longtopAs noted in a post yesterday, last Friday a federal jury held Derek Palaschuk, the former CFO of Longtop Financial, liable for the company’s financial misrepresentations. On Monday, the jury deliberated further on the percentage of investors’ damages for which Palaschuk is responsible. According to Nate Raymond’s Nov ember 24, 2014 Reuters article (here) the jury held the CFO responsible for only one percent of the investors’ damages. The jury assigned 49 percent of the responsibility to Longtop itself and 50 percent to the company’s former CEO, Wai Chau Lin. Max Stendahl’s November 24, 2014 Law 360 article about the jury’s division of responsibility for investors’ damages can be found here.

 

The jury did not determine the dollar value of Palaschuk’s one percent responsibility. The plaintiffs’ lawyer in the case is quoted in the press coverage as saying that the value of the jury’s 1% responsibility finding against Palaschuk has a value of somewhere between $5 million and $8.82, although the way the plaintiffs’ lawyers came up with this figure is by applying the percentage against the amount of the default judgment that Southern District of New York Judge Shira Scheindlin previously entered against the company and the CEO (as discussed here).

 

It should be noted that the damages amount in the default judgment was based solely on an uncontested proffer by plaintiffs’ counsel in connection with the plaintiffs’ motion for default judgment against defendants that failed to appear and defend. The Reuters article quotes Palaschuk’s counsel as saying that the plaintiffs’ counsel’s estimate of the dollar figure that the one percent responsibility allocation represents as “pie-in-the-sky.” The exact dollar value of one percent damages calculation is subject to further proceedings.

 

However, the Reuters article does also note that on Monday the jury did find that Longtop’s american depositary shares were inflated due to the securities law violations from Feb. 10, 2010 to May 17, 2011, by $11.89 to $19.51 per share. The Reuters article also reports that Palaschuk’s lawyers plan to ask a judge to set the verdict aside.

 

D&O Diary Named to American Bar Association Journal’s List of Top 100 Law Blogs: I am pleased to report that once again The D&O Diary has been voted onto the American Bar Association Journal’s list of the top 100 law blogs, as detailed here. I am very honored to be included on this list once again as the list includes many of the blogs that I regularly  follow. It is quite privilege to be included in the same list as all of the other fine blogs.

 

Now that the 2014 top law blawg list has been decided, what comes next is the voting for the best in category. The D&O Diary is contending for the title of best in the Niche blog category (for some reason the ABA Journal’s editors seem to think that D&O liability and insurance is niche topic). I would be grateful for any readers who would be willing to take the time to vote for my blog as the best of the Niche category. Thanks to everyone who already voted for my blog to be included in the ABA Top 100 Blawg list for 2014. Congrats to all of the 2014 nominees.

 

longtopOn November 21, 2014, after a securities class action trial that lasted less than three days and after less than a day of deliberation, an eight-person jury entered a verdict holding former Longtop Financial Technologies CFO Derek Palaschuk liable for the company’s alleged misrepresentations about its financial condition. According to Nate Raymond’s November 21, 2014 Reuters article about the verdict (here), the jury will return on Monday, November 24, 2014 to determine the damages to be awarded to investors. Max Stendahl’s November 21, 2014 Law 360 article about the verdict can be found here (subscription required).

 

As detailed below, trials in securities class action lawsuits are extremely rare – there has not been a trial in a securities class action lawsuit to reach a verdict since 2011. As also discussed below, there were a number of other unusual features about this case, including both the brevity of the trial and the dearth of witness testimony and other evidence.

 

Background

During the period 2010 to 2012, plaintiffs’ lawyers rushed to file a wave of securities suits against U.S.-listed Chinese companies, including against the Xiamen, China-based Longtop Financial (as detailed here). Unlike many of U.S.-listed Chinese companies caught up in the wave of securities litigation, Longtop Financial did not obtain its U.S. listing through a reverse merger, but instead it became a public company through a conventional IPO in 2007. Its shares traded on the NYSE. At one point, its market capitalization exceeded $1 billion.

 

Questions began to dog the company after Citron Research published an April 26, 2011 online report critical of the company. Among other things, the report questioned the company’s “unconventional staffing model,” alleged prior undisclosed “misdeeds” involving management, and referenced “non-transparent” stock transactions involving the company’s chairman, among other things. Other critical research coverage followed.

 

Longtop’s problems took another turn for the worse in May 2011 when, in advance of the high profile IPO of Chinese social networking company, Renren Network, Longtop’s CFO, who sat on Renren’s board as chair of the audit committee, resigned from the Renren Network board to prevent the questions at Longtop from affecting Renren’s IPO.

 

Then on May 23, 2011, in a filing with the SEC on Form 6-K, the company announced that both its CFO and its outside auditor, Deloitte Touche Tomatsu (DTT) had resigned. In its accompanying press release (here), the company said that DTT stated in its May 22, 2011 letter of resignation that it was resigning as a result of, among other things,

 

(1) the recently identified falsity of the Company’s financial records in relation to cash at bank and loan balances (and possibly in sales revenue); (2) the deliberate interference by certain members of Longtop management in DTT’s audit process; and (3) the unlawful detention of DTT’s audit files.

 

DTT further stated that it was “no longer able to rely on management’s representation’s in relation to prior period financial reports, and that continued reliance should no longer be place on DTT’s audit reports on the previous financial statements.” 

 

A copy of Palaschuk’s terse May 19, 2011 resignation letter can be found here.

 

Securities class action lawsuits followed. The actions were consolidated before Judge Shira Scheindlin in the Southern District of New York. The defendants in the lawsuits included the company, certain of its directors and officers and Deloitte Touche Tohmatsu. The plaintiffs alleged that the company had falsified its financial results by exaggerating revenues, underreporting bank loan balances, and transferring employee expenses to an off-balance sheet entity.  

 

In April 2013, Judge Scheindlin dismissed the claims against the audit firm. As discussed in detail here, on November 14, 2013, Judge Scheindlin entered a default judgment order including a damages award of $882.3 million against the company and its former CEO, Wai Chau Lin.

 

Following the dismissal of the auditor and the entry of default judgment against the company and the CEO, the sole remaining defendant left in the case was Palaschuk, the former CFO, whom the plaintiffs were able to serve in Canada in 2012 and who filed a motion to dismiss the plaintiffs’ claims against him. In a June 29, 2012 opinion (here), Judge Scheindlin, though acknowledging that the online research reports may well have been biased owing to the online analysts’ financial interests as short sellers of Longtop’s stock, denied Palaschuk’s motion. Among other things, she found that the plaintiffs had sufficiently alleged that in various company press release and financial filings, Palaschuk had made misleading statements about the company’s financial condition and the basis for its growth.

 

According to Nate Raymond’s Reuters article, in a July hearing, Palaschuk told the Court that he saw no reason “to have my insurance company pay for something where I wasn’t reckless.”

 

The Trial  

Trial in the plaintiffs’ case against Palaschuk commenced on Wednesday, November 19, 2014. The entire trial took less than three days, as investors were unable to call witnesses in China. Palaschuk himself was the only fact witness.

 

Palaschuk reportedly testified that in a May 2011 telephone conversation Lin, the company’s former CEO, had confessed to fraud, but that prior to that phone call, he (Palaschuk) didn’t know about the supposed false accounting. He claimed in his trial testimony that he acted in good faith and took steps to investigate the factual allegations as they arose.

 

According to the Law 360 article, the plaintiffs counsel argued in her closing argument that Palaschuk had repeatedly ignored warning signs of a “culture of fraud” at Longtop. The red flags included fake contracts and reports by outside analysts claiming the company’s revenues were too good to be true. The article quotes counsel as having argued that “when confronted with these warning signs – with these warning signs that begged for investigation – defendant Palaschuk failed to adequately respond. The lack of action the defendants took to find the truth is truly mind-boggling.”

 

The case went to the jury on Friday, November 21, 2014, and later that same day the jury entered a liability verdict in favor the plaintiffs and against Palaschuk. Damages in the case will be determined in separate proceedings that will begin on Monday, November 24, 2014.

 

Discussion 

As I noted at the outset, trial in securities class action lawsuits are extremely rare. According to information compiled by Adam Savett, Director, Class Action Services, Kurtzman Carson Consultants (KCC), LLC, including the trial against Palaschuk, there have been only 24 securities class action lawsuits that have gone to verdict since Congress enacted the Private Securities Litigation Reform Act (PSLRA) in December 2005. There have only been 13 trials during that period involving post-PSLRA conduct.

 

To put this into perspective, according to NERA (here), between January 1, 1996 and December 31, 2013, a total of 4,226 securities class action lawsuits were filed, meaning that only about one half of one percent of all cases filed during that period went to trial.

 

Taking post-trial proceedings into account (including post-verdict appeals), 12 of the 24 cases that have resulted in a verdict have gone for the plaintiffs and 12 have gone in the defendants’ favor.

 

Those familiar with securities class action litigation know that the cases that are not dismissed or otherwise resolved on procedural grounds almost always settle. It appears that this case did not settle because Palaschuk believed he did nothing wrong. You can certainly see that Palaschuk’s might conclude that he was being targeted on a sort of last-man-standing basis. It is hard to tell how much the difficulty of accessing witness testimony and other evidence hamstrung his efforts to defend himself. But his strategy to fight rather than settle seems to have backfired.

 

Of course, the trial verdict is only one procedural phase; Palaschuk can still attempt in post-trial motions and on appeal to have the verdict overturned. For now at least his decision to fight clearly didn’t play out as he had hoped. Depending on what happens in the damages phase, his decision to fight could wind up looking even worse.

 

Among the many reasons that these kinds of cases almost always settle is that the defendants recognize that they can’t run this risk of a jury verdict that might trigger the fraud exclusion typically found in D&O insurance policies (and that are usually only triggered “after adjudication” of fraud –meaning that a jury verdict is the potential trigger). Ironically, Palaschuk’s reason for refusing to settle (at least according to the July statement cited above) is that he didn’t think his insurer should have to pay anything even though he hadn’t acted recklessly. Depending on exactly what the jury actually decided here, Palaschuk’s decision to push this case to trial could wind up depriving him of any insurance, if the jury ruled that he had acted fraudulently (rather than merely recklessly). The jury verdict form has not yet been posted to the Court’s electronic docket so there is no way to determine exactly what was decided.

 

The insurance question is not only important to Palaschuk, it is important to the plaintiffs. It is extremely unlikely that the plaintiffs will collect a single penny of the cartoonishly inflated default judgment. If the jury verdict precludes coverage for Palaschuk under Longtop’s D&O policy, the plaintiffs will be left trying to enforce collect in Canada on his personal assets on the judgment entered against him. A judgment collection effort against a foreign domiciled individual seems likely to be an unpromising and possibly unrewarding project.

 

Just the same, it will be interesting to see what happens in the damages phase of this case. Post-trial proceedings seem likely. In any event, there is little about this case or about the mixed record of class action securities lawsuit trial verdicts that would encourage other defendants to try to push the cases against them to trial.

 

UPDATE: Dan Berger of the Grant & Eisenhoffer law firm and one of the trial counsel for the plaintiff at this trial communicated the following information to me: “the default judgment was not ‘cartoonishly inflated’ but rather computed by an expert using a typical event study; and we only tried a recklessness case against Palaschuk, so the judgment we have is not for intentional fraud and in theory should not be excluded by his D&O policy.”

 

What’s Next? Crowdsourced Litigation Financing, Apparently: In prior posts on this site (most recently here), I have noted the rise of litigation financing. Given this trend, and in the age of the Internet, it was perhaps inevitable that a litigation funding website facilitating crowdsourced litigation funding would arise. In any event, whether inevitable or not, a site for crowdsourced financing is now here.

 

According to its November 19, 2014 press release (here), a new venture called LexShares has launched “an online marketplace for investing in litigation.” The company’s website can be found here. According to the press release, the company’s online platform “connects accredited investors with plaintiffs in commercial lawsuits in order to make an equity investment in a specific case.” If the plaintiff wins, the investor will received a portion of the proceeds commensurate with the investor’s investment. If the plaintiff loses, the investors lose their investment.

 

According the press release, all legal claims investment opportunities to be posted on the LexShares website are “reviewed by its legal and securities professionals” and are to be offered to investors through a registered broker-dealer. Plaintiffs seeking to have their cases funded through the website must apply to have their cases posted on the site. Once the cases are posted, investors (who must have established their credentials as accredited investors) can review the case and decide if they want to invest. Investors who choose to invest can track the case on the site. The press release states that LexShares has already funded a case with a claim value of more than $40 million and currently has multiple other legal claim investment opportunities available for investment.

 

The press release quotes University of Minnesota Richard Painter as saying that “Litigation funding is maturing. The next logical step is using a technology platform like LexShares to broaden access to this asset class and equalize access to the legal system.”

 

A November 20, 2014 Bloomberg article about LexSource can be found here. A November 19, 2014 TechCrunch article about the site can be found here.  

 

sec sealThe number of whistleblower reports to the SEC increased again in the latest fiscal year, according to the annual report of the SEC whistleblower office. The report, which the SEC is required by the Dodd-Frank Act to provide to Congress annually, is entitled the “2014 Annual Report to Congress on the Dodd-Frank Whistleblower Program” and can be found here.

 

According to the report, there were 3,620 whistleblower reports to the SEC during the 2014 fiscal year (which ended on September 30, 2014).  That represents an increase of 382 (11.8%) over the 3,238 that were filed in the 2013 fiscal year. The number of reports has increased each fiscal year since the program’s inception. Overall, there have been a total of 10,193 whistleblower reports since the program commenced toward the end of the 2011 fiscal year.

 

The agency still has made relatively few of the whistleblower bounty awards authorized under the Dodd-Frank Act, although the number of awards is slowly increasing. The agency has now made a total of 14 whistleblower awards, nine of which were made during the 2014 fiscal year; as the report notes, the agency made more awards in the 2014 fiscal year than in all the other years of the program combined. Most significantly, the 2014 awards included a single award of $30 million, which, as discussed in greater detail here, is the largest bounty award the agency has made. Significantly, the $30 million award was also the fourth award under the program to a foreign-domiciled individual, meaning that 28.5% of the small number of awards have gone to non-U.S. whistleblowers.

 

The report also notes that in addition to new awards during the year, the amount of awards previously made increased during the year as size of the recoveries from the wrongdoers increased, either in the agency’s own proceedings or in other parallel proceedings.

 

In addition to making awards, during the year the agency also denied awards to other whistleblowers. The agency reports that it has denied a total of 19 claims for whistleblower awards, with 12 of those denials taking place during the 2014 fiscal year. Among other reasons for award denials is that the information provided by the whistleblower was not “original”; the filing for the award was not timely made; or that information provided by the whistleblower did not lead to a successful enforcement action.

 

The agency also noted in the report that it has taken steps to curb abuses of the program. Apparently one individual has submitted 143 different applications in responses to Notices of Covered Actions as well as numerous other forms trying to establish his right to a whistleblower award. (A “NoCa” is an item posted on the agency’s website identified Commission actions that resulted in monetary sanctions of over $1 mm, allowing anyone who believes they are entitled to a whistleblower award to submit an application.)  The individual’s filings apparently contained numerous deficiencies. While the individual was given an opportunity to remedy the deficiencies, he failed to do so. The Commission entered an order providing that the individual was ineligible for an award on any of the items he purported to identify to the agency or in any future covered or related action.

 

The most common categories of complaints reported by the whistleblowers to the SEC during the 2014 fiscal year were Corporate Disclosures and Financials (16.9%), Offering Fraud (16%), and Manipulation (15.5%).

 

During the 2014 fiscal year, individuals from all 50 states submitted whistleblower reports, as well as from Puerto Rico and the District of Columbia. The states with the highest numbers of reports were California (556, or about 15% of all reports); Florida (264); Texas (208); and New York (206).

 

During the 2014 fiscal year, the agency also received whistleblower reports from a total of 60 foreign countries, and since the program’s inception, the agency has received reports from a total of 83 different countries. The countries with the largest numbers of reports during fiscal 2014 were the United Kingdom (70); India (69); Canada (59); and China (32).

 

It is interesting to note that while the SEC whistleblower program has attracted numerous reports from overseas whistleblower, and while over a quarter of the bounty awards so far have been made to overseas whistleblowers, the Second Circuit recently held that the Dodd-Frank Act’s anti-retaliation provisions do not protect overseas whistleblowers (as discussed here). It remains to be seen whether the involvement of overseas whistleblowers will remain as active given this absence of anti-retaliation protection.

 

The report also contains some interesting information about the characteristics of the individuals that received bounty awards during 2014. Among other things the agency notes that in two instances the individuals receiving the awards only brought their information to the SEC after attempting to report the violation internally within their own companies and only after their company failed to take corrective action. The report quotes the head of the agency’s Whistleblower Office as saying that the awards to these two individuals “drive home another important message – that companies not only need to have internal reporting mechanisms in place, but they must act upon credible allegations of potential wrongdoing when voiced by their employees.”

 

Though the SEC has now made a number of bounty awards, including the record $30 million award, the agency’s powder is dry. The report notes that the Investor Protection Fund (which was provided by Congress in the Dodd-Frank Act and out of which whistleblower reports are made) at the end of the 2014 fiscal year had a balance of $437.8 million. Clearly the agency will be making many more awards in the future, which in turn should encourage other whistleblowers to come forward.

 

An ABA TIPS Webinar about Interrelatedness Issues: Readers of this blog know that one of the most vexing D&O insurance coverage issues involves questions of whether or not multiple claims are or are not interrelated. An upcoming webinar presented by the American Bar Association Tort Trial & Insurance Practice Section’s Professionals’ Officers’ and Directors’ Liability Committee will address this perennial issue.

 

On December 3, 2014, from 1:00 pm to 2:30 pm EST, my good friend Perry Granof of the Granof International Group will be moderating a webinar panel to discuss this topic. The panel will include Serge Adams of the Schuyler, Roche & Crisham law firm, Ommid Farashahi of the Bates Carry law firm, Neil Posner of the Much Shelist law firm, and Carol Zacharias of ACE. Information about the webinar including registration directions can be found here.

051aThe D&O Diary was in London this week to attend and participate in the Advisen European Insights Conference, which took place on Wednesday at the Willis Building, located conveniently across Lime Street from the Lloyd’s Building. The picture to the left was taken on Lime Street, with the Lloyd’s Building on the left, the Willis Building on the right, and in between and down the street,  the Gherkin (30 St. Mary Axe).  The Advisen event was interesting and well-attended, and drew attendees not only from the London market, but from the European continent as well.

 

Among other things, I had the opportunity to participate in a panel entitled “It’s Getting Personal: The Growing Focus on Individual Accountability,” that was chaired by my good friend Francis Kean of Willis. Here is a post-session photo of the panel. From left to right, Francis Kean, Willis; Noona Barlow, AIG; Victoria Watson, QBE; and me. 

 

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I also moderated a panel entitled “Privacy and Network Security Issues for Directors and Officers.” The panel (of which, unfortunately I did not get a picture) included Neil Arklie of Swiss Re; Cris Baez of QBE; Julia Graham of DLA Piper; and Geoff While of Barbican.

 

The conference also afforded a great opportunity to see old friends and industry colleagues. In the first picture below, I am standing with my former colleague and good friend Giovanni Fanizza of Gen Re (Madrid) and Cris Baez (QBE, Paris), and in the second picture, I am standing with Tim Walsh of Advisen; Enrico Nanni of AON; and Chris Warrior of Hiscox.

 

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The two following pictures were taken from the twenty-second floor of the Willis Building. The first picture was taken looking west, with the dome of St. Paul’s Cathedral in the center. The second picture was taken looking east. with Tower Bridge visible in the center, crossing the river.

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It was a pleasure to be in London this week. As Samuel Johnson famously said, “When a man is tired of London, he is tired of life, for there is in London all that life can afford.”

 

More pictures of London:

 

Trafalgar Square:

 

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Buckingham Palace:

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Piccadilly Circus:

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Green Park:

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St. James’s Park:

 

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Cheers! (Picture of my favorite London ale, Fuller’s London Pride, taken at my favorite London pub, The Prince of Teck, on Earl’s Court Road).

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021aThe D&O Diary is on assignment in Europe this week, with the first stop this past weekend in Paris for a field inspection of our junior-year study-abroad student’s scholarly and living arrangements. Our short weekend visit in the middle of rainy November, involving a variety of personal obligations and commitments, afforded only brief opportunities to observe and experience the city itself. But though it was dark and rainy, and though time was short, it was still Paris.

 

Despite grey skies, cool temperatures and occasional soaking rains, Paris059a still proved to be a marvelous place in which to promenade on Saturday afternoon. The conditions in November even afford some advantages over those prevailing in warmer months. The walkways along the river are less crowded, the museums are less jam-packed and seating is generally available at the sidewalk cafes.

 

048aEven after many visits to the city, an afternoon of rambling can still supply unexpected discoveries. On this visit, while walking from the Marais back toward the city center, we found behind the venerable church of St-Paul-St-Louis a hidden area of artisans’ workshops and small, comfortable cafes, known as the Village St-Paul. The Village sits between the Church apse and the river. The Village’s maze of pedestrian walkways and quiet courtyards –featuring shops with furniture, bricolage,  decorative fabrics and glass, toys, photographs and books, wine and other food — provides an oasis of calm just steps away from the noisy traffic of rue Saint-Antoine.

 

006aA brief stroll around Paris inevitably also involves numerous encounters with public artwork, particularly sculpture. The statuary is there to uplift, inspire, and instruct – as well as to display the wealth and sophistication of the state or of the patron that financed the emplacement. While much of the public art in Paris is beautiful, some is a bit more puzzling. We found ourselves contemplating a particularly elaborate fountain sculpture ensemble in the Jardin Marco Polo, south of the Jardin du Luxembourg in the greenway leading toward the Boulevard du Montparnasse. At the southern end of the greenway is an allegorical statuary arrangement, featuring four nymphs holding a globe, seven horses emerging from the waters of the inner basin, an arrangement of dolphin waterspouts within the inner fountain, and a circle of turtles arrayed in the outer fountain basin. The turtles are for some reason spouting water from their mouths. This elaborate and inexplicable arrangement sits in a relatively untrafficked area. Even given all the usual purposes of public art, this sculptural ensemble posed the simple question –why?

 

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A little research revealed that in the fountain (known as the Fontaine de l’Observatoire, owing to the proximity of the nearby Observatoire de Paris) the four female figures were intended to represent the four points of the compass, as a means of portraying the four parts of the world (that is, Europe, Africa, Asia and America). The other figures were merely decorative, rather than allegorical. So there is no deeper meaning behind the spouting turtles. As shown at the end of the post, Paris is full of public statuary, much of it interesting and even beautiful.

 

033aWhile we enjoyed some brief periods of sunshine, damp conditions generally prevailed otherwise. But regardless of the weather, there are always opportunities in Paris to enjoy the city’s wonderful food. We had a particularly pleasant meal Saturday evening at La Bastide Odeon  on rue Corneille, adjacent to the Odéon-Théâtre de l’Europe. We enjoyed a wonderful meal of a type that is all too difficult to find in the United States.  Our dinner included a bowl of chestnut soup, a tureen of bouillabaisse, a plate of rocket and walnuts, and an assortment of cheeses. Dinner at this quiet restaurant was relaxing and agreeable, and, given the quality of the food and the service, surprisingly affordable.

 

We also had an opportunity to experience one of Paris’s most venerable institutions in operation. On Sunday morning we attending the worship service at the church of  Saint-Germain- des-Prés. The church, 063awhich is the burial site for many of the  Merovingian kings, is this year celebrating the 1,000 year anniversary of its bell tower. Shortly before the service began, the church bells in the tower rang gloriously, with their peals echoing within the central nave, followed by a dramatic burst of organ music. A surprisingly large crowd attended the service – the seating area was completely full. Even though the church service was entirely in French, we nevertheless found it both interesting and inspiring. 

 

After the church service, we retreated to a brasserie on nearby rue de Buci, for a leisurely Sunday afternoon dejeuner during which we contemplated the eternal verities while watching the innumerable passersby. It is something of a mystery that in a city with a northern climate and cool temperatures for much of the year outdoor dining has become an almost inextricable part of the city’s identity.  Yet even on a cool November afternoon, enjoying a meal at a sidewalk café is, at least for an occasional visitor like me, one of those essential experiences without which a visit to the city would seem incomplete.

 

This time – as always seems to be the case – our Paris sojourn was far too brief. A weekend visit to Paris is like a taste of a delicious concoction, a brief experience that leaves you wishing you could enjoy the entire meal. As I rolled northward on the Eurostar train toward London, where I will be attending the Advisen European D&O Insights Conference this week, I felt more than a little envy for the study-abroad student who is even now looking forward to several more months in Paris.

 

More Pictures of Paris:

 

The Apse of the Church of St-Paul-St-Louis

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More Public statuary

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A Beautiful City in the Late Fall

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blumarbleImport laws and custom duties are not areas of the law into which I frequently (or lightly) venture, but I delve into these topics here and now because developments in these areas have served up yet another example where individual corporate officers have been held liable personally for matters that previously had been regarded exclusively as the source of corporate liability.

 

In September 16, 2014 en banc opinion (here), the United States Court of Appeals for the Federal Circuit held that a corporate official can be personally liable for unpaid duties and for (potentially massive) civil penalties in connection with  undervaluing merchandise imported by his company.

 

This decision is discussed in a September 18, 2014 memo from the Katten Muchin law firm entitled “Introducing Corporate Liability into Corporate Negligence: An Analysis of the Trek Leather Decision” (here) and in a November 2014  memo from the Kirkland & Ellis law firm entitled “Individual Found Liable for Violations of U.S. Import Laws” (here).

 

Background

Harish Shadadpuri is the President and sole shareholder of Trek Leather, Inc. Among other things, Trek imports men’s suits. The U.S Bureau of Customs and Border Protection (CBP) alleges that Trek was the importer of record of a 2004 shipment of men’s suits. The CPB alleges that by means of “false acts, statements and/or omissions” the company and its President “understated the dutiable value” of the shipment of suits, resulting in the underpayment of duties of $133, 605, in violation of the customs civil penalty statute, 19 U.S.C. Section 1592.

 

Section 1592 provides in pertinent part that “no person by fraud, gross negligence, or negligence” may “enter, introduce or attempt to enter or introduce any merchandise into the United States” by means of misrepresentations or omission.

 

The Court of International Trade had granted the government’s motion for summary judgment of liability as to both defendants. On appeal, the Federal Circuit had initially held that only importers of record and certain other indentified entities had the responsibility for making entry and that penalties under Section 1592 could only be imposed against those with that responsibility.

 

As the Katten Muchien memo summarized, in its initial decision the Federal Circuit had specified that “for the government to assess a penalty against an individual for violations stemming from entries filed by that individual’s import-of-record company, one of three activities had to arise: the government had to (1) ‘pierce the corporate veil’ to establish that the individual was in fact the importer-of-record; (2) establish that the individual him or herself was liable for fraud; or (3) establish that the individual was an aider and abettor of the company’s fraud.”

 

The individual sought en banc review of the Federal Circuit’s initial decision

 

The September 16, 2014 Decision

In a unanimous en banc decision written for the Federal Circuit by Judge Richard G. Taranto, the Court, setting aside the initial decision, held that the individual defendant could be held liable under the civil penalties statute for actions the Court found constituted the “introduction” of goods within the meaning of the statute.  The Federal Circuit held that the term “introduce” in Section 1592 is broad enough to include acts that extend beyond the formal filing of an entry for the importation of goods.

 

Specifically, the appellate court held that the term “introduce” was broad enough to “cover actions that bring good to the threshold of the process of entry by moving goods into CBP custody in the United States and providing critical documents (such as invoices dictating value) for use in the filing of papers for an anticipated release into the U.S. commerce.”

 

In finding the individual defendant liable, the appellate court was explicit that it was not piercing the corporate veil nor was it holding the individual liable simply because of his status as an officer of the company. Rather, the court stated that it was holding him liable for conduct it found to have violated Section 1592.

 

The appellate court affirmed the judgment against the individual for unpaid duties of $45,245 and penalties of $534,420, plus interest.

 

Discussion 

As I said at the outset, import law and customs duties are not within my usual bailiwick. However I am always concerned with issues affecting the potential liabilities of corporate directors and officers. What struck me in reading this opinion, and particularly, in reading the law firm memos, is that the upshot of the Federal Court’s en banc decision is that individual officers may now be held liable under the import laws for conduct that previously had been regarded exclusively as a potential source of corporate liability.

 

As the Kirkland memo puts it, under this decision, “any corporate officer, compliance officer, or customs broker helping prepare or send invoices to be used for CBP entry has potential liability for ‘introducing’ merchandise in violation of law.”

 

The Katten memo adds that by opening up the possibility of personal liability for “introducing” goods – while at the same time leaving the term “introduce” itself open to interpretation — the appellate court may be “opening exposure to personal liability for all sorts of individuals who are simply trying to do their job.” The law firm memo adds that personnel may find that “their ordinary routines are filled with activities that may be construed as ‘introducing’ merchandise into the United States,” for which “they could find themselves facing personal liability.”

 

This case obviously has important risk management implications. Companies and their personnel have significant incentives to ensure that procedures used are compliant with import law requirements.

 

Because of my lack of familiarity with this area of the law, I hesitate to attempt too may generalizations or conclusions. I note simply that, first, this development presents yet another area of personal liability for corporate officials ; and, second, that this development raises the possibility of individuals  being held responsible for liabilities that had previously been viewed as exclusively corporate. I note in that regard that the judgment against the individual here included not only a statutory penalty and interest, but also included the unpaid duties themselves, which to me clearly seems like a corporate rather than an individual responsibility.

 

From an insurance standpoint, it seems likely that the typical D&O Insurance policy would cover the defense fees and costs of an individual subject to an enforcement action of this type, However, most carriers would likely contend that the unpaid import duties as well as any civil penalties do not represent covered loss under their policies.

 

Speakers’ Corner: This week I will be in London to participate as a panelist and as a moderator at the Advisen European D&O Insights Conference (here), which will take place Wednesday at the Willis Building. If you will be at the conference, I hope you will make a point of saying hello, particularly if we have not previously met.

 

Break in the Action: There will be a brief interruption in the publication schedule for this site while I am on travel. The normal publication schedule will resume when I return to my office next week.

IFrancis Kean hi resn prior posts (most recently here), I have noted the growing problems involved with the increasing willingness of U.S. regulators to exert their regulatory and enforcement authority outside of the U.S. In the following guest post, Francis Kean of Willis examines a recent decision by the United States Court of Appeals for the Second Circuit in which the appellate court upheld the exercise of U.S. court jurisdiction under the U.S. Financial Anti-Terrorism Act against a financial institution domiciled outside the U.S. and involving alleged conduct taking place entirely outside of the U.S.

 

Francis Kean is executive director of Willis FINEX in London and the D&O expert for the WillisWire blog. This post was originally published November 7, 2014 on WillisWire (here).

 

I would like to thank Francis for his willingness to publish his article as a guest post on this site. I welcome guest post submissions from responsible authors on topics of interest to readers of this blog. Please contact me directly if you think you might be interested in submitting a guest post. Here is Francis’s guest post.

 

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I am indebted to John Blancett, partner of law firm SDMA for drawing my attention to a startling decision of the US Court of Appeal for the Second Circuit: Tzvi Weiss et al. v. National Westminster Bank Plc (judgment delivered 22nd September 2014). The case is striking and disturbing not just as fresh evidence that US long-arm jurisdiction is alive and well but also because it shows just how low the threshold test is for establishing liability against a financial institution which in the eyes of the US Courts might be said to have “… provided material support to a terrorist organization.”

 

The US Anti-Terrorism Act

The claim was originally brought against Natwest in the US District Court, for the Eastern District of New York under the US Financial Anti-Terrorism Act (ATA) on behalf of some two hundred US nationals (or their estates, survivors or heirs) who were victims of terrorist attacks launched in Israel by Hamas.

 

The ATA was introduced in the US expressly to provide a new civil cause of action in federal law for international terrorism. Not only does it provide extra-territorial jurisdiction over terrorist acts abroad against US nationals but it also confers jurisdiction on US courts for the conduct of financial institutions (or other organizations or individuals) anywhere in the world.

 

The Facts

The facts are simply stated. Between 1987 and 2007 Natwest provided banking services, first to the Palestine and Lebanon relief fund and then to its successor, the Palestine Relief and Development Fund (“Interpal”). In 2003 the United States Treasury Department Office of Foreign Assets Control (OFAC) designated Interpal a Specially Designated Global Terrorist (SDGT) on the basis that it “… has been a principal charity utilised to hide the flow of money to Hamas…”.

 

Following OFAC’s designation of Interpal as an SDGT, Natwest sought guidance from the Financial Sanctions Unit of the Bank of England and was told “… there are presently no plans to list [Interpal] under the Terrorism order in the UK” and “there is no need to take any further action…”. This stance was confirmed by both the UK Charity Commission and Special Branch. The Financial Sanctions Unit also told Natwest not to make any payments to or for the benefit of Hamas and that any suspicion of any such payments should be reported to the Charities Commission, the Bank of England and Special Branch.

 

Natwest subjected Interpal’s accounts to regular review and concluded in 2005 that some of the organisations receiving funds from Interpal were indeed suspected of having connections with Hamas. Natwest closed the last of Interpal’s accounts in March 2007. At no time was there any evidence that Natwest was aware of any Interpal payments either to Hamas or to any other organisations that were designated as terrorist organisations by the Bank of England or OFAC at the time of the payment.

 

The Court’s Decision

Natwest applied for summary judgment dismissing the victims’ claim on the basis that they could not show that it acted with the requisite knowledge to impose liability under ATA . The District Court dismissed the claim on this basis.

 

Perhaps unsurprisingly, based on the summary of Natwest’s actions above, the District Court concluded that there was insufficient evidence of any “..deliberate indifference as to whether Interpal funded terrorist activities….” After all, Natwest had expressly sought the views of the Bank of England and had also taken due account of the views of both the UK Special Branch and UK Charity Commission.

The surprise comes with the Court of Appeal’s decision overruling the District Court and finding in favour of the plaintiffs. This is how they summed up:

 

…we conclude that [the Anti-Terrorism Act’s] requirement is less exacting and requires only a showing that Natwest had knowledge that, or exhibited deliberate indifference to whether Interpal provided material support to a terrorist organisation, irrespective of whether Interpal’s support aided terrorist activities of the terrorist organisation. (Emphasis added)

 

What the Case Means

It seems (to me at least) that the difference between the two approaches could not be more significant. The focus of Natwest (and it may be said of the relevant UK authorities) was on the question as to whether Interpal could be suspected of “terror financing”.

 

By contrast, the US Court of Appeals has in effect said that Natwest’s focus should, for the purposes of the US Act at least, have been on the much broader question as to whether Interpal was “in any way financing a terrorist organisation”. In other words, if, for example, there was evidence that Interpal financed Hamas’ non-political and/or non-violent activities, that would be sufficient for the civil action for damages against Natwest to proceed. The fact that the UK authorities (and therefore perhaps understandably Natwest itself) may not have looked at this question in the same way was not an adequate defence to such civil liability under ATA.

 

Watch out!

The implications of this decision for companies anywhere in the world which do not follow precisely the same line as the US when it comes to the US ATA are sobering indeed.

 

Without wishing to finish on too apocalyptic a note, it is worth pointing out that the ATA does not just apply to financial institutions but to any and all organisations and individuals anywhere!

 

Update

11 November, 2014

Perhaps inevitably in the “Land of Litigation”, it wasn’t going to take long for others to catch on to the idea of trying to hold banks accountable for terrorist acts.

I spotted this piece in The New York Times of 10th November announcing new claims against HSBC, Barclays, Standard Chartered, the Royal Bank of Scotland and Credit Suisse following on from the NatWest case about which I blogged and another case involving Arab Bank. Although I haven’t seen the complaints themselves (and although they seem to focus on  Hezbollah, the Shiite militant group, as well as Iran’s Islamic Revolutionary Guard Corps-Qods Force rather than Hamas), they will undoubtedly  rely on the same US Anti-Terrorism Act.

It seems from the article that the claimants in this case will have an additional hurdle (or opportunity to extend the reach of the Act, depending on your point of view). This is because the Wall Street banks did not in these cases themselves make the transfers as opposed to allegedly facilitating them. Definitely one to watch!

 

– See more at: http://blog.willis.com/2014/11/us-long-arm-jurisdiction-creates-new-terrorism-headaches-for-banks-among-others/#sthash.FwXZGxLX.dpuf

marlyandThe question of whether or not a subsequent claim is interrelated with a prior claim — and therefore deemed first made at the time the earlier claim was filed – is a recurring D&O insurance coverage issue.  If the later claim is to be deemed first made at the time of the prior lawsuit, then the later claim is not covered under the claims made D&O insurance policy in force at the time the later claim arose.

 

In a November 7, 2014 opinion (here), District of Maryland Judge George Jerrod Hazel examined these recurring issues and determined that a 2010 action to enforce a judgment was interrelated with the 2006 adversary proceeding in which the judgment had been entered and therefore that the later action was not covered under the D&O policy in force at the time it was filed.  

 

Background

In 2002, Haymount Limited Partnership (HLP) retained International Benefits Group (IBG) to help HLP obtain financing for a real estate development project. HLP ultimately obtained financing but refused to pay IBG the finder’s fee IBG contended it was due. IBG claimed that HLP’s refusal to pay the finder’s fee forced IBG into bankruptcy. In 2006, IBG’s bankruptcy trustee filed an adversary proceeding in the District of New Jersey (the 2006 Adversary Proceeding) against HLP; its two general partners (Westminster and Haymount); Edward J. Miller, Jr., president of Haymount and Chairman of W.C. and A.N. Miller; and John A. Clark, vice president of Wesminter and president of the John A. Clark Company.

 

The trustee’s complaint in the 2006 Adversary Proceeding alleged conspiracy to deny IBG its finder’s fee; breach of contract; unjust enrichment; and tortious interference. On January 8, 2010, a judgment of $4.4 million was entered in the 2006 Adversary Proceeding against HLP and the others in favor of the Trustee.

 

On October 29, 2010, the Trustee filed a second action (the 2010 Action) in the District of New Jersey against several of the same defendants as had been named in the 2006 Adversary Proceeding, including HLP, Edward Miller and John Clark. The first paragraph of the 2010 Action stated that the suit was an “ancillary and adversary proceeding to recover and collect” the $4.4 million judgment entered the 2006 Adversary Proceeding. The complaint in the 2010 Action describes a number of actions the defendants allegedly took to transfer HLP’s assets in order to make them unavailable to satisfy the $4.4 million judgment. The complaint in the 2010 Action asserted claims against the defendants for fraudulent transfer, fraudulent conveyance, common law and statutory conspiracy, creditor fraud, and aiding and abetting.

 

In November 2010, W.C. and A.N. Miller Development Co. submitted notice of the 2010 Action to its D&O insurer, seeking to have the insurer pay its defense costs incurred in defending the 2010 Action. The carrier denied coverage for the claim, based on its assertion that the 2010 Action and the 2006 Adversary Proceeding involved interrelated wrongful acts and therefore that the 2010 Action is deemed under the policy to have been first made at the time the 2006 Action was filed. The insurance carrier argued that because the 2010 Action was deemed made in 2006, it was not first made during the coverage period of its claims made policy and therefore was not covered under the policy

 

Miller filed an action as against its D&O insurance carrier alleging that the insurer had breached its duties under the policy and seeking to recover the costs it incurred in defending the 2010 Action. The insurance carrier filed a motion for judgment on the pleadings and Miller filed a motion for summary judgment.

 

The D&O insurance policy provided that all “Interrelated Wrongful Acts” were considered one “Claim” for purposes of coverage. The Policy stated that “more than one Claim involving … Interrelated Wrongful Acts shall be considered one Claim which shall be deemed first made on … the date on which the earliest such Claim was first made.” The Policy defined “Interrelated Wrongful Acts” as “any Wrongful Acts which are logically or causally connected by reason of any common fact, circumstance, situation, transaction or event.”

 

The November 7 Opinion  

In his November 7 opinion, Judge Hazel granted the carrier’s motion for judgment on the pleadings and denied Miller’s motion for summary judgment, holding that the 2006 Adversary Proceeding and the 2010 Action involve Interrelated Wrongful Acts therefore that under the policy the two are deemed one Claim first made at the time the first action was filed. Because the subsequent lawsuit was deemed first made four years prior to the inception of the D&O insurance policy the 2010 Action  is not covered under the policy.

 

In reaching this conclusion, Judge Hazel rejected two arguments on which Miller sought to rely. First, he rejected Miller’s argument that because coverage under the D&O insurer’s policy for the 2006 Adversary Proceeding would have been precluded under the policy’s contract exclusion, it could be treated with the 2010 Action as a single Claim. Judge Hazel said the policy does not require a Claim to be covered in order for it to be treated the basis of an Interrelated Wrongful Act and therefore to be the basis of a single Claim. Judge Hazel also rejected Miller’s argument that the 2006 proceeding in bankruptcy was not a Claim within the meaning of the policy, finding that the 2006 Adversary Proceeding met the policy’s definition of the term Claim.

 

Judge Hazel went on to reject Miller’s argument that at most the two actions involve a “common motive” (that is, the defendants’ purported desire to avoid paying the finder’s fee), rather than a “common scheme.” Judge Hazel concluded that the two actions did arise out of a “common scheme” that “was directed at a specific entity (IBG), that involved a single contract (the fee agreement), that arose out of the same real-estate transaction (the Haymount Project) and that sought a single outcome (precluding IBG’s monetary recovery for its involvement in the Haymount Project).” Thus, Judge Hazel concluded, the two actins “shared a common nexus – namely, an alleged scheme involving the same claimant, the same fee commission, the same contract, and the same real estate transaction.”

 

Judge Hazel also found that the two actions were “logically or causally” connected, as It was “entirely logical” that the bankruptcy Trustee would file an action to recover damages associated with the alleged actions taken to avoid payment of the judgment entered in the 2006 Adversary Proceeding, noting that if the defendants in the 2006 Adversary Proceeding had satisfied the judgment, the 2010 Action would not have been filed.

 

Miller had tried to argue that there were important differences between the two actions, contending that the two lawsuits arose during different time periods, included different legal claims and involved a number of different parties. Judge Hazel said that these differences — “as well as any other differences” — were “irrelevant” to the question of whether the two actions involved Interrelated Wrongful Acts. Judge Hazel said that “the relevant focus is not on any number of differences” between the two actions, but instead “the relevant focus is on the similarities between the two.” Indeed, he added “so long as a single fact, circumstance, situation, transaction, or event logically or causally connects” the two actions, they would be deemed Interrelated Wrongful Acts.

 

Discussion

Because the 2010 Action expressly related to efforts by the bankruptcy Trustee to enforce or to collect upon the judgment the Trustee had obtained in the 2006 Adversary Proceeding, it was always going to be difficult for Miller to establish that the two actions were not “logically or causally connected by reason of any common fact, circumstance, situation, transaction or event.” Indeed, because the complaint in the 2010 Action stated on its face that it was “an ancillary and adversary proceeding to recover and collect” on the judgment entered in the 2006 Adversary Proceeding, there would seem to be little basis on which to contend that the two actions were not “logically or causally connected” by a common fact, circumstance or situation.

 

But while the outcome here may not necessarily be surprising, there are some noteworthy aspects of Judge Hazel’s ruling. First, his observation that any differences between the two actions are irrelevant is striking. While the differences between the 2006 Adversary Proceeding and the 2010 Action may well not have been determinative here, that is a long way from saying that consideration of the differences between two actions would never be relevant.

 

Second, Judge Hazel’s reading of the Policy’s definition of the term Interrelated Wrongful Acts is quite broad; his emphasis that two actions would involve Interrelated Wrongful Acts “so long as even a single fact, circumstance, situation, transaction, or event logically or causally connects” the two underscores how broadly the policy’s definition of Interrelated Wrongful Acts could sweep. The breadth of this reading suggests that points of overlap between two actions could be very peripheral or even remote and still be sufficient to connect the two as interrelated. The breadth of this expansive reading seemingly raises the possibility that coverage for entire categories of litigation could be precluded simply because there may have been an earlier lawsuit filed.

 

My concern in this regard is based in part on Judge Hazel’s suggestion that any differences between two actions are irrelevant, and that all that matters are the similarities between the two. While I understand that a party seeking to establish that differences between two actions matter has the burden of showing the significance of the differences (particularly with respect to the question of whether the two actions share a common factual nexus), it seems to me to be too much to suggest the differences between two action are never relevant.

 

I find it interesting that Judge Hazel gave the definition of Interrelated Wrongful Act here such an expansive reading even though the definition lacked the wording sometimes found in similar definitions in other D&O insurance policies; that is, while the definition in this case provided that alleged wrongful acts are interrelated if they are connected “by reason of” a common fact or circumstance, other policies’ definitions provide further that the alleged wrongful acts are interrelated if they are “based upon, arising out of or in any way relating to” a common fact or circumstance. Judge Hazel gave the policy wording here an expansive meaning notwithstanding the absence of this broader definitional wording.

 

As I noted at the outset of this discussion, the interrelatedness analysis in this case arguably was fairly straightforward. The reason I have nevertheless dwelt on these issues at length is because all too often interrelatedness issues can be vexatious and even confounding, as I noted at length in a prior post. My concern is that the sweep of Judge Hazel’s generalizations about the interrelatedness issues – particularly his statement that any differences between two actions are irrelevant to the interrelatedness analysis –could be read in a way that could cause problems in other cases where the lines of analysis may not be as straightforward as they arguably were here.

caesersThis past week the annual PLUS International Conference took place at the sprawling Caesar’s Palace complex in Las Vegas. Given the mass of confusing pathways and corridors and vast distances between the various event venues at the hotel, it wouldn’t surprise me at all to hear that a few conference attendees are still wandering around inside the Caesar’s Palace grounds, dazed into a trance by the blaring music and the slot machines’ flashing lights. Just the same, it was unquestionably a very successful event.

 

The high point of the event for me was the presentation of the PLUS1 award to my good friend Aruno Rajaratnam, of the Ince & Co. law firm in Singapore, whom I interviewed in a Q&A I posted on this site last week. In the first picture below I am standing outside the conference ballroom with Aruno. The next picture shows Aruno delivering her acceptance speech. In the third picture, Aruno stands with incoming PLUS President Jim Skarzynski and immediate Past PLUS President Dave Williams. The final picture was taken at the dinner in celebration of Aruno’s award; shown from left to right in the picture are Dave Williams of Chubb; Aruno; Ann Longmore of Marsh; Shasi Gangadharan of Chubb (Singapore); Joe Montelone of the Rivkin Radler law firm; and me.

 

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The PLUS International Conference is always a good opportunity to reunite with old friends. In the picture below, I am standing with my former colleague and good friend, Diane Parker of AWAC, together with Robert Chadwick of the Campbell Chadwick law firm in Dallas.

 

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This final picture was taken at the opening night reception. From left to right, Corbette Doyle of Vanderbilt University; me; Pete Herron of Travelers; and Jeff Lattman of Beecher Carlson.

 

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burzinThe recent Satyam scandal and ensuing litigation put the duties of independent directors under scrutiny.  The recently enacted Companies Act of 2013 addressed a number of issues relating to the duties and liabilities of independent directors.  In the following guest post, Burzin Somandy of Somandy & Associates in Mumbai takes a look at the approach that had been taken under prior law with respect to independent directors’ duties and also at the standards that the Companies Act of 2013 has put in place. As discussed below, the primary purposes of the new Act’s provisions were to ensure transparency and independence.

 

Many readers will recall that Burzin is the author of the chapter about India in the recently published book, The Global Directors and Officers Desk Book (about which refer here). I would like thank Burzin for his willingness to publish his guest post on this site. I welcome guest post submissions from responsible authors on topics of interest to readers of this blog. Please contact me directly if you would like to submit a guest post. Here is Burzin’s guest post:

 

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Introduction:

The case law that has evolved under the erstwhile Indian Companies Act of 1956 and ancillary legislation which concerns the activities of a company has iterated that the Directors and Officers of a company can be held vicariously liable for the acts of the company, which liability may arise as a consequence of the involvement of the Directors and Officers in the act complained of, the breach of fiduciary duties, negligence or ultra vires acts.

 

However, the erstwhile Companies Act 1956 did not draw any distinction between a Director and an Independent Director. This concept was first introduced by the Securities and Exchange Board of India in the year 2000 under clause 49 of the Listing Agreement in respect of all companies who wished to list their shares on the stock exchange, whereby the term Independent Director came to be introduced. However, since there was no statutory recognition of this term under the erstwhile Companies Act of 1956, this led to a degree of confusion as to the extent of liability which could be fastened on an independent director wherein proceedings were initiated against the Board of Directors of a company. Post the Satyam scandal and the lawsuit that emanated thereafter, the role of Independent Directors has come under scrutiny, including in a host of judgments that have been pronounced by various courts on the extent of liability which could be fastened on an independent director for acts committed by a company or the remaining directors on the board of a company.  However, this raging controversy was ultimately laid to rest in the New Companies Act of 2013, which defines who an Independent Director is thereby providing statutory recognition to the concept of an Independent Director.

 

The main spotlight of this article is to analyse the evolving concept of the recognition of an Independent Director in listed companies and the emerging trends in their liability exposure, including the sea changes brought about by the new Companies Act of 2013.

 

Background – Evolution of the concept of an Independent Director :

The severity of Independent Directors was recognized with the prologue of Corporate Governance. The Securities and Exchange Board of India specified the principles of corporate governance and thereby introduced clause 49 in the Listing agreement of the Stock Exchanges which was predominantly formulated for the improvement of corporate governance in all listed companies and which mandates the appoint of Independent Directors in all listed Companies in proportion to the number of directors on the Board of a company.

 

In spite of the fact that Clause 49 of the Listing Agreement characterizes the concept of an Independent Director, ambiguity persisted until the 2013 Companies Act was enacted, especially in light of the extent of liability of an Independent Director in the event of any contravention of law, as there was no distinction between Directors and Independent Directors in the Companies Act 1956 and since for the most part, it was perceived that Independent Directors were not involved in the day to day affairs and management of a company and were appointed to ensure appropriate corporate governance. Consequently, in legal proceedings filed against the Company and its directors for contravention of law, Independent Directors were faced with the herculean task of establishing their innocence in the acts complained of and that vicarious liability for the commission of an offence could not be attributed to them merely by virtue of their being directors in a company, especially given their lack of involvement in the day to day affairs or management of the company being prosecuted.

 

This controversy was substantially dealt with in two landmark judgements of the Supreme Court. In the case of K.K. Ahuja v. VK Vora[1], the Supreme Court observed that to be liable for the commission of an offence, a person should fulfill the legal requirement of being a person in law responsible for conduct of the business of the Company and also fulfill the factual requirement of being a person in charge of the business of the Company. Consequently, the Supreme Court provided a two-pronged test — the first prong being a legal, statute-based test, where it is required to be proven that a person is responsible to the company for the conduct of the business of the company. The second prong is a fact-based test, where through specific averments the complainant has to establish that the particular person was in-fact in overall control of the day-to-day business of the company. Both the prongs need to be complied with. Hence, if a person fails to satisfy the first test, he is not required to meet the second test. Similarly in the case of S.M.S. Pharmaceuticals Ltd. v. Neeta Bhalla and Another[2], it has been held by the Supreme Court that “The liability arises from being in charge of and responsible for conduct of business of the company at the relevant time when the offence was committed and not on the basis of merely holding a designation or office in a company.

 

These judgments came as a great relief to independent directors of companies who were facing prosecution alongwith other directors of companies merely by virtue of their being on the board, inconsequential to their involvement in the act complained of.

 

 Looking to the raging controversy on the liability of an independent director in the event of a complaint filed against a company and its directors and specifically post the revelation of the Satyam scam in January 2009 which raised serious doubts about the involvement of independent directors in the day to day working of a company, Independent Directors realised that their role was no longer going to be ceremonial which sparked a demand for better corporate governance. Corporate India during this period witnessed a marked increase in the number of resignations of Independent Directors from the boards of companies.  This period saw the issuance of a Circular[3] by the Ministry of Corporate Affairs, which sought to relieve non executive directors against penal action taken against them. This circular provided that directors should not be held liable for any act of omission or commission by the Company or by any officer of the Company which constitutes a breach or violation of any provision of the Companies Act, 1956 and which occurred without their knowledge attributable through the board process and without the consent or connivance of such director or where such director had acted diligently in the board process. The said circular, however, was issued in the context of action being taken by the Registrar of Companies for violation of provisions of the Companies Act 1956 and was not issued generically for all proceedings initiated against directors.

 

Should Independent Directors be held responsible if they did not smell a rat?

Independent directors are those not charged with the day-to-day affairs and management of the company and are usually involved in ensuring proper norms of corporate governance.

 

The recent scandals precisely ascertained the growing need for determining the liability of independent directors for prevention and detection of fraud, in view of the limited roles performed by them in the company. Under the 1956 Act and the judgements of the Supreme Court as referred above, an Independent Director can content that he should not be considered as an “officer in default” and consequently is not liable for the actions of the Board. The new Companies Act of 2013 however puts this controversy to rest and provides for the liability of an Independent Director to be limited to acts of omission or commission by a company which occurred with their knowledge, attributable through board processes, and with their consent and connivance or where they have not acted diligently. The said new Act thus saw a sea change and makes a considerable effort to bring the role of an Independent Director in line with the changing needs of corporate governance of India.

 

Another sea change are the provisions in the Companies Act which deals with the indemnification of a director. As per section 201 of the Companies Act, 1956, a company cannot indemnify a director till such time that she/he is found innocent by a court of law. However, section 197(3) of the Companies Act, 2013 provides that premium paid on an insurance policy shall be treated as part of the remuneration of a director only if such director is found guilty in respect of the violation for which indemnity is sought under a D & O policy. This would therefore mean that directors can now be indemnified and there is no prohibition on indemnification, as was the case with the Companies Act 1956.

 

Analytical review of Clause 49-Listing Agreement of the Companies Act, 1956 vis-à-vis Companies Act, 2013 :

Clause 49 of the Listing Agreement gives an inclusive definition of Independent Director, covering under its ambit non- executive directors who do not have a material pecuniary relationship with the company, its promoters, management and subsidiaries which may affect the independence of their judgment. Independent directors are those not charged with the day-to-day affairs and management of the company and are usually involved in ensuring proper norms of corporate governance. The Companies Act, 2013, sets to overhaul the provisions relating to Independent Directors and thus gives about a clear demarcation between a nominee director and an Independent Director.

 

Several other restrictions have also been built into the new act to ensure that there is no financial nexus between an independent director and the company. For instance, the new act prohibits independent directors from receiving stock options of the company. The Listing Agreement does not prohibit the issue of stock options. Rather it provides that the maximum limit on stock options to be granted to independent directors can be decided by a shareholders’ resolution. The new act limits the remuneration of independent directors to sitting fees, reimbursement of expenses for participation in the board and other meetings, and such profit-related commission as may be approved by the shareholders. This is yet another area of inconsistency with the Listing Agreement that will have to be clarified by the regulators.

 

 Conclusion:

The primary objective behind the new act’s provisions on independent directors are to ensure transparency and independence. The New Act casts great responsibility on the Independent Directors since it specifies that any decisions taken by the board in the absence of independent directors must be circulated to all directors and can be final only upon receiving ratification from at least one independent director. The Act has thus set high standards on the one hand and on the other ensured that Independent Directors are not privy to legal proceedings when they have no involvement in the act complained of.  It is expected that these changes would increase the pool of professionals into the stream of Independent Directors and restore the confidence in such persons to take up board positions knowing that they will not be frivolously prosecuted.

 

Reference :

[1] K.K. Ahuja v. VK Vora [(2005) SCC 89)]

[2] S.M.S. Pharmaceuticals Ltd. v. Neeta Bhalla and Another [(2009 (3) CC (NI) 194]

[3] (Circular no. 8/2011 No.2/13/2003/CL- V dated 25th March, 2011)