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

My primary objective on this blog is to address important developments in with world of directors’ and officers’ liability as they occur. From time to time, however, readers contact me with more fundamental questions about executive liability and protection, particularly regarding the basics of indemnification and D&O insurance. In response to these recurring questions, I intend to prepare a series of posts, to be published intermittently in the weeks ahead, discussing these more basic issues.

This post is the first of the series and will address the basics about indemnification and insurance and how they interact.

Introduction

It is a basic fact of life in this day and age that individuals serving as corporate directors and officers face a significant litigation exposure. Claims are regularly brought against corporate officials on a wide variety of legal theories, including, for example, allegations of breach of fiduciary duty or of securities law violations. These lawsuits are expensive to defend and they also potentially expose the individual to significant personal liability.

Companies typically protect their executives from these legal expenses and liability exposures are through indemnification and insurance.

Indemnification

Corporate officials’ front line of liability protection is indemnification. This statutorily authorized protection is usually embodied in corporate documents such as articles of incorporation or by-laws, and generally encompasses the rights to both advancement of defense expenses and indemnification.

Corporate indemnification represents important protection for company officials, even for those at companies that purchase and maintain significant levels of D&O insurance. D&O insurance is subject limits of liability, whereas indemnification is theoretically unlimited (although, of course, practically limited by the indemnifying company’s financial resources). Indemnification is often very broad, often extending "to the maximum extent permitted by law", whereas D&O insurance polices contain numerous exclusions and conditions. In addition, D&O insurance must be renewed each year, with possible changes in terms and conditions. Indemnification rights are much less likely to be changed, particularly for corporate officials who negotiate their own indemnification contracts.

The company’s indemnification provisions specify the procedures individuals must follow in order to obtain indemnification. It is worth considering that indemnification questions often arise when at a time of corporate turbulence, which may complicate an individual’s efforts to obtain indemnification or advancement. A separate written indemnification provision can not only provide much greater procedural specificity but it can also provide certain protections against wrongful withholding of indemnification, by providing presumptions in favor of indemnification and providing for "fees on fees" (that is, fees incurred in order to enforce rights to advancement or indemnification).

Although corporate indemnification is broad, it is not unlimited. There are times when a corporation may not indemnify an individual – for example, there generally are limitations on a corporation’s ability to indemnify individuals found liable in shareholders’ derivative suits. In addition, insolvency may prevent a company from honoring its indemnification obligations.

D&O Insurance　

D&O insurance provides protection for company officials when corporate indemnification is not available, whether due to insolvency or legal prohibition. D&O insurance also provides a mechanism for corporations to be reimbursed when they do indemnify their executives.

The coverage provision in which the D&O policy provides individuals with insurance protection when indemnification is not available is commonly referred to as Side A coverage. The D&O insurance policy’s provision for reimbursement of a company’s indemnification obligations is referred to as Side B coverage.

In more recent years, many D&O insurance policies have also incorporated a Side C coverage as well, which provides insurance protection for the corporate entity’s own liability exposures. In D&O insurance policies for public companies, this Side C protection is usually limited just to the company’s liabilities under the securities laws.

Coverage B and C essentially operate as balance sheet protection for the company. Coverage B also provides a way for companies to contractually transfer their indemnification obligations to the insurer (subject of course to all of the policy’s terms and conditions).

Coverage A is essentially catastrophe protection for the individual executives. It provides a way to ensure that litigation protection is still available to them even if the company is financially unable to indemnify them or legally prohibited from doing so.

D&O insurance policies are generally built to complement other types of insurance that most companies carry. For example, D&O policies will typically exclude coverage for loss arising from bodily injury or property damage, because those exposures are addressed in the company’s general liability and property insurance policies. The D&O policy, by contrast to these other types of coverage, protects the insured persons from economic loss arising from claims made against the insured persons for wrongful acts in their insured capacities.

Many companies find that the amount of insurance available in a single policy of D&O insurance insufficient to provide adequate protection and so they purchase additional limits of liability through excess D&O insurance policies as part of a tower of insurance arranged in various layers.

One of the most important functions of D&O insurance is to protect the individuals when the company has become insolvent and unable to honor its indemnification obligations. This protection is afforded under Side A, as discussed above. Because of the critical importance of this insurance protection, some companies choose to buy additional amounts of insurance providing additional limits of liability just for this Side A coverage, in the form of Excess Side A insurance.

In the current marketplace, this Excess Side A insurance often provides certain additional insurance protection in the form of coverages whereby the Excess Side A insurance will "drop down" and provide first dollar protections. These additional coverages are in the form of "Difference in Condition" (or "DIC") protection, and would apply, for example, in the event an underlying D&O insurance carrier is insolvent or if the underlying policy is rescinded.

Many D&O insurance buyers are very sensitive about the cost of the insurance -- and appropriately, as D&O insurance is often perceived as expensive (although currently relatively less expensive than it has been at times in the past). However, the scope of insurance protection afforded is much more important than the cost. Small incremental cost savings sometimes available pale by comparison to the potential financial significance of the scope of coverage afforded.

There is no standard D&O insurance policy. Each D&O insurance carrier has forms that differ from their competitors’ and most policies are generally the subject of extensive negotiations. In order for D&O insurance buyers to be assured that they have the broadest available terms and conditions and the appropriate insurance structure put in place, it is critically important that they associate a knowledgeable and experience broker in their acquisition of the insurance. The best brokers also have skilled and experience claims advocates available to protect their clients’ interests in the event of a claim.

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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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Private equity firms and the funds they organize frequently place individuals on their portfolio companies’ boards. However, all too frequently, it is not until a claim has arisen that the various entities consider how the potentially implicated indemnities and insurance will interact. Unanticipated interactions sometimes can produce unintended consequences, particularly from the perspective of the private equity firm.

A March 19, 2009 article by the Latham & Watkins firm on the Harvard Law School Corporate Governance Forum blog entitled "Indemnification of Director-representatives by PE Firms" (here) takes a closer look at these issues.

Among other things, the authors note that "the allocation of responsibility for indemnification and advancement obligations … are not considered until after litigation has been filed" and the same "holds true with respect to the amount of available insurance, especially at the portfolio company level."

The authors offer a number of excellent practical suggestions.

First, they suggest that the contractual arrangements between the private equity firm and the individuals serving on the portfolio company boards "provide clearly that the private equity firm’s indemnification and advancement obligations to its director-representatives are secondary to the indemnification and advancement obligations of the portfolio company." Otherwise, courts may consider the private equity firm and the portfolio company to be "co-equally liable," which could prove very costly for the private equity firm if it advances costs in the first instance and later seeks reimbursement from the portfolio company.

Second, the authors suggest that if the indemnification documents with the director-representative cannot be modified, the private equity firm "should seek an assignment of the director-representative’s rights to indemnification and advancement from the portfolio company prior to the fund paying out defense or settlement costs on their director-designees’ behalf."

Third, the authors point out that advancement rights are distinct from indemnification rights, and they suggest that the portfolio company’s advancement commitments "should be examined to be certain that advancement is contractually required and that any advancement obligations owed by the private equity firm or its fund are secondary to the obligations of the portfolio firm."

The authors’ final observations relate to insurance. They comment that typically "neither the director nor the private equity firm will look at the portfolio company’s D&O insurance policies until after the director needs to defend/or settle such claims."

The authors correctly note that the private equity firm should review the portfolio company’s policies to ensure that the policies are "adequate to protect their director-representatives." The authors also suggest a review of the provisions that will determine how the portfolio company’s policies and the private equity firm’s policies will interact in order to "prevent a battle of the insurance companies."

The authors cite the interaction between the portfolio company’s D&O insurance policy and the private equity firm’s policy as a potential concern. These insurance issues become particularly critical if the portfolio company goes bankrupt, in which case portfolio company indemnity issues drop out of the picture and the portfolio company's insurance can becomes critical.

Bankruptcy often has a way of demonstrating the insufficiency of the limits of insurance that the portfolio company purchased. Moreover, bankruptcy also has a way of demonstrating –after the fact – the need for auxiliary insurance structures (such as Side A/DIC insurance or independent director insurance) to protect individuals in the event of complex claims while the portfolio company is bankrupt.

The authors are correct that the the various potentially implicated insurance policies terms and prospective insurance interactions all too often go unexamined. However, looking at the terms alone is not enough. Limits selection and program structure should also be carefully considered. Private equity firms should take steps to ensure that the portfolio company’s insurance program will sufficiently protect the director-representatives in all contingencies, even bankruptcy—or, rather, especially in bankruptcy.

I disagree with the article’s authors on one point. The authors state that "private equity firms should also strongly consider having the same carrier write the primary policies at both the firm and at each of its portfolio companies." The authors suggest this approach avoids the "other guy’s" policy coverage dodge.

The authors are correct that this would avoid the "not my problem" dodge. But it could be a terrible insurance solution in every other respect, both for the private equity firm and for the portfolio companies. First, from the private equity firm's perspective, there are relatively few carriers willing to write those kinds of risks in the first place, and within that small group, the available terms and conditions vary dramatically. The private equity firm should focus first on placing the optimal insurance solution for its own risks and needs, without being forced to accept a suboptimal solution out of an artificial effort to try to match carriers with its portfolio companies.

By the same token, the portfolio companies are unlikely to have uniform exposures and interests. Given the incredible diversity of potential insurance alternatives available in the marketplace, it is very unlikely that the same carrier would provide the best insurance solution for each of the various portfolio companies. And by the same token, the portfolio companies should not have their range of potential D&O insurers restricted only to the relatively few carriers that also will write private equity firm D&O insurance.

In short, trying to cram all of the various insured entities under a single carrier’s umbrella could address one single issue but create a host of potentially more significant problems as a result. The preferred approach is exactly the one the authors otherwise recommend, which is to consider policy interaction issues in connection with the insurance placement process – a process that should in the first instance be addressed to providing the best solutions for each respective entity.

The authors’ interesting article highlights the need for private equity firms to enlist knowledgeable and experienced insurance professionals in connection with their insurance placement and in connection with their consideration of the issues discussed above. Insurance can sometime appear like a peripheral or relatively unimportant matter-- unless things go seriously wrong, in which case insurance can turn out to be the most important thing. At the point that things have gone seriously wrong it a very poor time to discover that critical insurance issues were insufficiently considered.

Break in the Action: The D&O Diary is taking its act overseas, and so the publication schedule will be disrupted for the next few days. Regular publication will resume the week of March 30.

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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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