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.

 

On October 30, 2013, the SEC announced  another whistleblower bounty award under the Dodd-Frank whistleblower program. Although the size of this latest award ($150,000) is relatively modest compared to the recent $14 million award (about which refer here), the most recent award does suggest that awards under the whistleblower program are gaining momentum.

 

I have long been concerned that as awards under the whistleblower bounty program start to accumulate that even more whistleblowers will be encouraged to come forward and make reports to the SEC. Among my concerns about this possibility is not only that increased numbers of whistleblower reports would result in more enforcement actions, but that the increase in the number of reports would also lead to a rise in civil litigation following in the wake of and based upon the whistleblower reports.

 

Anyone who wants to see what a follow-on civil action of this type might look like will want to take a look at the securities class action complaint filed on November 1, 2013 in the Middle District of Tennessee against Unilife Corporation and three of its directors and officers. A copy of the complaint can be found here. The plaintiff’s lawyers November 1, 2013 press release about the lawsuit can be found here.

 

Unilife is a medical device manufacturer that produces retractable medical syringes. The complaint alleges that the company misled investors by failing to disclose that

 

(1) the Company’s Unifill syringes failed to comply with the FDA’s validation processes; (2) the Company’s Quality Management System failed to comply with FDA regulations; (3) the Company purposefully increased its purchase of Unifill component parts to make suppliers believe that Unilife was producing at increased volumes despite the fact that there was no customer demand or manufacturing capacity to support such purchases; and (4) as a result of the foregoing, the Company’s statements were materially false and misleading at all relevant times.

 

In support of these allegations, the securities class action plaintiff’s complaint expressly references and quotes extensively from the complaint filed on August 30, 2013 by Talbot Smith, a former employee of the company who alleges that he was fired in retaliation for reporting the company’s regulatory violations to governmental authorities. In his retaliation complaint (a copy of which can be found here), Smith expressly alleges (in paragraph 16) that his employment was terminated in August 2012, “after he made whistleblowing complaints about violations of the law that had occurred or were about to occur, and after he provided information relating to a violation of the securities laws to the Securities and Exchange Commission.”

 

In his retaliation lawsuit, Smith alleges that his whistleblowing reports are protected under both Sarbanes-Oxley and the Dodd-Frank Act. Smith is suing Unilife and two of its officers for lost wages, lost benefits and the lost value on restricted stock arising from his alleged wrongful termination

 

The recently filed securities class action complaint quotes extensively from Smith’s retaliation complaint (see paragraph 43 of the securities complaint) as well as from a September 9, 2013 Forbes magazine article about Smith’s complaint (here). The complaint also quotes extensively from a September 3, 2013 Forbes magazine article about the company (here).

 

With respect to Smith’s retaliation complaint, the securities class action complaint states:

 

Smith alleges that the Company purposefully ran fake production at the Company’s facilities in order to lead visiting investors to believe that demand for the Company’s products was high. Moreover, according to Smith, the Company purposefully suppressed internal reports demonstrating that the cost of developing the Company’s syringes was higher than the price the Company was able to sell to customers. In addition, the complaint alleged that the Company failed to comply with the Food and Drug Administration’s required validation process.

 

In the Forbes article about Smith’s retaliation complaint, the company is quoted as having said that Smith is a disgruntled former employee who was released for poor performance not for his whistleblowing activities and that Smith only first raised his whistleblowing allegations after he learned that he was losing his job. A company spokesman also apparently suggested to Forbes that Smith was shorting the company’s stock and was financially motivated to try to lower the company’s share price.

 

From the Forbes magazine articles and from the allegations in the two complaints, about the only thing that is clear is that this is a very messy situation. The securities complaint has only just been filed and so there is no way of knowing whether or not it ultimately will succeed. However, there is no doubt that the plaintiff is trying to use Smith’s whistleblower allegations to bolster the allegations in the securities class action complaint.

 

The presence of the whistleblower’s allegations and the use made of the allegation in the securities class action complaint are consistent with what I have feared from whistleblowing – that is, that whistleblower reports will lead to follow-on civil litigation. My larger 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.

 

I make no predictions but it would not surprise me one bit if in the coming months we were to see a rash of complaints like the recently filed Unilife securities class action lawsuit complaint in which whistleblower allegations are featured prominently and used to try to bolster allegations of securities law violations.

 

Understanding the New Business Structures: I know that many of this site’s readers visit the site and the read the various posts in order to try to stay up to date on developments affecting the D&O liability insurance arena and environment. For the benefit of those readers who aim to stay on top of things, I commend an article that appeared in last week’s issue of The Economist magazine.

 

The October 26, 2013 article entitled “The New American Corporation: The Rise of the Distorpation” (here) reports and comments on the “shift in the way businesses structure themselves” that is “changing the way American capitalism works.” These essence of these changes is a move toward types of firms –such as master limited partnerships, business development corporations and real estate investment trusts – that “retain very little of their earnings” and pass them through to investors. And “crucially, so long as they distribute their earnings, such set-ups can largely avoid corporate tax.”

 

As the article puts it, “the corporation is becoming the distorporation.” These kinds of business forms have a valuation on the American markets in excess of $1 trillion. Though they represent only 9 percent of listed companies, these business took in 28% of all capital raised in 2012. The increasing prevalence of these kinds of structures has important implications for the ways that capital is raised and deployed and the ways that companies are doing business. And though there may be a variety of concerns about the rise in the number of businesses using these business forms, the likelihood is that the use of these structures will continue to grow.

 

Among other things, the rise in these business forms has important implications for the way that D&O insurance is structured and underwritten.

 

The Week Ahead: Next week I will be in Orlando attending the annual PLUS International Conference. On Tuesday November 5, 2013, I will be moderating a Conference panel entitled “Derivative Actions Grow Up – Are They the D&O Exposure to Watch?” The panel has a stellar line-up of participants, including Tower Snow of the Cooley law firm: Gay Parks Rainville of the Pepper Hamilton law firm; Steve Boughal of The Hartford; and George Aguilar of the Robbins Arroyo law firm. It should be an excellent session. Information about the Conference can be found here.

 

I look forward to seeing many of you in Orlando. I hope that if you are a reader and you see me at the conference that you will make a point of saying hello, particularly if we have not met before.

 

Due to my travel commitments over the next two weeks, there may be interruptions in my usual publishing schedule on this site.

 

In a criminal case against defendant Donald Powell pending in Tennessee (Williamson County) Circuit Court, the prosecution filed a motion in limine seeking to prevent defense counsel from referring to the prosecution as “the government.” In his brief in Opposition (here), Powell’s defense attorney, Drew Justice, pointed out that the term “the government” is frequently used by the courts to refer to the prosecution, and in any event, that the defense’s right to refer to the prosecution  as “the government” represents speech protected by the First Amendment.

 

The defense attorney had a few more things to say, just in case the court was inclined to grant the prosecution’s motion.

 

As defense counsel put it, if the court is “inclined to let the parties basically pick their own designations and ban words, then the defense has a few additional suggestions for amending the speech code.”

 

First, defense counsel advised the court that “the Defendant no longer wants to be called ‘the Defendant,’” a term that has “a fairly negative connotation” that “unfairly demeans and dehumanizes” Powell. Instead, defense counsel suggested that Powell “should be addressed only by his full name, preceded by the title ‘Mister.’” Alternatively, defense counsel suggested, Powell could be referred to as “the Citizen Accused,” adding that the designation “that innocent man” would also be acceptable.

 

Next, the defense attorney turned to how he wished to be referred to in court, rather than as a “lawyer” or as a “defense attorney:”

 

Rather, counsel for the Citizen Accused should be referred to primarily as the “Defender of the Innocent.” This title seems particularly appropriate, because every Citizen Accused is presumed innocent. Alternatively, counsel would also accept the designation “Guardian of the Realm.” Further, the Citizen Accused humbly requests an appropriate military title for his own representative, to match that of opposing counsel. Whenever addressed by name, the name “Captain Justice” will be appropriate. While less impressive than “General,” still, the more humble term seems suitable. After all, the Captain represents only a Citizen Accused, whereas the General represents an entire State.

 

Counsel – of should I say the Defender of the Realm — them moved on to the use of term “defense” because “the whole idea of being defensive comes across to most people as suspicious” So to “prevent the jury from being unfairly misled by this ancient English terminology, the opposition to the Plaintiff hereby names itself ‘the Resistance.’” This terminology “need only extend throughout the duration of the trial – not to any pretrial motions” as “during its heroic struggle against the State, the Resistance goes on the attack, not just the defense.”

 

Having completed his arguments, defense counsel wound up his Opposition by saying that “Captain Justice, Defender of the Realm and Leader of the Resistance primarily asks this Court to deny the State’s motion as lacking legal basis.” In the alternative, “the Citizen Accused moves for an order in limine modifying the speech code as aforementioned and requiring any other euphemisms and feel-good terms the Court finds appropriate.”

 

No word yet on the outcome of the prosecution’s motion or the court’s response to defense counsel’s opposition.

 

The question of when domestic securities laws provide remedies for investors who purchased their shares in foreign companies on foreign exchanges vexed U.S. courts for years until the U.S. Supreme Court sorted out the issues in Morrison v. National Australia Bank. But while the U.S. courts now have the  bright line standards of the Morrison case, the courts in Canada are still struggling to develop consistent principles to define when their securities laws should apply to foreign securities purchases. The results so far involve decisions in different Canadian provinces that seem to reach opposite conclusion s on the jurisdictional issues.

 

As discussed in an October 30, 2013 Financial Post article entitled “Canadian Courts Grapple With Jurisdiction in Securities Class Suits” (here), “a schism is forming between Ontario and Quebec courts over the extent to which they will entertain lawsuits for breaches of securities laws when shares are purchased on foreign exchanges.”

 

The article compares the September 4, 2013 decision of the Quebec Superior Court in the securities class action lawsuit filed by a Facebook IPO investor (about which refer here), in which the court concluded that it did not have jurisdiction,  with the October 9, 2013 decision by the Ontario Superior Court, in which the Court rejected BP’s attempts to stay Ontario proceedings with regard to the Canadian-based BP shareholders who had purchased their shares on non-Canadian exchanges (about which refer here).

 

As the Financial Post article states, in the Facebook case, the Quebec court “seems to have closed the door on such suits,” while in the BP case, the Ontario court “is taking an open-door approach.”

 

As the article notes, the courts are struggling to determine whether or not there is a basis for the exercise of jurisdiction in these cases. The jurisdictional question requires the court to determine whether or not there is a “real and substantial connection” between the dispute and the court.

 

As discussed here, in the Facebook case, the Quebec court held that the claimant’s brokerage account records did not show where her Facebook share transactions had occurred or where she paid for the shares. The court said that “nothing in the record indicates that the sales transactions occurred in Quebec,” adding that under Quebec statutory principles, “the Facebook shares would have been notionally delivered either at the NASDAQ exchange in New York or at Facebook’s head office in California.” On this basis, the court concluded that the claimant’s alleged loss would have occurred in the United States. The court said that “there is no basis to conclude that a real and substantial connection exists between the alleged facts of her motion and this Court,” and so the Court lacked jurisdiction.

 

The Quebec court when on to say that even were there jurisdiction, the court would have declined the jurisdiction (“a tenuous jurisdiction at best”) in favor of the Southern District of New York, under the principles of forum non conveniens. The court noted that the consolidated New York actions raised the same allegations; that the putative class in the consolidated action included the claimant and the class of Quebec purchasers she purported to represent; that New York law would govern the claims; that the underwriting defendants are domiciled in New York; and that any judgment would have to be executed in the United States.

 

As discussed here, in the BP case, the Ontario court, by contrast,  concluded that “there is nothing in the wording of the Act that restricts the cause of action to investors who purchased their shares on an Ontario exchange.” The court reasoned that if it were to adopt BP’s reasoning and to decline jurisdiction over the claims of the BP investors who purchased their shares outside of Canada, the court would be “imposing a limitation in the Act where none exists.”

 

The Ontario court went on to note that the relevant statutory provisions allowed shareholders to bring secondary market misrepresentation claims without having to prove reliance. The court reasoned that “if a responsible issuer makes a misrepresentation and the Act deems the Ontario investor to have relied on the misrepresentation when he purchased shares of that issuer, the statutory tort must be considered to have been committed in Ontario.” The court went on the say that it “cannot agree” that the location of the statutory tort “is to be determined, in each case, by the location of the exchange on which the action share purchase occurred.”

 

The Ontario court also rejected BP’s attempt to have the case stayed as to the non-TSX purchasers on the grounds of forum non conveniens. BP had argued that the TSX trading volume was negligible and should not serve as a basis to bring the claims of Canadian BP shareholders who purchased their shares in the U.S. and the U.K. into the Ontario courts. BP argued that U.S. and U.K. were more appropriate forums in which to litigate those claims.

 

In rejecting these arguments, the Ontario court said that in her view, “BP is seeking to restrict and fragment the proposed class at this early stage of the proceedings,” and the outcome BP sought would “result in this potential claim …being litigated in three different jurisdictions. That is not convenient, cost-effective or efficient.” She noted that no class has yet been certified in the U.S. action, and that even if certified, a NYSE purchaser who opted-out would not be able to participate in the Ontario action if stayed. Meanwhile, U.K. purchasers would be required to bring individual actions and seek to have their actions consolidated. “I cannot,” she said, “see how that would be a clearly more appropriate forum for their claims.”

 

The Ontario court expressly rejected BP’s argument that Canadian courts should adopt the kind of bright-line, exchange-based test that the U.S. Supreme Court adopted in Morrison v. National Australia Bank.

 

The Ontario court’s ruling in the BP case follows a March 30, 2012 Ontario Court of Appeal ruling in the Canadian Solar case (about which refer here). Canadian Solar’s shares traded only on NASDAQ. Its shares did not trade on any Canadian exchange and its principle place of business is in China. However the company is registered as a Canadian federal corporation with registered office and executive offices in Ontario. The Court of Appeals held “there is a sufficient connection between Ontario and Canadian Solar to support the application of Ontario’s regulatory regime.” The Court also noted that the claimant was an Ontario resident who placed his order in Ontario for shares in a corporate based in Ontario, and therefore could “reasonably expect that his claim for misrepresentation on documents released or presented in Ontario would be determined by an Ontario court.”

 

The Financial Post article quotes plaintiffs attorneys as saying that a narrow, exchange-based test like that adopted in Morrison does not make sense in a financial marketplace characterized by global electronic trading. Defense lawyers, by contrast, argued that corporations “need certainty” and that the application of too broad of a test that would subject non-Canadian companies to the jurisdiction of Canada’s courts is a “very vexing problem.” The defense counsel asked whether companies will be “potential liable to every securities regulator and subject to every securities regime around the world?” adding that “that is a troubling prospect for public issuers.”

 

These jurisdiction questions become even more complex when there are competing cases on opposite sides of the borders. The lawyers involved must struggle to avoid overlapping or conflicting case resolutions.

 

The article concludes with a statement from a defense attorney that “the reality is that we are still grappling in our lower courts with very preliminary issues associated with these types of actions. We’re a bit surprised by how long and arduous the process is.”

 

One thing that the Financial Post article does not address is whether or not there are differences between Quebec laws or procedural requirements and Ontario laws or procedural requirements that might explain the differences in outcome.

 

Towers Watson Releases 2013 D&O Insurance Survey: As D&O insurance practitioners know well, the annual Towers Watson D&O Insurance survey is one of the important information tools to which we all refer and on which we all rely. Towers Watson makes the survey results available for free to the entire industry. But as is the case with any survey, the survey results are only as meaningful as the level of survey participation. The more respondents that participate in the survey, the more helpful the survey results will be. For that reason all of us have a stake in trying to make sure that as many companies as possible participate in the survey.

 

Towers Watson has released the survey form for the 2013 D&O Insurance Survey. The survey form can be found here. Because we all have a stake in having as many companies as possible participate in the survey, it behooves all of us to try to get as many company as we can to respond. The more companies that respond, the more useful the survey report will be. Please consider providing the survey link to your clients and customers.

 

Although D&O insurance represents an important risk management tool for every company, the protection that a D&O insurance policy affords directors and officers is particularly important in the bankruptcy context, when the company is no longer able to indemnify the individuals. Yet, as industry practitioners know, a number of issues recur in the bankruptcy context, particularly as creditors and bankruptcy trustees seek to preserve policy proceeds while the failed company’s directors and officers are seeking to rely on the policy to defend themselves against pending claims.

 

The problem of trying to fund individuals’ defense expenses under the D&O insurance policy while the insured company is in bankruptcy is a recurring theme on this blog (refer, for example, here and here). Over time, a number of standard practices have evolved to facilitate defense expense funding in the bankruptcy context. For example, it is now fairly standard for the insureds and the insurers to approach the bankruptcy court to seek a “comfort order” allowing the insurer to fund the individuals’ defense expenses, notwithstanding any objections of the creditors or the bankruptcy trustee to the use of policy proceeds for these purposes.

 

Though these procedures are now routine, problems still nevertheless emerge, as discussed in an October 22, 2013 memorandum from the Lowenstein Sandler law firm entitled “How to Handle D&O Coverage in a Bankrupt Co.” (here).

 

As the memo’s authors note, while bankruptcy courts now routinely grant the requests of the insurers and the insureds to allow the D&O insurance to be used to fund the individuals’ defense, the order is often subject to an interim funding cap (sometimes called a “soft” cap) and accompanied by a requirement that the parties provide periodic updates on defense expenditures. To see an example of a recent case in which a bankruptcy court entered an order allowing the insurance to be used to fund the individuals’ defense subject to an interim cap and reporting requirements, refer here.

 

The authors refer to other recent cases where the order permitting the individuals’ defense expenses to be funded subject to an interim cap and reporting requirements. One of the cases the authors refer to is the high profile MF Global case. As discussed here, in April 2012, the bankruptcy judge lifted the stay in the MF Global bankruptcy to allow the company’s insurers to fund the company’s former directros and officers’ defenses, subject to an interim cap of $30 million and to reporting requirements. The law firm memo notes that the creditors and claimants who had opposed the order appealed the ruling to the district court, which affirmed the ruling, and have now appealed to the Second Circuit. The appeal is scheduled to be argued in late November.

 

One inherent problem with the use of interim funding caps became apparent in the MF Global case this summer, when the parties returned to court in order to try to get approval to fund defense expenses in excess of the initial $30 million cap. As discussed in a June 28, 2013 Law 360 article entitled “MF Global Judge Rips $40 Million Defense Cap Request” (here, subscription required), U.S. Bankruptcy Judge Martin Glenn took a negative view of defense requests to increase the interim cap to $40 million. He expressed concern that the defense expenses had so quickly reached the cap, particularly given that the case had barely gotten underway. According to the report, Judge Glenn said “individual insureds may have the right to coverage. They don’t have the right to a blank check.”

 

On September 20, 2013, Judge Glenn deferred ruling on the request to increase the cap, in light of the pending appeal. As discussed here, the executives recently asked the court to reconsider his ruling, in light of the fact that their defense expenses to date have exhausted the amounts within the initial cap, and that without relief they are unable to maintain their defenses in the ongoing proceedings.

 

As the law firm memo’s authors note, a bankruptcy court’s limitations imposed in interim funding agreements present a number of problems; first, the existence of interim caps and reporting requirements

 

puts directors in the awkward position of having the party that is suing them looking over their shoulders as they defend themselves and in a position of potentially scaling back a vigorous defense for fear of a future petition to limit the insurer’s reimbursement obligation for defense costs incurred.

 

The ruling also provides the committee with the added benefit of being able to “look behind the curtain” during settlement discussions to know exactly how much insurance money is available.

 

The other problem with the conditions bankruptcy courts place on the funding orders is demonstrated in the MF Global case; the interim funding cap creates the possibility that the court might refuse to increase the cap, putting the individual defendants in “limbo” as they are unable to access additional defense cost coverage for the claims pending against them.

 

The memo’s authors suggest that the funding problem in the MF Global case could have been avoided if it had had different wording the priority of payments clause in its D&O insurance policy. These clauses, which are now standard in most D&O insurance policies, address how the D&O insurance policy’s limits of liability are to be paid out so that the liabilities of the individual insureds are to be given priority and paid first. The authors suggest that the possibility that the problems the MF Global directors and officers are now facing could have been averted if its policy had the type of priority of payments provision that “unambiguously state that the corporate entity and any successor, trustee or receiver has no rights to the insurance policy proceeds until all claims asserted against the individual insureds have been resolved.”

 

There is no doubt that stronger wording of the priority of payments provisions is desirable and that policyholders should always endeavor to obtain the wording that is most protective of the individuals’ payment priority. However, I am not entirely sure that a different wording in the priority of payments provision alone would have been sufficient to avoid the problems the former MF Global officials are now facing.

 

First of all, MF Global’s policy not only has priority of payments provisions, but those provisions were instrumental in Judge Glenn’s initial ruling lifting the stay and allowing the individuals’ defense costs to be paid. As discussed here, in his initial ruling, Judge Glenn considered it particularly important that the primary D&O policy had a provision giving priority to payments under the insuring provisions that protects the individuals. Judge Glenn specifically stated about these provisions that “coverage potentially afforded to the Individual Insureds for non-indemnifiable losses must be paid prior to any payments for matters implicating coverage potentially provided to the Debtors.”

 

Second, Judge Glenn’s decision to defer a ruling on the individuals request to increase the cap apparently was based on the pendency of the appeal of his initial ruling lifting the stay and allowing the interim funding. His views on the petition to raise the interim funding cap seem to have been influenced more by what he viewed as the surprising magnitude of the fees incurred to date, rather than any specific interpretation of particular policy provisions.

 

I am not certain that different wording of the priority of payment provisions alone would eliminate the now fairly standard bankruptcy court practice of granting an order lifting the stay to allow D&O insurance to fund defense expenses subject to an interim cap and reporting requirements. The courts’ insistence on these requirements is more about the maintenance of judicial control than it is about the provisions of the insurance policy. In many bankruptcy cases (for example, even in the high profile Lehman Brothers bankruptcy) these judicial requirements are administered routinely and without incident. The problems involved in the MF Global case arguably are a reflection of circumstances unique to that case – particularly the pendency of the appeal.

 

I have always thought that all of these recurring bankruptcy court problems are the result of a fundamental misconception of the D&O insurance policy. For obvious reasons, claimants and creditors want to establish that the D&O insurance policy exists for their protection and benefit. For less obvious reasons, some courts fall for this, which I have always found frustrating.

 

The fact is that insurance buyers purchase D&O insurance to protect the insured persons from liability. No one pays insurance premium as a charitable act for the benefit of prospective third party claimants. Liability insurance exists to protect insured persons from liability, not to create a pool of money to compensate would-be claimants. The very idea that claimants who have not even established their right of recovery from the insureds should somehow be able to deprive the insureds of their right to use their insurance to protect themselves stands the entire insurance proposition on its head.

 

All of that said, I agree completely with the memo’s authors that the wording of the priority of payments clause is critically important, and that the time to address these concerns is at the time the coverage is placed.

 

A Final Note: The memo’s authors suggest that in light of the fact that D&O insurance policy wordings can be negotiated and that wordings are constantly changing, directors and officers “should consult with experienced coverage counsel and/or make a commitment to remain abreast of key changes in the policy forms.” I agree that the involvement of coverage counsel can be useful in the policy placement process. We frequently work with outside counsel when we place policies for our clients and generally find counsel’s involvement to be productive.

 

However, the memo’s authors also state the following in support of their contention that outside counsel should be involved in the D&O insurance placement process: “most individual officers will rely on their insurance brokers to ‘take care’ of policy placement and review of the policy terms. This is a mistake.”

 

Although we often work with our clients’ outside counsel in connection with policy placements, in the vast majority of the placements on which we work, there is no involvement of outside counsel. The fact is that in most instances there is absolutely no need for these companies to incur the added cost of outside counsel in the insurance placement process.

 

Of course it is important for companies to insure that they have knowledgeable, skilled broker involved in placing their insurance. If the company has taken care to ensure that it has a capable broker involved, it is not a “mistake” for the company to rely on the broker.

 

In some D&O insurance placements, counsel should be involved, and in other cases it is helpful to have counsel involved. Fortunately, in the vast majority of D&O insurance placements, there is no need for companies to incur the cost of outside counsel – and the suggestion that it is a “mistake” for those companies to rely on their brokers is unwarranted. Again, if the company has taken care to ensure that its broker is knowledgeable and experienced, the company is completely justified and conducting itself prudently in relying on their broker.

 

Fortunately, I find that knowledge outside lawyers involved in the placement process fully appreciate that the broker has a valuable and important role to play.

 

D&O insurance policies often address a policyholder’s particular circumstances. One way that D&O insurers sometimes address the fact that a company has experienced adverse circumstances is to incorporate into its policy a “known circumstances exclusion” precluding coverage for those circumstances. In an October 23, 2013 opinion (here), the First Circuit affirmed the opinion of the lower court that a known circumstance exclusion in a non-profit D&O insurance policy precluded coverage for the underlying claim. Although the holding itself is unsurprising in light of the exclusion, the case does underscore the critical importance of the wording used in creating these kinds of exclusions.

 

Background

The Clark School for Creative Learning is a non-profit educational institution located in Danvers, Massachusetts. The school faced financial difficulties, as it was running an operating deficit and its liabilities exceeded its assets. In May 2008, two parents of three of the school’s students (the Valentis) donated $500,000 to the school.

 

The school’s financial difficulties were disclosed at length in Note 8 to the school’s financial statements, which was entitled “Insufficient Net Assets.” Note 8 also referred to the Valentis’ gift:

 

Subsequent to the date of the accompanying financial statement, in May of 2008, the School was a recipient of a major gift totaling $500,000 (see footnote 7). The donation is unrestricted and will be used to support the School’s general operations as management’s plans for the School’s future are implemented and allowed time to succeed. Management feels that its plans and the subsequent major gift will enable the School to operate as a going concern.

 

The Valentis’ gift is further described in Note 7 of the school’s financial statements. Footnote 7 was entitled “Major Gift” and described the gift in detail.

 

In May 2009, the Valentis filed a lawsuit in Massachusetts state court against the school and its director alleging that the school had not followed through on alleged promises the school and the director allegedly made in soliciting the gift. The school eventually settled the Valentis’ lawsuit by agreeing to return a portion of the gift.

 

The school submitted the Valentis’ lawsuit as a claim under its D&O insurance policy. The insurance carrier denied coverage for the claim in reliance on an exclusion in the policy entitled “Known Circumstances Revealed in Financial Statement Exclusion.” The exclusion precluded coverage for any losses “in any way involving any matter, fact, or circumstance disclosed in connection with Note 8 of the [school’s] Financial Statement.”

 

The school initiated a lawsuit against the insurer seeking to have the insurer reimburse the school for the costs of defending and settling the Valentis’ lawsuit. The district court granted summary judgment in the insurer’s favor and the school appealed.

 

The October 23 Opinion

In an October 23, 2013 opinion written by Chief Judge Sandra Lynch for a unanimous three judge panel, the First Circuit affirmed the district court.

 

In her opinion, Judge Lynch observed that the known circumstance exclusion’s reference to Note 8 of the school’s financial statements is “both clear and broad,” that the exclusion precluded coverage for “any matter, fact, or circumstance disclosed in connection with Note 8 of the Financial Statement.” She added that

 

One matter, fact or circumstance disclosed in Note 8 is the Valentis’ gift, along with other information about the School’s troubled finances. And the loss and defense costs for which coverage is sought certainly “involve[es]” that gift, since the loss and costs were incurred in defending and settling litigation about the gift. The plain language of the Known Circumstances Exclusion excludes from coverage the losses from the suit brought by the Valentis about their gift.

 

The appellate court rejected the school’s argument that the exclusion was intended to apply only to the financial difficulties and going concern question discussed in Note 8, not to the Valentis gift, as well as the school’s argument that if the parties had intended for the exclusion to apply to the gift, the exclusion would have referenced Note 7. Judge Lynch said only that “the language here plainly is not limited to losses caused by financial difficulties,” adding that “the parties did reference Note 7: the discussion on the Valentis’ gift in Note 8 explicitly refers to Note 7.”

 

The appellate court also rejected the school’s argument that the application of the exclusion to preclude coverage deprives the school of coverage it reasonably expected. The school argued that it would not have expected the exclusion to reach the Valentis’ suit because the exclusion focused on the school’s financial difficulties and because the suit had not yet been filed and therefore could not have been a “known” circumstance.

 

In rejecting this argument, Judge Lynch said that “the footnote referred to the known circumstance of the gift and went further, describing the gift as unrestricted. The Valentis’ lawsuit alleged otherwise.” Judge Lynch added that “when a contract is not ambiguous, a party can have no reasonable expectation of coverage when that expectation would run counter to the unambiguous language of an insurance policy.”

 

Discussion

At one level, the outcome of this insurance coverage dispute is unremarkable. The policy had an exclusion that precluded coverage for loss involving any circumstance mentioned in Note 8. Note 8 referred to the Valentis’ gift. The Valentis’ lawsuit related to the gift. Under those circumstances, the outcome is no surprise.

 

However, consider if you will the circumstances involved in the placement of this policy. The school was facing financial difficulties, which were fully documented in Note 8, which was titled “Insufficient Net Assets.” The financial difficulties described in Note 8 obviously would be a concern for a D&O insurance underwriter and the underwriter would want to take protective measures against problems arising from the school’s financial difficulties. Fortunately for the school, it had also received a major gift that potentially could allow the school to continue as a going concern. The gift was described in detail in Note 7, which was titled “Major Gift,” and mentioned in Note 8 in connection with the going concern issue. So the purpose of Note 8, titled “Insufficient Net Assets,” was to describe the school’s financial difficulties and possible relief, and the purpose of Note 7 was to describe the gift.

 

The reason the insurer added the Known Circumstances Exclusion was because of the school’s financial difficulties, described in Note 8. The insurer wouldn’t have been concerned about the gift as that was the school’s best hope to be able to carry on.

 

Unfortunately for school, the exclusion that was added referred generally to Note 8. It did not refer to the specific financials issues within Note 8. The exclusion was written broadly so that it encompassed all circumstances reference in Note 8, not just the references in Note 8 to the school’s financial difficulties.

 

I want to make it clear here that I am not finding fault in any way with the way the exclusion at issue was worded. I have no way of knowing the circumstances surrounding the placement of this policy nor do I have any way of knowing whether the insurer in any event would have agreed to a narrower wording; given the school’s financial difficulties, the insurer may not have been willing to agree to a narrower wording in any event.

 

Nevertheless, this case is a reminder of the critical importance of making sure that when coverage limiting exclusions are added, that they are worded as narrowly as possible. Given the school’s financial difficulties, it may have been unavoidable that the school’s insurance policy would preclude coverage for claims relating to those difficulties. But there is no reason that the exclusion should have been written so broadly that it also precluded coverage for matters that not only were not part of the school’s financial difficulties, but that at that time were among the reasons that the school might hope to be able to continue as a going concern.

 

When organizations have experienced adverse circumstances, it may not be possible for the organization to obtain D&O insurance without an exclusion precluding coverage for those circumstances. (Obviously it is always better to have a policy without the exclusion, but sometimes it is not possible to find coverage without an exclusion.) But if an exclusion is to be added, it should be tailored as narrowly as possible, to try to ensure that the exclusion is not applied to preclude coverage for matters outside the area of concern.

 

On October 23, 2013, the SEC finally approved (unanimously) and released for public comment the proposed rules implementing the crowdfunding provisions of the JOBS Act. The rules will not become effective, subject to any revisions, until the end of a 90-day comment period, meaning that the rules will not go into effect until some time early in 2014. The SEC’s October 23, 2013 press release regarding the new rules can be found here. The proposed rules themselves can be found here.

 

The JOBS Act, signed into law in April 2012 (about which refer here), contained statutory provisions providing exemptions under the securities laws allowing certain kinds of start up ventures to raise equity financing from non-accredited investors using Internet fundraising platforms. The Act left many of the details to the SEC and directed the agency to release implementing regulations within 270 days. The deadline for the regulations came and went, and as time passed anticipation over the as-yet unreleased regulations grew. Indeed, earlier this week, a bipartisan group of eight U.S. Senators sent the SEC a letter urging the agency to “expedite” the release of the crowdfunding rules.

 

The proposed rules, which run some 585 pages, provide further specificity as to who may invest and how much they may invest; specifying what information the firm seeking fund raising must provide; and “create a regulatory framework for the intermediaries that would facilitate the crowdfunding transactions.”

 

Consistent with the Act’s provisions, the proposed rules specify that a company may raise no more than $1 million in any one 12 month period through crowdfunding . The rules also specify that investors may invest up to the greater of $12,000 or five percent of their annual income or net worth if both their annual income and net worth are less than $100,000, or ten percent of their annual income or net worth if their annual income or net worth are greater than $100,000. Securities purchased in a crowdfunding offering could not be resold for one year.

 

Certain companies would be ineligible for the crowdfunding exemption, including non-U.S. companies; current SEC reporting companies; certain investment companies, companies currently subject to disqualification; companies that have failed to comply with annual reporting requirements in the rules; and “companies that have no specific business plan or that have indicated that their business plan is to engage in a merger or acquisition with an unidentified company or companies.”

 

The proposed ruled specify that information that companies must provide in the crowdfunding offering documents, including the identities of the company’s directors and officers as well as anyone owning more than 20 percent of the company; a description of the company’s business and intended use of the offering proceeds;  and the target price of the offered securities and the intended size of the offering; The offering document must also identify related-party transactions and the financial condition of the company. The offering documents must include the company’s financial statements, which, depending on the size of the offering, may have to be accompanies by a copy of the company’s tax returns or be reviewed or audited by an accountant. The issuing company would have to provide updates of material changes as well as provide updates on the company’s progress toward reaching the target offering amount.

 

The proposed rules also specify the issuing company’s ongoing reporting requirements after the completion of the offering. This portion of the Act’s requirements has generated  a great deal of comment as some observers wanted to minimize the ongoing requirements on the offering companies while others wanted to provide investor protection through reporting requirements. The proposed rules would require companies to file an annual report no later than 120 days after the end of their financial year, with the reports to be filed with the SEC and posted on the company’s website. The company would not be required to provide investors with a physical copy of the report. The annual report would have to include information similar to the information required in the offering document about the company’s business and financial condition. Because the crowdfunding securities are freely tradable after one year, the reporting requirement would be continuous in order to provide potential future investors with information about the company.

 

The proposed regulations also provide specifications regarding the funding platforms, which must be operated by a registered broker or by a funding portal, which is a new type of SEC registrant. The platforms are required to provide individuals with educational materials; take measures to reduce fraud; make issuer and offering information available; permit discussions on the platform about the offering; and facilitate the sale of crowdfunding securities.

 

The crowdfunding portals would be prohibited from offering investment advice or making recommendations; soliciting the purchase or sale of the securities offered on its website; avoid paying prohibited compensation and commissions; avoid holding or handling investor funds or securities.

 

In the discussion in the proposed rules regarding the Act’s liability provisions, the rules affirm that the range of persons who potentially could be held liable for misrepresentations in the crowdfunding offering are involved intermediaries, including the offering platforms. The rules provide that in light of these potential liability provisions, the platforms should “establishing policies and procedures that are reasonably designed to achieve compliance with the requirements of Regulation Crowdfunding, and that include the intermediary conducting a review of the issuer’s offering documents, before posting them to the platform, to evaluate whether they contain materially false or misleading information.”

 

The agency undoubtedly will receive extensive commentary on the proposed rules, although they are not likely to be as controversial as they potentially could have been because they largely follow the structure laid down in the Act. Based on the comments submitted during the comment period, the rules may be further revised before they are final and companies can commence conducting financing through crowdfunding offerings.

 

Although we will still have to wait a few months before companies can commence crowdfunding financings, it will be interesting to see when we finally get there how much interest there ultimately will be in raising funds through these kinds of offerings. The limitations put on the amount of funds that can be raised as well as the information requirements for the offerings, along with the annual reporting requirements, may represent burdens that some start up ventures may be unwilling to undertake (especially because they will almost inevitably require the association of outside professionals, including accountants and attorneys).

 

Another thing that will be interesting to see is the extent of investor interest, particularly if there are (as there inevitably will be) high profile stories about online scams involving crowdfunding financings. I hope I am not being too skeptical, but it just seems inevitable there will be offerings where the issuing company’s principals abscond with the funds or use them for purposes other than those proposed in the offerings. Even if there are no frauds, there inevitably will be innumerable instances where investors lose their money because the company fails or no secondary market forms for the company’s securities.

 

From an insurance perspective, it will also be interesting to see both how extensively the crowdfunding liability provisions are used and whether a market develops for insurance products providing crowdfunding companies and their directors and officers insurance protection for crowdfunding liability. I suspect that many carriers will develop liability insurance products targeted at crowdfunding companies, but it will be interesting to see if crowdfunding companies are interested in using their limited funds to purchase the insurance.

 

When the SEC Whistleblower Office presented its first full fiscal year annual report last November, the agency reported that 324 (or 10.8%) of the 3,001 whistleblower reports the agency received came from whistleblowers outside the United States. This statistic suggested that the Dodd-Frank whistleblower provisions could lead to the revelation of financial misconduct overseas, and also suggested the possibility that these non-U.S. whistleblower reports could lead to increased revelation of FCPA violations. (The report noted that 3.8% of the whistleblower reports involved alleged FCPA violations.)

 

However, a recent decision in the Southern District of New York could put a damper on overseas whistleblowing. In an October 21, 2013 opinion, Judge William H. Pauley held that the Dodd-Frank Act’s whistleblower anti-retaliation provisions do not protect whistleblowers outside the U.S. Judge Pauley’s opinion can be foundhere. Judge Pauley’s decision follows a June 2013 Southern District of Texas decision in the GE Energy (USA) case (here) in which Judge Nancy Atlas held that the anti-retaliation provisions do not apply extraterritorially. Without the protection of the anti-retaliation provisions, prospective overseas whistleblowers could be deterred from submitting reports to the SEC.

 

Meng-Lin Liu, a Taiwanese national, served as Group Compliance Officer for Siemens A.G.’s Chinese healthcare division. He became concerned that the Chinese unit was paying kickbacks to obtain imaging equipment contracts with Chinese and North Korean hospitals. He reported concerns to company officials, including his concern that the payments circumvented compliance procedures put in place following the company’s 2008 guilty plea to FCPA charges. Liu received negative performance reviews he believed were written in retaliation for raising concerns. He was later demoted and in early 2011 his employment contract was terminated.  In May 2011, Liu reported possible FCPA violations to the SEC.

 

Liu instituted a Dodd-Frank Act whistleblower anti-retaliation action against Siemens in the Southern District of New York. Siemens moved to dismiss, arguing that the anti-retaliation provisions do not apply extraterritorially.

 

In his October 21 opinion, Judge Pauley granted the company’s motion to dismiss. Citing the U.S. Supreme Court’s decision in Morrison v. National Australia Bank for the proposition that U.S laws do not apply extraterritorially unless Congress clearly expresses intent for a statute to apply extraterritorially, Judge Pauley found that in enacting the Dodd-Frank Act, Congress had not show an intent for the anti-retaliation provisions to apply extraterritorially.

 

Judge Pauley also rejected Liu’s argument that the anti-retaliation provisions should apply to Siemens merely because Siemens has ADRs that trade on the NYSE, noting that in the Morrison case, National Australia Bank had ADRs trading in the U.S. but that that fact was not determinative of the question of the reach of the securities laws.

 

Judge Pauley said:

 

This is a case brought by a Taiwanese resident against a German corporation for acts concerning its Chinese subsidiary relating to alleged corruption in China and North Korea. The only connection between the United States is the fact that Siemens has ADRs traded on an American exchange, just as in Morrison…There is simply no indication that Congress intended the Anti-Retaliation Provision to apply extraterritorially.

 

Judge Pauley also rejected Liu’s argument that he was entitled to protection under the Sarbanes-Oxley whistleblower provisions. He also considered but concluded that he did not need to decide the question whether or not Liu was even a “whistleblower” to whom anti-retaliation protections would otherwise apply given that he did not file his whistleblower report until after he his employment contract had been terminated.

 

Judge Pauley accepted that overseas employees could be a whistleblower within the meaning of the Dodd-Frank Act. Clearly, given the significant number of whistleblower reports from outside the U.S. in the program’s first full fiscal year, overseas employees have responded to the opportunity to provide whistleblower reports.

 

However, 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, which in turn potentially could result in fewer reported violations of the FCPA.

 

The one consideration that might reassure prospective overseas whistleblowers is the extent of the SEC’s effort to protect the anonymity of the whistleblower to whom the agency recently awarded the record-level $14 million whistleblower bounty. At least some prospective overseas whistleblowers might yet come forward even without the anti-retaliation protections if they believe their anonymity will be preserved.

 

Nevertheless, the absence of anti-retaliation protection for non-U.S. whistleblower could deter many prospective overseas whistleblowers from filing reports with the SEC.

 

Hat tip to the S.D.N.Y. Blog (here) for the link to Judge Pauley’s opinion.