Whistleblower reports to the SEC continued to rise during the latest fiscal year, according to the agency’s annual Dodd-Frank Whistleblower Program report to Congress. According to the November 15, 2013 report, a copy of which can be found here, there were 3,238 whistleblower reports to the SEC during the 2013 fiscal year, brining the total number of whistleblower reports to the agency since the program’s August 2011 inception to 6,573.

 

The whistleblower program Dodd-Frank Act provides for the payment of a whistleblower bounty to individuals who voluntarily provide original information that leads a successful enforcement action resulting in monetary sanctions over $ 1 million. The eligible whistleblowers may receive a n award of ten to thirty percent of the amounts the agency collects. To ensure that bounty awards would not decrease the amount of recovery for the victims of securities law violations, Congress established a separate fund, called the Investor Protection Fund out of which the bounty payments are to be made.

 

In 2012, the first full fiscal year in which the program was in place, the agency received 3,001 whistleblower tips. The number of whistleblower reports increased in fiscal 2013 to 3,228, an increase of about 7.5%, bringing the total number of whistleblower reports since the program’s inception to 6,573.

 

The most common complaint categories reported by whistleblowers during the 2013 fiscal year were Corporate Disclosures and Financials (17.2%); Offering Fraud (17.1%) and Manipulation (16.2%). Other significant categories include insider trading (with 6% of tips during fiscal 2013)and FCPA violations (4.6%). The distribution of reports by complaint category during fiscal 2013 was roughly comparable to the distribution of whistleblower reports during the 2012 fiscal year.

 

During the 2013 fiscal year, the Commission received whistleblower submissions from individuals in all fifty states, as well as from the District of Columbia, Puerto Rico, Guam, and the U.S. Virgin Islands. The states with the highest numbers of whistleblowers in fiscal 2013 were California (375 tips, or 11.6% of all tips during the fiscal year), New York (215), Florida (187) and Texas (135).

 

The SEC also received whistleblower reports from individuals in fifty-five countries during fiscal 2013, bringing the total number of countries from which the agency has received whistleblower reports since the program’s inception to sixty-eight. The countries with the highest numbers of whistleblower reports during fiscal 2013 were the United Kingdom (66), Canada (62) and China (52).

 

Though the agency has now received over 6,500 whistleblower reports, so far the agency has made only a total of six whistleblower bounty awards, including four during fiscal 2013. The 2013 awards included the largest award to date, an award of over $14 million at the very end of the 2013 fiscal year. The agency awarded a total amount of about $14.8 million during fiscal 2013. The balance remaining in the Investor Protection Fund (out of which the awards are made) was $439 million at the end of the fiscal year – so the SEC has plenty of funds out of which to make further awards.

 

Though the program has so far made only a few awards relative to the number of whistleblower reports, it seems likely that the number of awards will accelerate in the future. The very painstaking process the agency follow in making awards (described in the report to Congress) shows that the agency is being very careful and very deliberate in making awards. As the agency makes more awards, it seems likely that the program will attract more whistleblower reports, particularly to the extent that the agency makes more large awards (the recent $14 million award came only at the very end of the fiscal year and so had no impact in connection with the figures presented in the most recent report to Congress). The lengths to which the agency has gone to protect the anonymity of the whistleblower is also likely to encourage others to come forward.

 

The significant numbers of whistleblowers from outside the United States is very interesting. The agency reports that during fiscal 2013, the agency received 404 whistleblower reports from individuals located outside the United States, representing 11.77% of all whistleblower reports during the fiscal year. This is up slightly from the prior fiscal year, both in absolute numbers and in percentages; there were 324 whistleblower reports from outside the Unites States, representing 10.8% of all fiscal 2012 tips.

 

It will be interesting to see how these non-U.S. reports play out over time, and whether and to what extent the agency makes bounty awards to whistleblowers from outside the U.S. It will also be interesting to see if reports from outside the U.S. continue at the current levels in light of the fact that courts have held that the Dodd-Frank provisions protecting whistleblowers from retaliation do not apply outside the U.S. (about which refer here). Many prospective whistleblowers learning that they would not have the benefit of the anti-retaliation provisions might now be less willing to come forward. In the absence of these protections, the volume of whistleblower reports from outside the U.S. might well decline.

 

Another question that will be interesting to follow is whether or not there will be further follow -on civil lawsuits following in the wake of whistleblower reports (of the kind discussed here). My concern is that increased whistleblowing activity, encouraged by the availability of whistleblower bounties, could lead to an increase not only in SEC enforcement activity but also to an increase in follow-on civil litigation, including in particular securities class action litigation activity.

 

On November 19, 2013, Cornerstone Research, in conjunction with the Latham & Watkins law firm, released a report analyzing securities suit opt-out cases. The report, entitled “Opt-Out Cases in Securities Class Action Settlements,” and which can be found here, takes a comprehensive look at cases in which individual class members have opted out of the class action settlement and pursued a separate lawsuit. Cornerstone Research’s November 19, 2013 press release about the report can be found here.

 

The report’s analysis is interesting on its own, but it may take on a special significance in light of the fact that the Supreme Court’s reconsideration of the fraud on the market theory could lead to a securities litigation environment in which aggrieved investors may have to decide whether or not to pursue individual claims rather than class action claims. The analysis of the opt-out cases may help understand the circumstances in which investors might pursue their claims individually.

 

The report’s authors examined 1,272 securities class action lawsuit settlements between 1996 and 2011. The authors identified 38 cases, or about 3% of the total, in which at least one plaintiff opted out of the class action settlement and pursued a separate case against the defendants.

 

Unsurprisingly, the authors found that as the size of the class action settlement grew larger, “the propensity of plaintiffs to bring an opt-out case also increases.” The authors found that in ten percent of the cases involving class action settlements over $20 million and eight of 15 cases with settlements over $500 million had associated opt-out actions. However, only 0.9 percent of class action cases with settlements below $20 million had associated opt-out cases.

 

In 21 of the 38 class action settlements with associated opt-out cases, the authors were able to find publicly available information regarding settlements or judgments in the opt-out cases. The average total opt-out settlement amount was $85.4 million, or 12.5% of the average class action settlement for these cases. The averages are “skewed by the larger opt-out settlements,” as the median opt-out is only $3.9 million, or 3.9 percent of the related class action settlements.

 

The largest opt-out settlement was in the AOL Time Warner case, where the $764 million in opt-out settlements represented 30.6% of the class action settlement (refer here for background) . The largest opt-opt settlement as a percentage of the class settlement was the Qwest Communications case, where the $411 million opt-out settlement was 92.4 percent of the final, adjusted class action settlement (refer here for background).

 

In six of the cases involving opt-out settlements, the opt-out settlements exceeded 20 percent of the size of the class action settlement. However, all of the cases in which the opt-out settlement was greater than 5 percent of the class action settlement took place prior to 2007. The largest opt-out settlements took place between October 2004 and December 2007. The authors did not identify any opt-out settlements greater than $10 million from a class action settlement after 2007.

 

The most common plaintiffs in opt-out cases were pension funds, which were involved in 13 of the opt-out cases between 1996 and 2011.

 

While the report details a variety of impressive statistics detailing the opt-out plaintiffs’ recoveries, the report also shows that not all opt-outs succeed. The report describes a number of cases where the class action claims settled but in which the opt-out claimants’ separate cases were dismissed.

 

Discussion

The report’s analysis about the timing of the larger opt out cases is interesting. The reports findings suggest that opting out as a significant phenomenon in securities class action litigation was most prevalent  — and seemingly most productive for the opting-out party — during the era of corporate scandals, which resulted in some of the largest class action settlements ever.

 

It is worth noting that there are at least two significant opt-out actions that remain pending: the Countrywide securities lawsuit opt-out action (about which refer here) and the Pfizer securities lawsuit opt-out action (refer here). Both of these were filed more recently; their outcomes could eventually affect the analysis. But the existence of these cases does is not inconsistent with the general conclusion that the opt-out phenomenon is largely associated with the largest cases.

 

At first I was somewhat surprised the opt-out cases are associated with only 3 percent of securities class action settlements. However, this general observation may be a reflection of the number of smaller settlements. What is most interesting is that opt out cases were associated with ten percent of cases with class action settlements over $20 million.

 

These observations are interesting in and of themselves, but they are also interesting to think about in light of the fact that the U.S. Supreme Court will now be reconsidering the fraud on the market theory in the Halliburton case. The outcome of the Halliburton case is uncertain, but if the Supreme Court does set aside the fraud on the market theory, it will be more difficult for aggrieved investors to pursue securities suits as class actions. The investors will then have to consider whether or not they want to pursue a claim individually. While there are a host of factors that might affect this analysis, the authors’ report suggests that individual investors would be less likely to pursue individual claims in smaller cases, although likelier to proceed individually in larger cases.

 

The relatively short report contains a number of interesting observations and is worth reading at length and in full. The report includes a number of interesting observations about the motivations of opt-out plaintiffs and about the effect of the possibility of opt-outs on the class action settlement dynamic.

 

Third Quarter Securities Litigation Filing Trends: Readers interested in tracking securities class action filings trends will want to take a look at the November 2013 memo from Woodruff Sawyer reporting on filing trends through September 30, 2013. The report contains a number of interesting observations about securities class action filings. Among other things, the report notes that though there was an “upswing” in filings during the third quarter compared to the first two quarter of 2013, “we anticipate that total filings per year will be on par with 2012 at around 125 cases (127 cases were filed in 2012).” The full memo can be found here.

 

In a development that has the potential to change the way private securities suits in the United States are litigated, the U.S. Supreme Court has agreed to take up a case in which the petitioners seek to have the Court revisit the “fraud on the market” presumption. The presumption allows plaintiffs in securities suits under Section 10(b) to seek certification of a shareholder class without having to show that each one of the shareholders relied on the alleged misrepresentation. Without the benefit of the presumption, it would be much more difficult for Section 10(b) claimants to pursue their claims as a class action.

 

Because of the possibility that the Court could set aside the “fraud on the market” theory in the case, the long-running Halliburton securities suit could prove to be the most important securities case before the Court in a generation. 

 

However, as discussed below, though the Court’s willingness to take up the Halliburton case raises the possibility that the Court might set aside the “fraud on the market” presumption, a variety of other outcomes are possible. And even if the Court were to set aside the presumption entirely, private securities litigation would go on, even if in a distinctly different form.

 

Just the same, if the presumption is set aside, the D&O claims landscape as we have known it would be significantly changed, with very significant implications for the securities litigation bar and for the D&O insurance industry.

 

Background

Since the U.S. Supreme Court’s 1988 decision in Basic, Inc. v. Levinson, securities plaintiffs seeking class certification have been able to dispense with the need to show that each of the individual class members relied on the alleged misrepresentation, based on the presumption that in an efficient marketplace, a company’s share price reflects all publicly available information about a company, including the alleged misrepresentation, and that the plaintiff class members relied on the market price.

 

The “fraud on the market” presumption has many critics. And in connection with the U.S. Supreme Court’s 2013 decision in the Amgen case (about which refer here), at least four justices (Alito, Scalia, Thomas and Kennedy) appeared to question the continuing validity of the presumption. In his concurring opinion, Justice Alito asserted that the presumption “may rest on a faulty economic premise,” and specifically stated that “reconsideration” of the Basic presumption “may be appropriate.” In his dissenting opinion in the case (in which Justices Scalia and Kennedy joined), Justice Thomas noted that the “Basic” decision itself is "questionable.”

 

Recognizing the opportunity to have the Court reconsider the fraud on the market theory, the defendants in the long-running Halliburton securities class action litigation filed a petition for a writ of certiorari expressly seeking to have the Court consider whether the Court should “overturn or significantly modify” the Basic presumption of “class wide reliance derived from the fraud on the market theory.”

 

Halliburton filed its petition in connection with a securities class action lawsuit that has been pending against the company and certain of its directors and officers since 2002. In their complaint, the plaintiffs allege that the company and certain of its directors and offices understated the company’s exposure to asbestos liability and overestimated the benefits of the company’s merger with Dresser Industries. The plaintiffs also allege that the defendants overstated the company’s ability to realize the full revenue benefit of certain cost-plus contracts.

 

For several years now, the parties in the case have been engaged in full-scale combat on the issue of whether or not a class should be certified in the case. Indeed, the class certification issue in the case has already been before the U.S. Supreme Court; in 2011, the Court unanimously rejected the company’s argument (and the Fifth Circuit’s holding) that in order for a plaintiff to obtain class certification, the plaintiff must first establish loss causation. Following the Supreme Court’s ruling, the case was remanded back to the lower courts and in in June the Fifth Circuit certified a class in the case.

 

The Halliburton case is now back before the Court for a second time, for the Court to again review what issues may appropriately be considered at the class certification stage. In its petition, the company argued that the Basic presumption is based on outdated economic theory and that the special considerations given putative class plaintiffs in securities suits are out of keeping with the Court’s more recent class action case law, particularly the Wal-Mart case and the Comcast case. Among other things, the company argued that the stock market just isn’t as efficient as the Basic decision assumed. In opposing the petition, the plainitffs argued, among other things, that Congress has amended the securities laws numerous times since the Supreme Court decided the Basic case, but Congress did not set aside the “fraud on the market” presumption.

 

Discussion

The possibility that the Court could set aside the fraud on the market presumption means that the Halliburton case could be, in the words of leading securities plaintiffs’ attorney Max Berger of the Bernstein Litowitz firm (as quoted in Alison Frankel’s November 15, 2013 post on her On the Case blog) a “game changer.” As Jordan Eth and Mark R.S. Foster of the Morrison Foerster law firm noted in their November 15, 2013 memo about the Supreme Court’s cert grant in the case (here), Halliburton “has the potential to be the most significant securities case in a generation.” As Frankel noted in her blog post, without the benefit of the presumption of reliance at the class certification stage, “it is hard to imagine how plaintiffs’ lawyers will be able to win certification of securities fraud class actions.”

 

But while the Halliburton case has the potential the change the way private securities lawsuits are litigated in the United States, the outcome of the case is far from certain. There are a range of possible outcomes in the Supreme Court’s consideration of the case.

 

First, though it only requires four votes for the Court to take up a case, it takes five votes to determine the outcome of a case. The obvious candidate to supply the fifth vote in Halliburton is Chief Justice John Roberts, who generally votes with the four justices in the Court’s conservative wing who wanted the Court to reconsider Basic. However, in the Court’s recent Amgen decision, Roberts did not vote with the dissenting and concurring conservatives; instead, he joined Justice Ginsberg’s majority opinion, where she specifically noted that Congress had amended the securities laws in 1995 without altering the Basic presumption. In other words, just because the Court granted the cert petition, that doesn’t necessarily mean that the Basic presumption will be set aside.

 

Second, although the petitioners expressly sought to have the Court consider whether to “overturn or significantly modify” the Basic presumption, that was only one of two issues the petitioners sought to have the Court address. The petitioners also sought to have the Court consider (seemingly in the alternative to the possibilities presented by their first issue) “Whether, in a case where the plaintiff invokes the presumption of reliance to seek class certification, the defendant may rebut the presumption and prevent class certification by introducing evidence that the alleged misrepresentations did not distort the market price of its stock.”

 

In its order granting the cert petition, the Court did not restrict its consideration of the case to either of the two issues, which suggests that the Court will consider both issues. The existence of the second issue raises the possibility that, rather than setting aside a precedent of 25 years’ standing, the Court might instead explain the ways in which (and when) the Basic presumption may be rebutted, if at all, at the class certification stage. While this outcome would unquestionably be represent a significant securities litigation development, it would not be as revolutionary as would be the setting aside of the Basic presumption.

 

In his November 17, 2013 post on his D&O Discourse blog (here), Doug Greene of the Lane Powell law firm outlines a range of other additional ways the Supreme Court might rule short of simply throwing out the fraud on the market theory.

 

Even of the Supreme Court sets the fraud on the market presumption aside, private securities litigation will go on. As Doug Greene observes in his blog post, "the plaintiffs’ securities bar woudl adjust." 

 

Among other things, it is important to note that the Basic presumption applies to misrepresentation cases under Section 10(b) of the Exchange Act. As Stanford Law Professor Joseph Grundfest is quoted as saying is Alison Frankel’s blog post, even if the court eliminates the Basis presumption, “investors in some cases will still be able to bring class actions under Section 11 of the Securities Act of 1933,” which does not require a showing of reliance but holds defendants strictly liable for material misrepresentations

.

In addition, the requirement to show reliance arguably is limited to misrepresentation cases. As one commentator in Frankel’s blog post notes, there is precedent holding that in cases alleging omissions rather than misrepresentations, the shareholder claimants do not have to show that they relied on the omissions. In other words, even if the Court were to set aside the Basic presumption, the plaintiffs’ attorneys could try to work their way around the problem by recasting their alleging as omissions rather than as misrepresentations.

 

It is also worth noting that the way securities cases are being litigated was already changing in significant ways. Many of the securities suits filed in the wake of the financial crisis were filed as individual actions or group actions, not as class actions. And while that was due in part to the fact that many of the claimants in the credit crisis cases were able to plead massive individual damages, the fact is that the leading plaintiffs’ firms all already have extensive experience litigating securities cases on other than a class basis. In addition the plaintiffs’ firms have established significant client relationships with pension funds and other large institutional investors whose claims could be aggregated to present a collective action on behalf of a group of investors, even if those claimants might not be able to proceed as a class action.

 

As Doug Greene notes in his blog post, the non-cass securities lawsuits "would be no less expensive to defend than today’s class actions" — and could be even more expensive as they couldl require more complex case management. Greene also notes that experience with opt-out litigation shows that individual actions have tended to settle for a larger percentage of damages than today’s securities class actions. And even those cases that do settle won’t preclude additional suits by other investors, raising the possibility of opportunistic follow-on suits.

 

And even if the Court were to set aside the presumption, there is the question of what would happen next. Would the SEC be under pressure to bring more enforcement cases? Would Congress be under political pressure to provide an alternative means for aggrieved shareholders to obtain a recovery, particularly small investors who might be shut out of class action cases?

 

All of that said, there is no doubt that if the Basic presumption were set aside, it would change the way that securities lawsuits are litigated in this country. In Section 10(b) misrepresentation cases, it would become much more difficult for plaintiffs to obtain class certification. Without the benefit of being able to hold out the threat of ruinously large class-wide damages, plaintiffs’ lawyers would be less able to extract the kind of massive settlements that have become a feature of private securities litigation.

 

Without the possibility of being able to leverage outsized settlements, plaintiffs’ lawyers would likely file fewer cases. In insurance industry terms, the elimination of the fraud on the market presumption could mean material reduction in both claim frequency and severity.

 

It seems likely that among the many consequences that would result if the Basic presumption were set aside, the way many public companies purchase D&O insurance would also change. As Joe Monteleone noted on his D&O E&O Monitor blog (here), the end result could be that “there will be less of a need to buy large towers of D&O insurance, a likely reduction in rates and perhaps an overall shrinking of the D&O marketplace with fewer players and less revenue in both the insurer and brokerage communities.” Of course, if securities litigation were to mutate into something smaller but more complex, the impact on D&O purchasing patterns and rates could take a different turn.

 

In other words, though there are a lot of possible outcomes here, the Halliburton case has enormous potential significance for the D&O insurance industry – this one is likely to have an impact. 

 

For better or worse, we will not have to wait very long to see how all of this will play out. The Supreme Court has not yet set a briefing schedule for the case, but the case will likely be heard and decided before the end of the current term, in June 2014.

 

In a case that has important implications for the potential liabilities of individual directors and officers, on October 28, 2013 twelve former directors and officers of bankrupt Northstar Aerospace agreed to pay a total of $CAN 4.75 million to the Ontario environmental regulator for costs to remediate environmental contamination at the company’s manufacturing site. The case also raises important D&O liability insurance questions as well.

 

An October 28, 2013 new report describing the settlement can be found here. A November 12, 2013 memo from the McCarthy, Tetrault law firm about the case can be found here. A November 6, 2013 memo from the Faskin Martineau law firm can be found here. A November 1, 2013 memo from the Osler, Hoskin & Harcourt law firm can be found here.

 

 Background

Between 1981 and 2009, Northstar Aerospace (Canada) manufactured airplane parts at a plant in Cambridge, Ontario. In 2010, it was determined that chemicals the company had used in its manufacturing operations had migrated to nearby residential properties. Northstar had commenced remediation efforts prior to its 2012 bankruptcy. The proceeds realized from the bankruptcy sale of the company’s assets were not sufficient to fund further remediation efforts.

 

The Ontario Ministry of the Environment (MOE) took over the remediation efforts and filed a regulatory action against twelve former directors and officers of the company seeking to hold them responsible for remediation costs of approximately $CAN 15 million. In June 2013, the Environmental Review Tribunal entered an order holding the individuals personally responsible for the ongoing costs (about $CAN 1.4 million per year) while they pursued an appeal of the regulator’s action against them.

 

In their appeal, the individuals argued among other things that they had not been involved with the company at the time of the alleged contamination, and that in any event they had not been responsible for environmental issues at the company.

 

Undoubtedly because they were obliged to provide interim funding while they pursued their appeal, the individuals reached a settlement agreement with the MOE. According to news reports, the MOE said that the settlement represents “the first time that the Ministry has held corporate directors of a public company personally responsible for an environmental cleanup after a company has gone bankrupt.”

 

Francis Kean has additional interesting background regarding this case in an earlier  post on the Willis WIre blog, here.

 

Discussion

It is true that this case involves only the activities of a provincial regulator pursuing its mandate according to the particular requirements of the specific jurisdiction’s laws. I am not an environmental attorney and there may well be important differences between Ontario’s laws and those applicable in other jurisdictions that limit the significance of this case to the specific jurisdiction, circumstances and situation involved.

 

Nevertheless, the case presents yet another example where regulators have aggressively disregarded the corporate form in order to hold individual directors and officers responsible for corporate liabilities without regard to the individual’s personal culpability, a deeply troubling phenomenon on which I have frequently commented on this blog (most recently here). Because of regulators increasing willingness to try to impose direct personal liability on individual directors and officers for corporate violations – including for environmental violations – this case presents important implications for all individuals serving as directors and officers, not just those in Ontario.

 

At a minimum, this case has important implications for individuals serving companies whose operations potentially could produce environmental contamination. These individuals certainly will want to become informed about their company’s operations’ environmental impacts, as well as about their company’s environmental monitoring efforts.

 

Directors and officers concerned about their potential liabilities will also want know whether their directors’ and officers’ liability insurance will be available to protect them against their potential environmental remediation liabilities. (Because environment liability insurance is outside my area of expertise, I do not attempt to address here whether that type of insurance would provide protection. I certainly welcome comments from readers who have greater knowledge about the protection available from that type of insurance.)

 

The traditional D&O insurance policy typically includes an exclusion precluding coverage for all loss arising from pollution and environmental liabilities. These standard exclusions often include a coverage carve back for securities and shareholder claims, but a carve back of this type would be of little help for individual directors and officers’ remediation cost liabilities. The standard D&O pollution exclusion also sometimes will include a carve back preserving defense cost coverage protection for claims under the policy’s Insuring Agreement A (that is, when the company is insolvent or otherwise unable to indemnify them). While defense cost coverage could be very important, it provides no protection for remediation cost liabilities.

 

More recently some public company D&O insurers have eliminated the pollution exclusion from their base policy forms. However, carriers willing to remove the exclusion from the policy typically will require the policy’s definition of “loss” covered under the policy to specify that “loss” does not include environmental remediation costs. With remediation costs precluded from covered loss, even one of the new style policies that lack an actual pollution exclusion would not provide individual directors and officers remediation cost protection.

 

These days, many publicly traded companies also purchase Excess Side A/DIC insurance as part of their D&O insurance program. Many of these policies have no pollution exclusion, which raises the question whether one of these policies would “drop down” and provide insurance protection for insured directors and officers for the environmental remediation liabilities. Side A/DIC policies do not affirmatively grant coverage for these kinds of liability exposures, but then again the exposures are not excluded either, which suggests the possibility that the Side A/DIC policies could be called upon to provide protection for individuals’ environmental remediation liabilities.

 

In any event, these questions are likely to be raised with increasing frequency in the future. Though this case involved only a provincial environmental regulator in Canada, the issues involved are hardly unique to that jurisdiction. Give the increasing willingness of regulators everywhere to try to impose personal responsibility on individual directors and officers for corporate liabilities, these issues are likely to recur elsewhere.

 

It is a topic for another day, but I think we need to be seriously concerned about what regulators are trying to do to the corporate form. Modern economic activity requires the recognition of the corporation as a separate legal “person.” If this construct is undermined, many forms of economic activity could be imperiled. At the same time, our entire legal system is built around the principle that liability should not be imposed without culpability. Regulators’ willingness to impose liability on corporate officials for their company’s legal violations without regard to the individuals’ personal culpability also threatens to undermine the basic principles of liability.

 

Special thanks to a loyal Canadian reader for calling my attention to this case.

 

Corporate Officials Can Be Held Liable for Company’s Copyright Infringement: Speaking of the potential liabilities of individual directors and officers for their company’s legal violations, Northern District of Illinois Thomas Durkin held in an August 26, 2013 order (here) that under the facts presented, the two former corporate officials who ran their company as their “alter ego” could be held liable for their company’s alleged copyright infringement.

 

Asher Worldwide sells commercial kitchen equipment online. It has filed for copyright protection for the descriptions of the kitchen equipment that it uses on its website. In its complaint, Asher alleged that Housewaresonly.com had infringed on Asher’s copyright by using hundreds of Asher’s website’s kitchen equipment product descriptions for its own website.

 

Asher’s complaint also named as defendants Housewaresonly.com’s principals, Stuart and Marcia Rubin. After the lawsuit was filed, the Rubins allegedly shut down their website and allegedly depleted the company’s assets, according to Asher, to “avoid financial liability.”

 

The Rubins moved to dismiss Asher’s claims against them on the ground that Asher’s allegations were insufficient to hold them personally liable for their company’s alleged copyright infringement.

 

In his August 26 order, Judge Durkin, first noted Seventh Circuit standards specify that directors and officers typically cannot be held liable for their company’s copyright infringement absent a “special showing” that the individuals acted “willfully and knowingly” by “personally participating” in the infringement.

 

Judge Durkin noted that it was a “close question” whether Asher’s allegations were sufficient to impose liability on the Rubins personally given these standards. However, based on Asher’s allegations that the Rubins were the only two individuals associated with the company and therefore “comprised the entire work force” – which Judge Durkin found to lead to the “reasonable inference that they were personally involved in the corporate infringement” – the Rubins were “in fact ‘the corporation’” which they treated as their “alter ego.”

 

Judge Rubin concluded that Asher had alleged a sufficient level of personal participation to allow Asher’s copyright infringement claim against the Rubins to survive a motion to dismiss.

 

Housewaresonly.com was obviously a private company. Private company D&O insurance policies will typically include an entity- only intellectual property exclusion, meaning that the policy would not provide insurance coverage for the insured company’s copyright violations. The exclusion typically does not apply to individuals; however, because individual company officials can only be held liable for their company’s copyright violations for having acted “willfully” or “knowingly,” the imposition of liability on individuals would potentially trigger the policy’s conduct exclusion. The policy would, however, presumptively provide the individuals with defense cost protection, at least in the absence of a judicial determination that would trigger the conduct exclusion.

 

Given my comments above about regulators’ disregard of the corporate form, It is worth noting that the allegations in this copyright infringement case represent the kind of circumstances in which court historically have been willing to disregard the corporation’s separate legal existence. Judge Durkin also found that Asher had sufficiently alleged “personal participation” in the alleged infringing activity. My concerns about regulators and courts disregarding the corporate form do not involve the kind of circumstances involved in this case, in which the individuals allegedly were directly involved in the alleged wrongdoing.

 

A November 8, 2013 memo from the McDermott, Will & Emery law firm about the copyright case can be found here.

 

Earlier this year, when Chancellor Leo Strine issued an opinion in the Chevron case upholding the validity under Delaware law of a forum selection clause in the company’s corporate by-laws, a number of questions remained unanswered, including in particular what would happen if, notwithstanding the forum selection provision, a shareholder nevertheless filed an action in another jurisdiction.

 

In a November 5, 2013 proceeding, Vice Chancellor Laster considered these questions in a Delaware action filed by Edgen Group seeking to enjoin a merger objection lawsuit  filed in Louisiana, based on a forum selection clause in the company’s corporate charter. As reflected in a transcript of the proceeding (here), Vice Chancellor Laster declined to issue a temporary restraining order enjoining the Louisiana proceeding, in a ruling that addresses a number of interesting issues.

 

Background

Edgen went public on April 27, 2012. Its corporate charter contains a provision designating Delaware as the exclusive forum for breach of fiduciary duty claims against directors and claims relating to the internal affairs of the company.

 

On October 1, 2013, the company announced that its board had approved a merger with Sumitomo Corporation. On October 11, 2013, Jason Genoud, a Canadian shareholder of the company, filed an action in Louisiana (where Edgen has its corporate headquarters) alleging breach of fiduciary duty and seeking to enjoin the merger.

 

Edgen filed a motion to dismiss the Louisiana action based on the forum selection clause. Edgen also filed a separate action in Delaware against Genoud, seeking to have its forum selection clause validated and also seeking to have the Delaware court enforce the clause by enjoining Genoud’s Louisiana action. Because of an upcoming hearing in the Louisiana action, Edgen sought to have the Delaware court expedite its consideration of its request for a temporary restraining order. Because of the request for expedited consideration, Vice Chancellor Laster considered the motion on November 5, 2013, in a telephone proceeding.

 

At the time of the November 5 telephone hearing, Genoud had not yet been served with Edgen’s Delaware complaint. The November 5 proceeding opened with Edgen’s counsel’s description of their efforts to try to serve Genoud with the Delaware complaint. Though Genoud had not yet been served, the counsel that represents him in the Louisiana action participated in the November 5 telephone proceeding as a “friend of the court.” (Hereafter, I refer to Genoud’s counsel as plaintiff’s counsel). In the November 5 telephone proceeding, Edgen’s counsel advised the court that they (Edgen’s counsel) had asked plaintiff’s counsel to assist in helping to locate Genoud, but plaintiff’s counsel declined to do so.

 

In seeking to have the Delaware court enjoin the Louisiana proceeding, Edgen argued that if the Louisana court were to proceed and rule on Genoud’s request to enjoin the merger, the Louisiana court’s ruling could have res judicata effects that could irreparably harm Edgen’s interests. Plaintiff’s counsel, participating in the November 5th proceeding only as a friend of the court, argued that the Delaware action was at best premature, as the question of the enforceability of the forum selection clause was “teed up” and ready to be heard in the Louisiana action.

 

Vice Chancellor Laster’s Ruling

After having heard the parties’ arguments over the telephone, Vice Chancellor Laster proceeded to rule on Edgen’s request to have the Delaware court issue a temporary restraining order enjoining the Louisiana proceeding.

 

Vice Chancellor Laster opened by observing that the case “exemplifies the interforum dynamics that have allowed plaintiffs’ counsel to extract settlements in M&A litigation and that have generated truly absurdly high rates of litigation challenging transactions.” He also noted that plaintiffs’ counsel and the shareholders they “purport to represent” have the ability to sue in multiple forums, which “is a factor that imposes materially increased costs on deals and effectively disadvantages stockholders as a whole.”

 

Vice Chancellor Laster also observed that the case demonstrates why companies “have seen fit to respond” with the adoption of forum selection clauses “in an effort to reduce the ability of plaintiff’s counsel to extract rents from what is really a market externality.” The Vice Chancellor also emphasized that there is “no competition” between the Delaware courts and the courts of Louisiana or any other jurisdiction.

 

The Vice Chancellor then proceeded to review the details of the proposed merger and the basis on which the plaintiff sought to enjoin the deal. Laster said that in light of the particulars “under Delaware law, this is an exceedingly weak challenge to a deal” that would not likely survive a motion to dismiss.

 

Laster also noted that under the internal affairs doctrine, Genoud’s suit is governed by Delaware law and that the “logical and most efficient place” for the merger challenge to be heard is in Delaware.

 

Laster went on to say that the Louisiana action is “quite obviously violative” of the forum selection provision in Edgen’s charter, which Laster found to be “valid as a matter of Delaware corporate law.” He went on to say that the filing of the Louisiana action “facially breached the exclusive forum clause” because the claim asserted in the Louisiana action “falls squarely within the clause.” Laster also found that based on the pendency of the Louisiana action, Edgen had shown “irreparable harm sufficient to support the issuance of an injunction.”

 

However, despite the showing of “irreparable harm,” Vice Chancellor Laster declined to grant Edgen’s request for injunction relief, first because of remaining questions about the Delaware court’s exercise of personal jurisdiction over Genoud (he noted in that regard that the forum selection clause does not specify consent to personal jurisdiction).

 

The second reason Laster denied the request was out of concern for “interforum comity.” He said, in consideration of Chancellor Strine’s opinion in the Chevron case, that the question  of the enforceability of the enforceability of the forum selection clause should be made in the “non-contractually selected forum,” adding that “it is not clear to me that it is appropriate at this time to be making anti-suit injunctions the initial tool of judicial first resort.” Though the effect of his ruling was to allow the Louisiana proceeding to go forward, he did hold open the opportunity for the parties to return to his court “if there are concrete circumstances that would require me revisiting that issue.”

 

The Vice Chancellor did go out of his way to excoriate the plaintiff’s counsel for their actions (or lack thereof) with respect to Edgen’s efforts to effect service on Genoud. He said that plaintiff’s counsel – “a firm that I generally have respect for” – has “engaged in unsatisfying and, dare I say, pathetic representational contortions” in contending that they represent Genoud in the Louisiana action but not in the Delaware action. He added that “anyone remotely familiar” with this type of litigation understands that the plaintiff’s firm “is not taking its direction from a nominal client” but rather “is calling the shots itself.” Plaintiff’s counsel’s suggestion that they could not reach their client “is either, one, not credible” or “confirmatory that [the plaintiff’s firm] is not taking direction from its client about how to handle this litigation.”

 

Laster added that it is “quite disappointing behavior from a firm that otherwise has done a great deal to build up its reputational capital and credibility with the Delaware courts.”

 

Discussion

Although the adoption of a forum selection clause offers one way to try to eliminate the curse of multi-jurisdiction litigation, as this case shows, one of the shortcomings of the clauses is that they are not self-enforcing. Even with a forum selection clause, there is nothing to prevent a shareholder plaintiff, like the one involved here, from filing an action in another jurisdiction that the clause would require to be filed in Delaware. The company still has to face the action in the other jurisdiction and hope that the other jurisdiction’s court will respect the requirements of the forum selection clause.

 

Though Vice Chancellor Laster declined to grant the TRO, there are nevertheless a number of useful aspects to his ruling.

 

First, he ruled that a forum selection clause in a corporate charter is valid and enforceable. While this seems a logical extension of Chancellor Strine’s ruling in the Chevron case, Strine’s ruling had been with respect to a forum selection clause in a corporate by-law. Vice Chancellor Laster’s ruling confirms that forum selection clauses in corporate charters are equally enforceable.

 

Second, Laster made it clear that in his view, and under Delaware law, the filing of the Louisiana action violated the forum selection clause. Though he declined base on principles of comity to enjoin the Louisiana action, his discussion of these issues makes it clear what a forum selection clause permits and requires. His analysis of these issues should be instructive for a court in another jurisdiction considering whether or not to enforce a forum selection clause.

 

Third, although Laster was clearly concerned by plaintiff’s counsel’s actions with respect to service of process, he was also clearly concerned by personal jurisdiction questions. His observation that Edgen’s forum selection clause lacked any provision specifying shareholders’ consent to personal jurisdiction in Delaware does suggest that it would be advisable for companies adopting forum selection clauses to consider addressing the personal jurisdiction issue in the clause.

 

Laster did hold open the possibility that as forum selection clause issues evolve in Delaware, it could eventually become appropriate for Delaware court’s to provide injunctive relief enjoining proceedings in other jurisdictions.

 

There obviously are many issues yet to be worked out as companies seek to rely on forum selection clauses. The one thing that is clear is that the adoption of a forum selection clause alone will not be sufficient to eliminate the possibility that a company might still face shareholder litigation in other jurisdictions. Perhaps as time goes by a body of case law will develop in with other jurisdictions’ courts establishing their willingness to enforce these clauses and to defer to the selected forum, but until that time the possibility of multi-jurisdiction litigation will remain.

 

Special thanks to Bob Varian of the Orrick law form for sending me a copy of the transcript.

 

The D&O Diary is on assignment in Europe this week. In an abrupt and vivid scene change, I left the PLUS International Conference in Orlando last week and flew straight to Paris, to attend a conference of the International Association of Claims Professionals last Thursday and Friday.

 

My prior visits to Paris have all taken place in the warmer months; I was unsure what Paris might be like in November. Here’s what you need to know about Paris in November. Yes, it is late fall – temperatures are cooler, skies are greyer, evening gathers earlier, and it rains a bit. But it is still Paris.

 

Because we have visited the major monuments on prior visits to Paris, during this visit we focused on places and locations that while perhaps visited less frequently by tourists are nonetheless fully Parisian. Paris is a city of neighborhoods and the great thing about the Paris metro is that you can descend in one part of the city and emerge just moments later in a completely different neighborhood. One special area away from the busier environs of the Latin Quarter is the Rue Mouffetard. At the northern end of the street at the top of Mont Sainte-Geneviève is the Place de la Contrescarpe, a large quiet square ringed with cafes and brasseries that has something of a small village feel. The Rue Mouffetard itself – which is lined with small shops selling wine, cheese, tea, clothing and books – has rolled downhill toward the south since the Roman era. The area is also now laced with student bars, including one called (I am not making this up) “Student Bar.” 

 

Despite the cooler temperatures and occasional rain, the city retains its romantic atmosphere, even in November. Late one rainy evening while we sat at a sidewalk café in the Place de la Contrescarpe, a pair of dogs trotted past. The canine couple apparently decided that — despite the rainy conditions and cool temperatures, and the fact that an entire café full of people was watching them — the moment had arrived to try to make some puppies, right then and there. Même pour les chiens, Paris est une ville de l’amour.

 

We also visited another neighborhood away from the usual tourist itineraries. One of our law school classmates recently moved to Ménilmontant, a gentrifying area where clubs and restaurants sit next to falafel shops and halal butcheries. On our way out to the neighborhood on the metro, we paused along the way to have a look at the Bassin de la Villette (pictured left), on the Canal de L’Ourcq, a pleasant area far off the tourist grid that was an agreeable place to visit on a sunny afternoon. We then met our friend at the Restaurant Astier, a brilliantly updated realization of the traditional Parisian Bistro, on rue Jean-Pierre Timbaud. (Our friend, who has lived in Paris for many years, chose the restaurant with a great deal of care. It did not disappoint.) During dinner, we chided our friend for complaining about how young the habitués of the clubs on nearby rue Oberkampf seemed, but on the way home we saw for ourselves the crowds of adolescents spilling out of the bars and smoking on the sidewalks. Man, they looked young. (For those readers who have college age kids spending a semester in Paris and wondering what their kids up to, I can testify that they are hanging out on Rue Oberkampf.)

 

Though it is remarkably easy to move around Paris on the metro, it is even better to walk. Even in November, it is great just to walk around Paris. We started out Saturday morning in the Jardin des Plantes, where a few blooms remain despite the cooler temperatures, and then we made our way along the Quai Saint Bernard to the île St Louis. After lunch on the island, we crossed to the opposite bank and walked to the Bassin de l ‘Arsenal, where the Canal Saint-Martin connects to the Seine, adjacent to and just south of the Place de Bastille. In one of those happy coincidences that can make travel so rewarding, it turned out that there was an antique fair on the streets along the Bassin. Over 350 stalls lined the sidewalks, full of a fascinating array of art, furniture, jewelry, linens, and various other remnants of centuries of Parisian luxury living.

 

We had stumbled upon a real Parisian event, but we were not the only American tourists strolling through the stalls. We overheard one American couple trying to determine whether they could have the painting they wanted to buy shipped back to the U.S. Their question whether they could have the painting shipped via UPS or Fed Ex drew a blank look and an uncertain shrug from the proprietor, so in the time-honored tradition of Americans overseas, the American gentleman raised his voice and said with great care “WE (pause) WANT (pause) TO (pause) SHIP (pause) IT (pause) TO (pause) A-MER-I-CA.” It is well known that by shouting and speaking very slowly even a Frenchman can be made to understand plain English. (Actually, most everyone I ran across in Paris spoke perfectly serviceable English; even with my poorly remembered college French, I had few language issues.)

 

We made another interesting discovery in the streets just east of the antiques festival. Running along the Avenue Daumesnil to the east of the Opéra Bastille in the Faubourg Saint-Antoine is an abandoned railway overpass –now called the Viaduc des Arts — that has been converted into a colony for artisans and craftsman.  The structure’s brick archways been transformed into workshops and galleries where artisans make and display furniture, vases, plates, sculpture, ceramics, musical instruments, picture frames, toys, leather goods, clothing, shoes and a vast array of other goods.

 

As fascinating as it was to watch the artisans at work, we chanced upon yet another hidden Parisian treasure nearby that was an even better discovery. Along the top of the viaduct is the Promenade plantées, a pleasant green walkway that runs for over two miles at rooftop level above the hubbub of the street through the heart of the 12th arrondissement. The walkway is a verdant retreat from the busy city’s commotion. Despite a light rain, we walked the length of the promenade, feeling as if we had discovered a secret spot in the heart of Paris.

 

In addition to exploring new neighborhoods, we also had a chance to fulfill some long-unfulfilled tourist objectives. Anyone who has spent time in Paris has seen the advertisements announcing various artistic performances that adorn many walls and buildings, particularly on the Left Bank. I have long wanted to see what these shows were about. On Friday night, we attended a chamber music concert in the venerable Abbey of Saint-Germain-des-Prés, one of the city’s oldest religious sites and the burial site of many of the Merovingian kings. The beautiful music from the stringed instruments soared into the ancient structure’s vaulted ceilings. The historic setting and the beautiful music made a pretty amazing combination.

 

Not everything we did involved unfamiliar places and experiences. We chose some places to visit precisely because we had visited them before.

 

Several years ago, I took a public speaking course that included an extemporaneous speaking exercise in which the class participants were given five minutes to compose a speech on the topic “my favorite restaurant.” The others spoke about their preferred neighborhood establishment or the local place where they could take their children without strain or trauma. By contrast, when it was my turn to present, I described Restaurant Le Christine, a restaurant on rue Christine in Paris’s Sixth arrondissement, which we first visited on our honeymoon, in 1983. We visited the restaurant a second time when we visited Paris with our children in 2003. We returned to Le Christine again this past Saturday night, thirty years after our original visit.

 

The restaurant’s décor has been updated since our first visit; the interior is now lighter and more colorful, but the service and food remain memorable. Our three-hour meal — consisting of seven courses, each paired with its own delightful matching wine — was a truly remarkable culinary experience. After soup, foie gras, two fish courses, a rumpsteak entrée, a plate of cheeses and salad, a desert and coffee, we wandered very slowly but contentedly back to our hotel. Were I called upon again to deliver a speech about my favorite restaurant, I would still refer to Le Christine, which remains an important landmark on the map of my own personal Paris. 

 

The next morning, we walked to the Church of Saint-Sulpice, nearby our hotel. Though we had trouble following the French-language liturgy, the service was beautiful and the music was stirring. The 17th century church may not be as renowned as its slightly larger and more celebrated neighbor Notre Dame de Paris, but it has recently enjoyed a little of its own celebrity status as a result of its star appearance in the book and movie The DaVinci Code. In an earlier time, churchmen marked out on the church floor a longitudinal meridian between the church’s two transepts, as an astronomical tool to aid more accurate calculation of the correct date for Easter. Sunlight coming though small openings in the southern transept at noon on the equinoxes strikes various demarcated points along the meridian. The book erroneously identifies the line as the Paris meridian; numerous plot twists follow the suggestion that the line provides a signpost pointing the way to the hiding place of the Holy Grail. Following the church service, we were among the many tourists photographing the gnomon demarking the meridian line in the north transept.

 

After the church service, we rambled through the quiet Left Bank streets, eventually making our way to a brasserie near the Pantheon. Sitting in the early afternoon sun and huddled against the chilly breeze, we shared a plate of Normandy oysters along with a little white wine. After lunch, we strolled in the crisp November sunshine through the Jardin du Luxembourg (pictured below right), which is yet another important landmark on my personal map of Paris. The most essential Parisian spirits inhabit the gardens, where romantic couples slowly promenade and little children sailing their boats in the central fountain shout happily “Regardez, Maman! Regardez!”

 

In his memoir of his time in Paris, A Moveable Feast, Ernest Hemingway wrote “There is never any ending to Paris and the memory of each person who has lived it differs from that of any other.” Hemingway’s words confirm a view I have long held, which is that everyone who has visited the city believes, like me, that nestled within the city’s timeless monuments and beautiful streets is their own personal Paris. I sometime think that Paris is like an experienced courtesan who manages to convince her many lovers that each of them alone is the only one that has enjoyed her secret pleasures.

 

On Monday morning, I boarded the Eurostar at the Gare du Nord to make my way to London to attend the Advisen Euro D&O conference. As the train raced northward through the countryside, I couldn’t help looking back toward Paris wistfully. I hope I get a chance to return to Paris again before too long. But even though I know I can always go back, it is difficult to leave Paris behind..

 

Very special thanks to my good friend Helga Munger of Munich Re for inviting me to participate in the International Association of Claims Professionals event and giving me the chance to visit Paris again.

 

November in Paris

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

It is time to post another round of photos that readers have taken of their D&O Diary mugs I never cease to be amazed at the diversity of shots and the different photographic visions that readers’ pictures exhibit. .

 

Readers will recall that in a recent post, I offered to send out to anyone who requested one a D&O Diary coffee mug – for free – but only if the mug recipient agreed to send me back a picture of the mug and a description of the circumstances in which the picture was taken. In previous posts (here, here, here, here, here, here, here, here and here), I published prior rounds of readers’ pictures. The pictures have continued to arrive and I have posted the latest round below.

 

The first shot in today’s round of pictures comes from Jillian Meyer of the Aon office in Chicago. Jillian took this picture while she was on vacation in Maryland. She reports that the picture “was taken looking southeast across the Severn River from the US Naval Academy (founded in 1845) in Annapolis Maryland, while the sailing team practices maneuvers in the background.’ I enjoyed seeing this picture because I did a lot of sailing on the Severn near the Naval Academy and on the adjacent Chesapeake Bay when I was a kid.

 

 

 

 

 

 

 

 

 

 

 

 

 

One of the striking things about many of the mug shots I have seen is the incredible diversity of ways that various readers devise to depict their mugs. Loyal reader Gene Comey of the Comey Rigby law firm in Washington envisioned a distinctly unique tableau for his mug shot; in the photo below, the mug is paired with an rather striking ensemble of figurines.

 

 

 

 

 

 

 

 

 

 

 

 

 

The next picture provides yet another demonstration of this blog’s international reach. This mug shot, depicting the Rotterdam “euromast” tower, as sent in my Bernard Vroom of Markel International Nederland.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Loyal reader Kellly Reyher sent in this photo taken from his office window on the 21st floor of WTC 7 of the World Trade Center site in downtown Manhattan. A sobering sight and reminder of the tragic events of 9/11..  

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

The next photo represents something of an unusual twist on the mug shot theme. This picture came about as a result of my recent visit to Zurich (about which refer here). While I was there, I was fortunate to meet a number of industry colleagues for the first time, including Pawel Paluch of the Zurich Insurance Company office in Zurich. Pawel and I agreed that if I sent him a D&O Diary mug that he would send me a Zurich mug. I am happy to report that the mug Pawel sent me arrived safely. In the picture below, I am back home in Ohio enjoying some early November sunshine. Pawel reports that he is waiting for the sun to come back out in Zurich to take a picture of his D&O Diary mug.

 

 

 

 

 

 

 

 

 

 

 

 

It is so much fun to receive readers’ pictures and to see how (and where) they have decided to photograph their mugs. My thanks to everyone who has sent in a mug shot.

 

If there are still readers out there who would like to have a mug and have not yet ordered one, I still have a few mugs left. If you would like one, just drop me a note and I will be happy to send one along to you, as long as remaining supplies last. Just remember that if you order a mug, you have to send back a picture. Also, please be patient if you order a mug, it may be toward the end of the month before we can mail  out the next round of mugs.

 

One of the more troublesome trends in recent years has been the increasing willingness of lawmakers and regulators to try to impose liability on corporate officials without regard for the requirements of the corporate form and even without reference to whether the officials are culpable in any way. (Refer here for my most recent discussion of these concerns).

 

The theoretical basis for these efforts to impose liability on corporate officials often is the “responsible corporate officer” doctrine (sometimes referred to as the Park doctrine in reference to the U.S. Supreme Court case in which the doctrine was first recognized by the Court). As discussed at greater length here, under this doctrine, senior corporate officials can be held responsible for the corporation’s legal violations not because they are “responsible” for the violation but because they are “responsible” for the corporation.

 

An October 29, 2013 New York Times article entitled “Buckyball Recall Stirs a Wider Legal Campaign” (here) describes the latest attempt to use this doctrine to impose personal liability on corporate officials for alleged legal violations of their company. The article describes an action being pursued by the federal Consumer Product Safety Commission to require a product recall by Maxfield & Oberton, the manufacturer of Buckyballs, which are tiny magnetic stacking balls. The agency declared the balls to be a swallowing hazard to young children and filed an administrative action against the company to require a recall.

 

The company challenged the recall order, arguing among other things that packaging labels clearly warned that the product is unsafe for children. The company went out of business last December, citing the costs associated with the recall dispute. At that point, lawyers for the CFPC “took the highly unusual step of adding the chief executive of the dissolved firm, Craig Zucker, as a respondent, arguing that he controlled the company’s activities.” Zucker claims that the action could “ultimately make him personally responsible for the estimated recall costs of $57 million.”

 

The basis of the Commission’s action against Zucker is the “responsible corporate officer” doctrine. But while this doctrine is well established in many contexts, the Commission’s use of the doctrine in the recall proceeding arguably is unprecedented. The Times article cites unnamed “experts” who “say its use is virtually unheard-of in an administrative action where no violations of the law or regulations are claimed.” The article also cites a spokesman for the Commission as saying that the Commission “had never used it in a recall action,” without specifying why it was being used in this case.

 

The Times article reports that a number of business groups, including the National Association of Manufacturers, the National Retail Federation and the Retail Industry Leaders Association, had come together to urge the administrative law judge reviewing the recall case to drop Zucker from the action. However, to this point the ALJ has declined to drop the case against Zucker.

 

Along with these industry organizations, I have serious concerns about the Commission’s use of the responsible corporate officer doctrine in an administrative proceeding and without regard to whether Zucker himself is alleged to have violated law or regulations. I want to make it clear that my concerns in this regard having nothing to do (either way) with merits of the Commission’s recall action against the company. In that regard, the article describes the concerns that had led the Commission to seek to recall the Buckyballs. The Commission apparaently has reports of 1,700 emergency room visits involving children that had swallowed Buckyballs, and a spokesman for the Commission quoted in the article explaining the recall action said that the agency was concerned that “we did not see progress on safety to children” and that “the labels were not effective.”

 

The agency may well have appropriate grounds to seek a recall. The question is whether the cost and burdens of the recall appropriately should be imposed on Zucker. The problem with the Commission’s attempt to impose the recall costs on Zucker is that they are not seeking to impose these costs on him based on allegations that his personal actions as an individual provide a basis for holding him liable; rather, the Commission is seeking to impose these costs on him simply because of his position with the company. The Commission is saying that he should be held liable not because he is “responsible” for the problems that the Commission says justify the recall; they are saying the he should be held liable because he is “responsible” for the company.

 

The problem with this approach is that it disregards the now centuries-old recognition of the fact that corporations are legally separate from the individuals who run them. The idea that liability can be imposed on an individual for corporate misconduct, in apparent disregard of the corporate form and without culpable involvement or even a requirement of a culpable state of mind, seems inconsistent with the most basic concepts surrounding the corporate form. Used in this way, the responsible corporate officer doctrine imposes liability for nothing more than for a person’s status. Keep in mind that the agency has not alleged that Zucker has culpably violated a specific standard of liability; rather, the agency is saying only that Zucker should be liable because of his position, in complete disregard of the corporate form and without any regard to whether is culpable.

 

I understand that public policy advocates might well argue that corporate officials should have to pay out of their own resources for corporate misconduct so that the liability threat would deter future violations and motivate compliance. These kinds of arguments seem most compelling to someone who is secure in the knowledge that they will never have to worry about having liability imposed on them for conduct or activity in which they may have had no culpable involvement.

 

I appreciate that there is a current popular sentiment that corporate officials need to be held liable more frequently or perhaps even that regulators do not do enough to hold corporate officials accountable. Just the same, I am concerned that with the increased tendency to impose liability on corporate executives without any showing or requirement for a showing that the officials were culpable, there is a contrary danger that corporate executives could be held liable too frequently, or at least in instances where they have done nothing themselves to deserve it.

 

Even if there are circumstances where, as the U.S. Supreme Court has long recognized, that public health and welfare may justify the imposition of liability without culpability under certain circumstance, the enormous burden this possibility would impose on the civil rights and liberties of the affected individuals would seem to argue that these principles be used to impose liability on individuals only in the rarest and most extreme circumstances.

 

But rather than restrict its use of these principles out of an appropriate respect for basic notions of fairness and individual liberty, regulators are moving in the exact opposite direction and apparently seeking new opportunities to use these principles to expand their regulatory reach.

 

The regulators may well feel this approach may be justified in order to accomplish regulatory goals and ensure that somebody pays the price for wrongdoing. The problem is that scapegoating individuals for misconduct in which they not been proved to be culpably responsible is fundamentally unfair. In my view, this approach is inconsistent with some of the most basic assumptions of a well-ordered society governed by law.

 

If there are circumstances where public health and welfare might sometimes require the imposition of responsibility on a strict liability basis, the use of those circumstances should be infrequent and unusual. Regulators should be looking for ways to avoid relying on these powers rather than looking to expand their use. The imposition of penalties without regard to fault or culpability is a fundamentally unfair practice that should be discouraged at every possible opportunity.

 

The threat of a cybersecurity breach is unfortunately one of the ongoing business risks companies face n the current operating environment. For that reason, corporate disclosures of cyber-breach related risks have been a priority of the SEC’s Division of Corporate Finance as well as the agency’s new Chair, Mary Jo White. The agency’s developing practices and priorities in the area of cyber-risk related disclosure, as well as the implications of the agency’s practices for potential director and officer liability, is the subject of a November 1, 2013 Law 360 article by Anthony Rodriguez of the Morrison & Foerster law firm entitled “SEC Continues to Target Cybersecurity Disclosure” (here, subscription required).

 

It has been over two years since the SEC Division of Corporate Finance issued its Disclosure Guidance on cybersecurity (about which refer here). Among other things, the Guidance suggested that appropriate risk factor disclosures might include:

 

  • Discussion of aspects of the registrant’s business or operations that give rise to material cybersecurity risks and the potential costs and consequences;
  • To the extent the registrant outsources functions that have material cybersecurity risks, description of those functions and how the registrant addresses those risks;
  • Description of cyber incidents experienced by the registrant that are individually, or in the aggregate, material, including a description of the costs and other consequences;
  • Risks related to cyber incidents that may remain undetected for an extended period; and
  • Description of relevant insurance coverage.

 

Though the Corporate Finance Division issued these provisions in the form of disclosure guidance only, the Division has also made it clear that it intends to police company’s practices in this area. According to the article, the agency’s Corporate Finance Division “has issued comments to approximately 50 companies about cybersecurity since it issued the disclosure guidance.” The comments not only underscore the agency’s “sustained interest” in the topic, but its comments also encourage disclosures “that go beyond a rote warning that a cyber problem could have some type of adverse impact on the business.”

 

As discussed here, the kinds of things about which the Corporate Finance Division has requested further elaboration include: that companies disclose whether data breaches have actually occurred and how the companies have responded to such breaches; that cybersecurity risks should be broken out separately and stand alone from disclosure of other types of risks because of the distinct differences between the risk of cybersecurity attacks and the risk of other types of disasters or attacks; and for companies that have suffered cyber breaches, additional information regarding why the public company does not believe the attack is sufficiently material to warrant disclosure.

 

According to the Law 360 article, the kinds of comments the agency has provided include a request that a company’s statement that cyber attacks are regarded as “unlikely” be reviewed and that consideration be given to revising the statement. Similarly, a company that had disclosed that what “could” happen in the event of a cyber attack was asked to disclose whether it had experienced “any cyber breaches, cyber attacks or other similar events in the past.”

 

The article notes that

 

It may just be a matter of time before two factors align: (1) news of a successful cyber attack that sends a company’s share price plunging, and (2) the company’s public statements about it cyber defenses appear in hindsight (at least to a plaintiff’s attorney) to have been clearly erroneous.

 

When this happens, the article’s author suggests, the company and it is directors and officers will likely be hit with “one or more complaints asserting securities, fiduciary duty and other claims on behalf of a class, derivatively or both.”

 

Though the company would have defenses to any claim of this type, “the quality of the company’s cybersecurity disclosures could be important to deter or defeat such claims.” The company’s management should ensure that the company’s cybersecurity disclosures “are made with as much care as the typically well-vetted statements regarding financial results, growth prospects and unique business risks.”

 

At the same time, the company’s directors “should work in good faith to stay informed about the corporation’s cybersecurity defenses and the processes by which management builds and maintains those defenses.”

 

The extent of the SEC Corporate Finance Division’s scrutiny of companies’ cybersecurity disclosure is an important point. The fact is that (as noted in a recent post) many companies have not modified their disclosure practices notwithstanding the SEC’s cybersecurity disclosure guidance.

 

As always whenever there are disclosure requirements, there is always room for allegations that the disclosures are misleading or incomplete. Whether or not plaintiffs’ attorneys target companies for their cybersecurity disclosures, there is the possibility that the SEC may target a company for its cybersecurity disclosures as a way to highlight the importance of the issue and as a way to encourage other companies to focus more on their cybersecurity risk disclosures.

 

Though there have already been a small number of cases in which plaintiffs’ attorneys have sought to hold corporate directors and offices liable for cybersecurity disclosure violations or for breaches of fiduciary duties in connection with cybersecurity, these kinds of cases have not yet become a common phenomenon. Whether these kinds of cases will become more frequent, it does seem probable that cybersecurity disclosure will continue to face heightened scrutiny.

 

A guest post on this blog by D&O maven Dan Bailey on the steps companies should take in light of the continuing importance of these issues can be found here. A summary of the critical questions directors should be asking about cyber risk insurance can be found here.

 

In an October 22, 2013 opinion (here) that underscores the important distinction between indemnification and advancement and that highlights the sometimes surprising extent to which corporate officials are entitled to advancement of their attorneys’ fees when claims are filed against them, District of New Jersey Judge Kevin McNulty held that Goldman Sachs must advance the costs that its former employee Sergey Aleynikov is incurring in defending himself against New York state criminal charges that Aleynikov stole high-speed trading computer source code from Goldman.

 

Peter Lattman’s October 22, 2013 New York Times Dealbook column about Judge McNulty’s ruling can be found here. An October 31, 2013 memorandum about the decision by Angelo Savino and Kristie Abel of the Cozen O’Conner law firm can be found here.

 

Background

Goldman, Sachs & Co is a broker-dealer limited liability partnership organized under New York law. It is a non-corporate subsidiary of GS Group, a Delaware Corporation. Aleynikov was employed by GSCo from May 2007 through June 2009 as part of a team of computer programmers responsible for developing source code for GSCo’s high frequency trading system. During his GSCo employment, Aleynikov carried the title of “vice president.”

 

In April 2009, Aleynikov accepted a job with a start up company in Chicago. Before leaving GSCo, Aleynikov allegedly copied onto his home computer thousands of lines of confidential source code. Aleynikov was later arrested and charged federally with theft of trade secrets in violation of the Electronic Espionage Act. Aleynikov was convicted of the federal charges and sentenced to 97 months in prison. However, the Second Circuit reversed the conviction on the grounds that Aleynikov’s conduct did not fall within the scope of the charged federal offenses. Shortly thereafter, Aleynikov was indicted by a state court grand jury on charges of unlawful use of secret scientific material and unlawful duplication of computer related material. The state court charges remain pending.

 

Aleynikov filed a civil action in the District of New Jersey seeking indemnification for the defense expenses he incurred in the federal criminal action and seeking advancement of his defense expenses in the state criminal action. In seeking indemnification and advancement, Aleynikov sought to rely on Goldman’s bylaws, under which indemnification and advancement are mandatory presuming certain conditions were met. Goldman opposed Aleynikov’s entitlement to either indemnification or advancement, arguing that despite his “vice president’ title, Aleynikov was not an officer of his company, and that in any event, whatever indemnification rights Aleynikov may have for his successful defense of the federal criminal action, his rights are subject to set-off based on the company’s counterclaims against him for breach of contract, misappropriation of trade secrets and conversion. The parties cross-moved for summary judgment.

 

The October 22 Opinion

In his October 22, 2013 Opinion, Judge McNulty granted Aleynikov’s motion for summary judgment as to his claim for advancement of his defense expenses incurred in the state criminal action, and also ruled that he was entitled to “fees on fees” – that is, his fees incurred in establishing his right to advancement. However, Judge McNulty denied Aleynikov’s motion for summary judgment as to his claimed right to indemnification for his defense fees incurred in the federal criminal action. Judge McNulty held that Goldman was entitled to additional discovery in support of its counterclaims, which in turn could substantially affect that amount if any that Aleynikov might be able to recover.

 

In ruling in Aleynikov’s favor on his right to advancement of his attorneys’ fees incurred in the state criminal action, Judge McNulty acknowledged that the question whether Aleynikov was entitled to advancement was a “close question.” He ultimately ruled in Aleynikov’s favor in reliance on “Delaware’s strong statutory policy favoring advancement of fees” which he found to suggest that “the By-Laws should be read liberally and expansively.”

 

In reviewing Delaware’s strong public policy in favor of advancement, Judge McNulty answered a question that many observers might have about this case, which is — how could Goldman possibly have to pay the fees of someone who is criminally accused of stealing from the company?

 

Judge McNulty noted that the relevant Delaware statutes and the By-Laws require companies are designed to provide immediate assistance and to postpone the question whether or not such assistance is deserved. Judge McNulty noted that these provisions “do not distinguish between ‘worthy’ and ‘unworthy’ recipients” and they “do not distinguish between claims brought by Goldman and claims brought by outsiders.” He observed that “the advancement provision almost explicitly prioritizes speed over accuracy,” requiring the funds to be advanced subject only to an undertaking to repay.

 

Judge McNulty added that “in contrast to indemnification, which is reserved for persons who prevail in the underlying case, advancement if indifferent as to the underlying merits.”

 

In light of this strong bias in favor of advancement, Goldman did not try to argue that Aleynikov was not entitled to advancement because he was accused of stealing from the company; rather, Goldman argued that Alenikov as not entitled to advancement because, notwithstanding his “Vice President” title, he was not an officer of the company. Goldman argued that the title was a mere functional title and a reflection of “title inflation” in the financial services industry, Goldman argued that Aleynikov did not actually have any officer or even managerial functions and had not been appointed to his position pursuant the company’s putative officer appointment processes. Aleynikov presented evidence that Goldman had paid the legal fees of 51 of 53 persons who had sought them, including 15, who, like him were vice presidents.

 

In response to Goldman’s argument about “title inflation,” Judge McNally said that

 

It may be the case that Goldman (or the industry of which it is a part) had been profligate in conferring the title of vice president. If so, Goldman must bear the consequences of that profligacy. Goldman might easily have chosen to be more sparing with job titles, or to confer them in some other way. It might easily have drafted its By-Laws to restrict indemnification to a well-defined class. It did not.

 

Judge McNulty acknowledged that in light of the charges against McNulty, Goldman might well be unhappy having to pay Aleynikov’s defense expenses in the state criminal action; Judge McNulty said:

 

Goldman may understandably find this result galling; it believes that Aleynikov has stolen its property. If there is any comfort, it may lie in the fact that Goldman has also indemnified and advanced fees in cases where the conduct was alleged to be unlawful and, in the broader sense, no less harmful to Goldman, even if Goldman was not the alleged or intended victim.

 

But while Judge McNulty ruled in Aleynikov’s favor on the question of his right to advancement of his expenses incurred in defending the state criminal action, Judge McNulty withheld judgment on the question whether Aleynikov is entitled to indemnification for his fees incurred in his successful defense of the federal criminal action, pending discovery on Goldman’s counterclaims, which might provide an offset to Aleynikov’s claims for indemnification.

 

Discussion

As I have noted in prior posts (refer for example here), the question of advancement often arises in the context of claims in which the person seeking advancement is accused of wrongdoing against the company. The questions also are considered in light of broadly written advancement provisions that were implemented at a time when those responsible for adopting the provisions had no way of knowing whether or not whether or not they might be the ones seeking to rely on the provisions.

 

Judge McNulty’s opinion highlights the extent to which courts are inclined to liberally interpret these broadly written advancement provisions. As the Cozen O’Conner memo to which I linked above notes, Judge McNulty’s opinion “demonstrates the liberality with which courts may interpret advancement provisions in corporate bylaws governed by Delaware law.”

 

While mandatory advancement provisions are expansive and generally interpreted liberally, they do also include a requirement that the person seeking advancement provide an undertaking to repay. Though this undertaking may have little value in many instances since the person providing the undertaking may have few resources out of which to make the repayment, the undertaking can sometimes have value. That may be the case for the legal costs that former Goldman director Rajat Gupta incurred in defending himself against insider trading allegations; as noted here, Judge Jed Rakoff ordered Gupta to repay his criminal defense fees as part of Gupta’s criminal sentencing for insider trading. (Gupta’s appeal of his conviction remains pending.)

 

The question of a company’s obligation to advance the defense costs of corporate officials accused of criminal wrongdoing is a recurring one, and one that is arising with increasing frequency as the governmental authorities pursue an increasingly diverse array of criminal allegations against corporate officials. As Peter Lattman noted in his Times article to which I linked above, “the question of who should pay the legal bills of an employee accused of wrongdoing has become an increasingly important topic at banks and among the white-collar bar.”

 

The Aleynikov case does highlight one problem that many companies face when trying to interpret who is entitled to rely on a company’s advancement provisions; that is, questions frequently occur when lover level personnel seek advancement. That is because by-law provisions often are unclear on the question of who is an officer and a company’s practices may not even conform to the by-law provisions. As the Cozen O’Conner memo noted, Judge McNulty’s opinion “illustrates the pitfalls companies may face when they fail to define precisely who is an office for purposes of entitlement to advancement or indemnification – a not uncommon situation in corporate bylaws.”

 

One final note about Judge McNulty’s opinion is the extent to which it emphasized the difference between advancement and indemnification. While Judge McNulty enforced a broad public policy in favor of advancement, even noting that the advancement provision here “explicitly prioritizes speed over accuracy,” indemnification is not only not automatic, but may be disputed even where the defense in the underlying claim is successful.

 

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