks
• Share Link