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

As I detailed in recent blog posts (here and here), these days virtually every public company M&A transaction is likely to involve M&A-related litigation. For that reason, M&A litigation represents a significant liability exposure for directors and officers of the companies involved in the M&A transaction and they have a keen interest in taking steps to try to reduce that exposure.

These concerns are the topic of a new paper from Chubb entitled “Director Liability Loss Prevention in Mergers and Acquisitions” (here). The paper was written by D&O maven Dan Bailey of the Bailey and Cavalieri law firm. (Readers know that The D&O Diary is a big fan of Dan’s; we recently published a guest post by Dan on Cyber Liability issues.) The paper “reviews the basic legal duties of directors in this context and summarizes many loss control procedures for directors when addressing a proposed M&A transaction.”

The paper notes at the outset that directors “are routinely rewarded” for their hard work on a proposed M&A transaction “by being sued.” The shareholder plaintiffs “typically allege the directors acted improperly in investigating, negotiating, approving, rejecting or disclosing the acquisition transaction, regardless of how thoroughly and prudently the directors acted.”  Though the lawsuits cannot be prevented, “directors can increase the defensibility of those lawsuits and improve the quality of their decision-making process with respect to a proposed acquisition by anticipating and implementing various loss prevention practices.”

The paper outlines the basic legal principles that define the standard of conduct for directors of the target company. The paper then goes on to outline the steps directors can take to try to manage their liability exposure. Among other things, the paper states that “directors should create a record demonstrating that they carefully and thoroughly considered relevant information regarding the proposed transact.” Directors should also “obtain advice from experienced, qualified and independent experts in each of the relevant substantive areas.” In addition, “only independent and disinterested outside directors should act on behalf of the company with respect to the proposed transaction.” In addition, “directors should seek to obtain the best value available for the company,” in the specific ways that the paper enumerates. Finally, the company must manage the timing and content of its disclosures of the transaction in order to try to minimize disclosure-related risks.

There are also a number of transaction-related pre-litigation strategies the company can implement to improve the companies ability to defend the inevitable litigation. These include, among other things, amending the by-laws to designate a specific jurisdiction as the exclusive venue for shareholder suits involving governance issues; retaining qualified defense counsel in advance of the transaction; develop an external communication protocol to reduce disclosure –related risks; and the provision of detailed directors training in anticipating of the takeover process, including the “likely sequence of events, recommended governance practices and various best practices related to the proposed transaction.”

Finally, the paper reviews the indemnification and insurance issues relevant in the M&A context.  Among other things the paper discusses the need for the target company to have in place prior to the closing “a prepaid, noncancelable, extended run-off policy that cannot be amended or affected in any way by the acquiring company or subsequent management.”

Another M&A related insurance topic that the paper does not discuss is the possible need for representations and warranties insurance protection. Readers may be interested to note that the Professional Liability Underwriting Society (PLUS is hosting a webinar on Tuesday March 19, 2013 at 11:00 am EDT on the topic of Representations and Warranties insurance coverage. Information about this free webinar can be found here.

D&O Year in Review: Once again, my good friends at Troutman Sanders have published their annual roundup of D&O insurance coverage decisions. The publication, which is entitled “D&O Professional Liability: A Year in Review,” which provides a comprehensive overview of coverage decisions from the world of D&O in the last year, can be found here.

Board Minutes: I recently was asked to attend a meeting of the board of directors of a large financial institution client. While I was in the meeting, one director asked my views about board meeting minutes: should the board minutes be very detailed? Or should they be bare-boned? Which was better from a risk management standpoint? From the way the director asked the question, I knew that that was a topic on which he himself had strong views, and his manner also suggested that this topic was an issue of some debate at the board level. I looked across the table to the company’s general counsel, to see how I should handle the question. Her face said “Don’t throw me under the bus.” So all I said was that the question of board minutes is an important topic that should be discussed with your in-house counsel and if needed your outside counsel.

The question about the appropriate level of detail in board minutes is a recurring question. There is, in fact, no single right answer. The correct answer will vary, depending on the age and size of the company, as well as the advice of the company’s counsel. There are a number of important considerations to keep in mind, which are reviewed in a March 6, 2013 JD Supra Law News article written by Stephen Honig of the Duane Morris firm and entitled “Director Liability: Corporate Minutes as Trojan Horse” (here). The article reviews the liability issues that may arise from the board minutes and also reviews how the ground rules change as companies mature and grow larger. The article reviews the legal touchstones and lays out the basic ground rules. The article concludes by saying that directors “should remember that they are protected if they utilize robust process in the board room and are well-served if they document that process.”

Is a Pending Appellate Decision Interpreting Morrison Off the Docket?: For some time, we have been awaiting a ruling from the Second Circuit in the hedge fund claimants’ appeal of a district court dismissal of their action against Porsche and certain of its directors and officers. The hedge funds, which had shorted Volkswagen stock in the belief that its share price would fall, claimed that Porsche misled investors by denying through much of 2008 that it intended to acquire VW. Porsche later disclosed that it had been positioning itself to acquire the company.

As discussed here, in a December 30, 2010 ruling, Southern District of New York Harold Baer granted the defendants’ motions to dismiss. In granting the motion, Baer relied on the U.S. Supreme Court’s decision in National Australia Bank v. Morrison. Judge Baer found that because the securities underlying the swap instruments the hedge funds had acquired were traded on the German stock exchange, acquiring the swaps was the “functional equivalent of trading the underlying shares on a German exchange."

The hedge funds filed an appeal of Judge Baer’s dismissal. As discussed here, while the appeal was pending, the Second Circuit issued a ruling in the Absolute Activist Value Master Fund case interpreting Morrison’s application to non-exchange traded securities. The court held that in order to pursue a securities claim in connection with a transaction in non-exchange securities, the claimant has to allege either “irrevocable liability was incurred or title transferred within the United States.” I noted at the time that the Absolute Activist Value Master Fund case The Second Circuit’s holding in the Absolute Activist Value Master Fund case, in which the Second Circuit said among other things that the identify of the securities involved in the transaction is not determinative, would seem to suggest that the district court’s holding in the Porsche case may not withstand scrutiny on appeal.

Ever since the Second Circuit issued its ruling in the Absolute Activist Value Master Fund case, observers have been awaiting the Second Circuit’s ruling in the Porsche case. However, on March 6, 2013, Bloomberg reported (here) that the hedge funds have filed a motion to withdraw their appeal in the Porsche case. The Second Circuit must grant the motion to withdraw, but assuming it is granted, it appears that the appeal would be withdrawn, meaning that the lower court dismissal of the case would stand. The Bloomberg article notes that four cases against Porsche and certain of its directors and officers remain pending in Germany. It appears that the hedge funds may have decided to focus their efforts on the Germany cases.

In any event, if the Second Circuit grants the motion to withdraw, the long-anticipated resolution of the hedge funds’ appeal of the dismissal will not be forthcoming. That would mean at a minimum that the Absolute Activist Value Master Fund ruling will continue to represent the standard for securities cases involving non-U.S. entity defendants whose shares do not trade on U.S. exchanges.

I can’t help having a “that’s too bad” reaction. I have been looking forward to seeing what the Second Circuit was going to do with the appeal in the Porsche case.

One Director Defendant in Latest FDIC Failed Bank Suit: As the FDIC has been ramping up its litigation against the directors and officers of failed banks, one of the things that has been hard to figure is how the agency decides who it is going to sue. Sometimes it files cases only against former bank officers, sometimes it includes director defendants. And now in the latest case to be filed, the FDIC has filed a suit against only a single director defendant. However, in this case, there is some information available to explain why the one director was the only defendant.

On February 22, 2013, the FDIC, acting in its capacity as the receiver of the failed Carson River Community Bank, filed an action in the District of Nevada against James M. Jacobs, a former director of the bank. A copy of the FDIC”s complaint can be found here. Regulators closed the bank on February 26, 2010, which means that the agency filed its compliant just before the third-year anniversary of the bank’s closure. The sole defendant is described in the complaint as the co-founder and as a stockholder of the bank, as well as a director in the bank. Importantly for purposes of the suit, the complaint also states that Jacobs also had ownership interests in certain Oklahoma banks that participated in some of the loans that the FDIC referenced in the complaint.

As detailed in a March 1, 2013 memo by W. Bard Brockman of the Bryan Cave law firm (here), according to the FDIC’s complaint, the three subject loans were participated out to two Oklahoma banks owned by Mr. Jacobs’ family and for which Mr. Jacobs served as a director. The other directors on the Senior Loan Committee knew about Mr. Jacobs’ interest in the participating banks, but they did not know that Mr. Jacobs allegedly had secretly arranged for the Oklahoma participating banks to have preferential rights to repayment upon default. The Oklahoma banks were ultimately paid in full and Carson River Community Bank sustained most of the loss on the loans. This conduct, the FDIC alleges, constituted a breach of Mr. Jacobs’ fiduciary duty to Carson River Community Bank.

Brockman speculates that there may be an additional reason why the other loan committee members were not named as defendants because “Nevada has a very forgiving standard of liability for corporate directors. Under the Nevada corporate code, a director is not liable unless it is proven that: (a) the director’s act or failure to act constituted a breach of his fiduciary duties; and (b) the breach of those duties involved intentional misconduct, fraud or a knowing violation of law.” Brockman suggests that the FDIC must not have had sufficient facts to support an allegation that the other directors had committed “intentional misconduct, fraud, or a knowing violation of the law.” Brockman concludes by noting that this case is “a true factual outlier and it does not signal a trend that the FDIC will target single director defendants.”

A Break in the Action: For the next few days, I will be traveling overseas on business. The D&O Diary’s publication schedule (such as it is) will be disrupted for the next few days. I hope to resume the normal publication schedule during the week of March 18, 2013.

And Finally: A recurring topic of interest to everyone here is the question of why The Netherlands is sometimes referred to as Holland. This topic is amusingly explained in the accompanying video (with more information on the topic than you might have thought possible). Enjoy. (Sorry about the short commercial at the beginning.)

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As the current wave of bank failure litigation has unfolded, the directors and officers of banking institutions rightly have become more concerned about the own potential liability exposures and interested in learning more about how they might be able to reduce their risks and exposures. In the following guest post, Joseph T. Lynyak III and Rodney R. Peck of the Pillsbury law firm take a look at the current litigation environment facing directors and officers of financial institutions and provide some practical steps that these officials can take to try to mitigate their risks

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I would like to thank Joe and Rob for their willingness to publish their articcle on this site. I welcome guest posts from responsible commentators on topics of relevance to this blog. Any readers who are interested in publishing a guest post on this site are encouraged to contact me directly. Here is Joe's and Rod’s guest post.

In this article, we analyze the steps that officers and directors of bank and non-bank financial companies and their holding companies and affiliates can take to address personal liability for alleged breaches of duty to manage and supervise a financial company’s operations, allegations which are being made in an increasing number by federal and state regulatory agencies, including the federal banking agencies and the U.S. Consumer Financial Protection Bureau (CFPB).

On December 10, 2012, a California jury returned a verdict of $169 million in a case brought by the FDIC against three former IndyMac Bancorp Inc. executives after determining that those officers were negligent in making loans to homebuilders by continuing to push for growth in loan production without proper regard for creditworthiness and market conditions. Soon thereafter, the former CEO of IndyMac Bank agreed to pay $1 million from his personal assets in addition to available insurance proceeds to settle another FDIC claim related to the failure of IndyMac Bank. In an unrelated yet problematic series of developments, the newly formed CFPB recently assessed civil money penalties against three holding companies for aggressive marketing practices in an aggregate amount exceeding $500 million.

Approximately 25 lawsuits were filed in 2012 by the FDIC against former officers and directors of failed institutions, up from 16 in 2011. In total, more than 40 lawsuits have been filed against officers and directors of failed institutions since 2010. Since the beginning of 2007, approximately 467 financial institutions have failed. The FDIC has indicated that it is continuing its investigation of many bank failures and additional actions can be expected. Outside directors, in addition to inside directors and senior officers, were named in 30 of the cases. (See, Cornerstone Research, “Characteristics of FDIC Lawsuits Against Directors and Officers of Failed Financial Institutions,” December 2012.)

These and similar administrative and civil enforcement actions brought by governmental entities have caused considerable concern among officers and directors of financial services companies. Specifically, many individuals have raised questions whether—and in what circumstances—management or members of a board of directors might be held personally liable for similar penalties or damages, and if so, what prudent actions could be taken to mitigate that risk.

Although these issues are complex and the risk will vary based upon differences between the corporate laws of state jurisdictions and the possible applicability of several banking and securities laws (among others), this article presents an overview and proposed approach to analyzing the risk of personal liability. It also includes a methodology to evaluate protections that might be available under current corporate governance provisions.

What follows is a summary of pertinent legal issues relating to the risk of personal liability, distinctions to be drawn between liability arising in the bank and non-bank context, and steps that directors and officers might take to minimize personal liability risk, as well as a methodology for taking an inventory of existing protections available to a board and management.

Overview and Summary—State Corporate Laws

From a traditional corporate law perspective, both officers and directors of a corporation owe a duty to the corporation to avoid self-dealing and conflicts of interest (the “duty of loyalty”) and an affirmative obligation to use reasonable efforts to properly manage and supervise the business of the company (the “duty of care”). The degree or standard by which an officer or director must comply with his or her duty of care is generally governed by the corporate law of the state in which the company is incorporated. That standard can range from an obligation to act in a reasonable manner and avoid negligent actions or decisions, to a diminished level of care that creates personal liability only in the case in which one acts in a grossly negligent fashion.

Because most state legislatures have considered these questions, each state’s Corporations Code has its own version of the duty of care, and in many jurisdictions the courts have further refined that standard by judicial interpretation. For example, in several states, liability for breaching the duty of care can only be actionable when a director or officer is grossly negligent, while in other states the standard of gross negligence protects only outside directors while management is held to the higher standard of mere negligence. Further, in many jurisdictions there is recognition—either by statute, case law or common law—that directors and/or officers may rely upon the so-called “business judgment rule” that protects them against personal liability provided that the officer or director took reasonable steps to come to a decision even when the decision is proven to be wrong.

In addition, several states have authorized limitations of liability for corporate misfeasance by permitting a corporation to adopt provisions in its articles or bylaws that further limit liability for board members or management. Importantly, in recent years, several states have adopted expanded indemnification rights for corporate stakeholders by permitting a corporation to adopt in its articles and bylaws very broad rights to indemnify officers and directors against individual damage claims brought against them in their individual capacities.

The lesson to be learned is that concerned officers and directors should establish a baseline to identify by what state law standard they will be measured when being judged regarding compliance with the duty of care, as well as related state law limitations regarding liability.

Additional Concerns for FDIC-Insured Institutions, Subsidiaries and Holding Companies

In addition to the state law standards regarding a director or officer complying with his/her duty of care, there are several other significant considerations that require attention for an officer or director of an FDIC-insured institution or a bank or savings and loan holding company.

First, an important U.S. Supreme Court decision, Atherton v. FDIC, confirms that there is no federal common law regarding the duty of care for a national bank or a federal savings association. Accordingly, based upon the Atherton decision (which interpreted a provision of the Federal Deposit Insurance Act, or the “FDI Act”, for receivership claims brought by the FDIC following a failure of a bank or thrift), the standard for national bank and federal association officers and directors generally follows state law, except that state law cannot impose a standard lower than gross negligence. Of course, for banks and bank holding companies organized under state corporate laws, the duties of care on the part of officers and directors are governed by such laws (subject to the partial preemption under the Atherton decision).

Second, applicable regulations for national banks and federal savings associations provide a useful alternative that permits a national bank or federal savings association to adopt for corporate governance purposes the Corporations Code of the state in which the institution is located, the Model Business Corporations Act or the Delaware General Corporations Code. This is a potentially valuable option that should be carefully considered. For example, in states in which liability for bank officers is based upon the higher standard of mere negligence, adopting the corporate law of Delaware not only lowers the standard for breach of the duty of care to gross negligence, but may also provide enhanced protection in regard to indemnification and the availability of the Delaware version of the business judgment rule.

However, it should be noted that Section 18(k) of the FDI Act (and thus, FDIC’s regulations) severely (and unfairly) limits indemnification rights of officers and directors of FDIC-insured institutions, their subsidiaries and their holding companies in instances in which civil money penalties and other regulatory enforcement orders are assessed against an “institution affiliated party,” which includes officers and directors of an FDIC-insured institution, its subsidiaries and any parent holding company. Even though defense costs may be paid or advanced by an institution (and commercial insurance may be purchased to pay such expenses), the proceeds of the insurance cannot be used to pay for penalties assessed.

Mitigation Considerations for Officers and Directors

If there is a key conclusion that can be drawn from this discussion, it should be that individuals acting as officers and directors of financial intermediaries should engage in advance planning and clearly understand the nature of their rights in regard to administrative enforcement actions that might be brought by one of the federal banking agencies or the CFPB. Importantly, when complying with his or her duty of care, an officer or director should ensure that the record reflects reasonable steps to comply with that standard.

In that regard, an officer or director should be provided with legal advice as to what degree of diligence and review should be incorporated into the decision-making process, as well as how that process is reflected in the records of the institution. Particularly in the case in which the business judgment rule is available, the business records of the entity should reflect that all appropriate steps were taken prior to decisions being made.

It should be noted, however, that a distinction should be drawn between an FDIC receivership claim and assessment of civil money penalties by the CFPB or one of the federal banking agencies. In the case of a receivership claim following a bank failure, the above-referenced duty of care for personal liability purposes (e.g., negligence, gross negligence, etc.) is most often a determinative factor. However, in the administrative context in which civil money penalties are being assessed, culpability need not be based upon the failure to comply with a duty of care, but rather, can be based upon an institution’s compliance or non-compliance with an enforcement order previously issued in which officers and directors are ordered to take specific remedial steps to achieve compliance.

A Methodology for Determining and Achieving Reasonable Risk Mitigation to Avoid Personal Liability

As even the casual observer can see, being an officer or director for a financial institution—whether FDIC-insured or otherwise—presents a range of challenges. Complicating the situation is the nature of legal representation of companies, in that counsel for a company is usually not deemed to be providing individual legal advice to officers or directors, and hence the use of in-house counsel or a company’s outside lawyers to provide personal advice may not be appropriate or available in all cases.

We suggest that several steps be considered to address the concerns discussed by this article.

First, as noted above, officers and board members should obtain an overview of the rules governing compliance with the duty of care applicable to the company, including how courts and agencies have interpreted those rules. Among other things, identifying process issues and evidencing development of policies and procedures is essential, as well as ensuring that business records reflect robust discussion and reasonable reliance on experts (i.e., to be able to take advantage of the business judgment rule).

Second, a corporate governance review should take place to determine whether corporate documents such as articles and bylaws include the most favorable indemnification rights permitted under applicable law. (In that regard, it is important to note that in most cases such protections are optional under state corporate law and must be affirmatively adopted by a company’s board of directors.)

Third, employment agreements and indemnification agreements should be reviewed and updated on an annual basis to maximize contractual rights for designated officers and directors.

Fourth, extreme care should be exercised when transactions or other matters arise in which the director or officer may be seen as having a conflict of interest. All corporate processes should be followed, including full disclosure of the nature of the conflict, approval of the matter by a majority of disinterested directors, advice of counsel, etc.

Fifth, directors should work with management to establish internal tracking systems on matters requiring attention (“MRA”) arising out of regulatory examinations. Repeat violations of law or failure to remediate troublesome conditions by the next examination can be seen as a lack of proper board oversight. Careful attention should be given to the regulators’ evaluation of management and appropriate action taken when poor ratings are given. However, reliance on the regulators’ evaluations of management alone may not be sufficient because it appears that regulatory evaluations of management in many cases of failed banks have not been significantly downgraded by the regulators until a year or two before the bank’s failure. (Cornerstone Research, supra.)

Finally, a legal review of a company’s directors’ and officers’ liability insurance policies should be conducted and benchmarked against similar institutions in similar circumstances. It should also be noted that the contractual terms of directors’ and officers’ liability policies are frequently negotiable, and can result in valuable additional liability protection.

Other Standards of Liability Impacting Officers and Directors of a Financial Company

Although this article focuses on corporate and banking liability standards applicable to officers and directors of a financial intermediary, other standards of care arise in particular circumstances as part of the performance of the activities of an officer or director of a financial company. For example, in several instances under the federal securities laws, a corporate officer for a registered company can be held liable in civil or SEC actions for material misstatements in offering materials unless the director has engaged in a “due diligence” review. In regard to companies and “institution affiliated parties” that are subject to Section 8 of the FDI Act, liability might be viewed as a strict liability standard if a federal banking agency views the actions of an officer or director as having engaged in a violation of a federal law, regulation, or unsafe or unsound banking practice. Similarly, the newly established CFPB may also directly access civil money penalties and other remedial measures if an officer or director has participated in the violation of a covered federal consumer protection law.

Please note that this article summarizes several complex liability topics and by its nature is a starting point for further inquiry by officers and directors of banks and non-banks participating in the financial services industry.

Joseph T. Lynyak III is a partner in the Finance practice at Pillsbury Winthrop Shaw Pittman LLP in Washington, D.C., and Los Angeles. He can be reached at (213) 488-7265 or joseph.lynyak@pillsburylaw.com.

Rodney R. Peck is a partner in the Corporate & Securities practice at Pillsbury in San Francisco. He can be reached at (415) 983-1516 or rodney.peck@pillsburylaw.com.

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