Does the multiplied portion of an attorneys’ fee award constitute the “multiplied portion of multiplied damages” such that it is precluded from coverage under a D&O insurance policy? That was the question addressed in a July 16, 2013 decision from the Seventh Circuit. In an interesting opinion from Chief Judge Frank Easterbrook, the appellate court, applying Illinois law, concluded that the multiplied portion of the fee award does not represent multiplied damages and accordingly the entire fee award is within the D&O policy’s coverage.

 

Background

Amicas agreed to merge with Thoma Brava in a transaction valued at $5.35 per share. Shareholders filed a state court action in Massachusetts objecting to the merger. After the Massachusetts court entered a preliminary injunction stopping the merger vote, the lawsuit settled. Amicas shareholders ultimately received $6.05 per share in the merger transaction, representing a $26 million increase in the value of the transaction.

 

The Massachusetts lawsuit plaintiffs sought to recover their attorneys’ fees. The Massachusetts judge awarded the plaintiffs’ attorneys fees consisting of a lodestar of $630,000, increased by a multiplier of five. The multiplier represented an adjustment for the risk to the plaintiffs’’ lawyers that they might have recovered nothing and also for the “exceptionally favorable result” for Amicas’ shareholders. The total value of the award after application of the multiplier was $3,150,000.

 

The D&O insurer for Amicas acknowledged coverage for the lodestar amount, but disputed that its policy covered the multiplied amount of the fee award. In making this argument, the carrier relied on the policy’s definition of the word “Loss” for which the policy provides coverage. The definition states that “Loss shall not include civil or criminal fines or penalties imposed by law, punitive or exemplary damages, the multiplied portion of multiplied damages, taxes, [etc.]”

 

The carrier filed an action in federal court in Illinois seeking a judicial declaration that the multiplied portion of the fee award represents the “multiplied portion of multiplied damages,” and is therefore not within the policy’s definition of covered loss. Amicas filed a counterclaim against the insurer for its bad faith refusal to pay the multiplied portion of the fee award.

 

The district court ruled that the D&O insurer owes the full amount of the fee award, but rejected Amicas claim for bad faith. Both sides appealed.

 

The July 16 Opinion

In a short eight-page opinion written by Chief Judge Easterbrook for a unanimous three-judge panel, the Seventh Circuit, applying Illinois law, affirmed the district court on both issues.

 

Judge Easterbrook began by noting that the award of attorneys’ fees differs from “damages” and that “nothing in [the] policy defines the word ‘damages’ broadly enough to include attorneys’ fees.” He also noted that the court could not find a decision from any court that addressed the question whether the phrase “multiplied portion of multiplied damages” includes the multiplied portion of an attorney fee award. 

 

Looking at the policy language itself, Judge Easterbrook noted that “the context of the phrase …tells us that treble damages and the like are the target.” The list of items that the definition excludes from the definition of covered loss “covers a category of losses that insurers regularly exclude to curtail moral hazard – the fact that insurance induces the insured to take extra risks.”

 

However, Judge Easterbrook noted, adversaries attorneys fees “are not remotely like punitive damages, trebled damages, or criminal fines and penalties,” adding that “ a multiplier of hourly rates provides compensation for the attorneys’ risks,” which “does not entail a moral hazard.”

 

Judge Easterbrook then went on to state that the way that the state court judge had calculated the fee award is irrelevant to whether or not fee award is covered. The state court judge could have, rather than using a multiplier, reached the same fee award amount by simply reckoning it as 12.11% of the shareholders’ gain, in which case, Judge Easterbrook said, “we assume that [the insurer] would not be relying on the exclusion.” He added the observation that “why should it matter that the judge got to the final award using the lodestar method rather than the percentage-of-benefit method?”

 

Finally, the Court rejected Amicas’ bad faith cross-appeal, finding that “the insurer did what Illinois prefers: it filed a declaratory judgment action to resolve the meaning of the policy.”

 

Discussion

The interesting thing about this opinion is that it appears that the parties and the court both assumed that plaintiffs’ fees were covered under the policy; the only dispute was over the amount of the fee award that was covered.  This is an interesting context for the dispute because the more common quarrel, at least from a historical perspective, is whether or not there is any coverage at all under a D&O policies for a plaintiffs’ fee award (See a recent post here for a discussion of this issue). This question often arises in the very type of merger objection lawsuit as was involved in the underlying litigation here.

 

To be sure, the question usually arises where the defendants have agreed to pay the plaintiffs’ fees as part of a settlement of a merger objection suit. In this case, the fee award was the product of an actual court award – although, it should be noted, an award made only after the underlying merger objection case had settled. It is interesting to me that — at least from the face of the Seventh Circuit’s opinion — there did not seem to be a dispute on the question whether the policy here provided any coverage for plaintiffs’ fees. (Indeed, Judge Easterbrook says in an opening paragraph of the opinion that the insurer had issued a policy that covered “not only what Amicas and its directors pay their own lawyers, but also what Amicas must pay to its adversaries’ lawyers.”) The only fight here was whether there was coverage for the multiplied portion of the award – not because it involved a fee award, but because it involved a multiplied portion.

 

I can certainly see how the carrier got to the position it took in the case. If you don’t get hung up on the question whether or not a fee award represents “damages,” the language precluding multiplied damages from the definition of covered loss might well be relevant. However, in the wake of Judge Easterbrook’s opinion, it seems unlikely that any carrier will try to raise the argument again.  There is really no room left for a carrier to try to argue that the amount of an attorney fee award represents damages.

 

In addition, it will be very hard for any carrier to try to argue that the question of whether or not an attorney fee award is covered depends on the method the court uses in determining the size of the award. Whether the court in calculating the amount of a fee award  uses a multiplier or a percentage of recovery measure, or some other approach, should not make a difference to the question of whether or not a D&O insurance policy provides coverage for a plaintiffs’ attorneys’ fee award.

 

There is one contextual issue here that bothers me. And that is that the exclusionary language at issue here was not in the exclusion section of the policy; rather, it was in the policy definitions section of the policy. The language clearly operates like a policy exclusion. Indeed, Judge Easterbrook even referred in his opinion to the specific phrase at issue as “an exclusion.”

 

I know that the appearance of this language in the definitions section is standard (if not universal). But that is a feature of the standard D&O policy structure that has always bothered me. I think a policyholder ought to be able to look at the policy’s exclusions section and be able to discern from a review of that section what loss the insurer intends to exclude from coverage. Analytically, the definitions section should say what is included within the meaning of the term loss, and the exclusions section should say what is excluded from loss. 

 

Some might think this a mere formality as the policy must be read as a whole in any event. However, one of the recurring concerns I have heard policyholders express over the years about their D&O policy is that they are surprised when they have a claim to find out things that the carrier will say is not covered. One way to try to avoid this problem would be for the policy to say more clearly what the insurer intends to assert is not covered under the policy. A small step to providing this kind of clarity would be to put all of the policy’s exclusionary language in the exclusions section.

 

I know that the standard D&O policy form, with the presence of this exclusionary language in the definition of Loss, is unlikely to change any time soon. I still think it is worth calling attention to this issue. It is worth thinking about ways to make the policy more transparent to the policyholder. One way to do that is to make sure that all of the exclusionary language is in the exclusions section of the policy.

 

In an environment where public company directors and officers face increasing scrutiny and expanding liability exposures, the indemnification and insurance protections available to them are increasingly important. A July 15, 2013 memorandum from the Gibson Dunn law firm entitled “Director and Officer Indemnification and Insurance – Issues for Public Companies to Consider” (here) takes a look at these complementary and critical liability protections for corporate officials. The memo provides a useful overview of the issues that companies and their boards should consider in connection with corporate indemnification and D&O insurance.

 

The memo explains that most companies rely on some combination of three liability protections for their corporate directors and officers. The first of these are so-called “exculpatory” charter provisions, which are permitted under Delaware General Corporation Law and equivalent statutes in other states. These provisions generally insulate directors from liability for monetary damages for breaches of the duty of care, but not breach of the duty of loyalty or actions found to be in bad faith.

 

The “first line of defense” when corporate officials do face liability is indemnification. Indemnification is “broader than insurance in some respects, so it can provide protection in situations where insurance coverage may be more limited” – for example, in the early stages of an investigation, when the costs typically would not be insured because no claim has yet been made.

 

Delaware’s courts and the courts of most other states generally enforce indemnification provisions as written in corporate bylaws. Nevertheless, corporate officials interested in securing their indemnification rights will want to consider entering a written indemnification agreement. The advantage of an agreement is that it enables companies and their officials to address the rights in more detail. For example, agreements often provide definition of key terms and outline procedures and time frames for obtaining payment and specifying who will authorize indemnification payments. The agreements can include presumptions in favor of indemnification and provide for “fees on fees” (that is, indemnification of fees incurred to enforce indemnification rights). An indemnification agreement can also provide an added layer of protection against unilateral amendment or rescission of indemnification rights.

 

In the end, however, the company’s indemnification commitment is only as reliable as the company’s balance sheet. A key purpose of D&O insurance is to “fill gaps” when indemnification is unavailable – for example, when the corporation is insolvent or unable to indemnify due to legal prohibition. Examples where the company cannot indemnify include derivative suit settlements (which may not be indemnifiable under some state’s laws) or where the individual has not met the standard of conduct for indemnification. In these situations or when the company is insolvent, the D&O insurance can provide the “last line of defense.”

 

As the memo notes, D&O insurance is not an “off the shelf” product. The policy terms and conditions are the subject of extensive negotiation. Minor wording changes “can mean the difference between having and not having coverage, or having significantly more limited coverage.”

 

In addition to the terms and conditions, D&O Insurance program structure also matters as well. A company’s D&O insurance will often involve multiple layers of insurance, usually composed of a layer of primary insurance and one or more layers of excess insurance above the primary layer. Though the excess insurance usually is intended to be “follow form” insurance – that is, providing the same coverage as the primary layer — there can be important wording considerations pertaining to the excess insurance as well. Among these considerations is the question of the “trigger of coverage.” 

 

Many older excess D&O insurance policies specified that they would only apply if the underlying insurance was exhausted by payment of loss. These provisions could cause problems when for one reason or another there was a payment “gap” in the underling insurance (about which, refer here). More modern policies specify that the excess insurance will apply regardless of whether the underlying amount is paid by the underlying insurer, the policyholder or a third party. (For a more detailed discuss of the problems associated with D&O insurance layering, refer here.)

 

Another increasingly common feature of many D&O insurance programs is Excess Side A insurance, which provide an added layer of protection when the company is unable to indemnify whether due to insolvency or legal prohibition, Many of these Excess Side A policies include so-called “Difference in Condition” (DIC) protection as well, by which the policy will be triggered – and will fill the gap – for example if an underlying insurer is insolvent or wrongfully refuses to pay.

 

The memo cites the recent Second Circuit opinion in the Commodore International case (about which refer here), in which the several layers of the bankrupt company’s D&O insurance program had been written by carriers that were insolvent when the time to make insurance payments arrived. As the memo note, “the Commodore case provides a compelling illustration of why Side A DIC coverage is so important.”

 

The memo also includes a brief discussion of the increasing importance of cyber liability issues. The emergency of these issues has important implications for board oversight issues. The issues also raise important D&O liability insurance issues, and also present the need for policies “that are specifically designed to address cyber liability issues.” The memo notes that there are now policies available in the marketplace that typically provide “for losses that the company incurs in responding to a cyber incident, such as the cost of notifying customers of a data breach, and claims brought by third parties, such as customers alleging unauthorized disclosure of their data.” (My recent discussion of the critical importance for boards to consider and address the question of insurance for cyber issues can be found here.)

 

According to the memo, given all of these important considerations, “D&O insurance should be reviewed annually,” because “changes in the external environment and the D&O insurance market may warrant changes in coverage.” The memo notes that “for the first time in several years, companies reviewing their D&O insurance can expect higher premiums and the possibility of restrictions of coverage.”

 

The memo closes with a very important message for every D&O insurance policyholder:
“Due to the complexity of policy language and the issues involved, expert advice from qualified professionals is important in obtaining a through understanding of the coverage available under a company’s D&O insurance program.” The professionals should include both legal counsel and skilled insurance professionals. The memo notes that “many boards of directors seek comprehensive analyses of their companies’ D&O insurance programs, undertaken with the assistance of experts, at the time of the initial purchase or renewal of D&O insurance coverage.”

 

My recent discussion of advancement and indemnification issues can be found here. In a prior post (here), I examined the limits of indemnification. My own overview of indemnification and insurance can be found here. Finally, in my series entitled “The Nuts and Bolts of D&O Insurance” (here), a provide an basic overview of D&O insurance.

 

New corporate and securities lawsuits filings in the second quarter of 2013 were “down dramatically” compared to 2013’s first quarter, according to the quarterly D&O Claims Trends report of insurance industry information firm Advisen, which was released today and which can be found here. At the current filing level, the total of all corporate and securities lawsuit filings for 2013 “will have the lowest level of filings since 2006.”

 

Readers reviewing the Advisen report will want to be very careful to note that the report uses its own unique terminology. In particular, the report uses the term “securities suits” to refer to all categories of corporate and securities litigation. Among the subsets within this larger category of “securities suits” is what the report calls “securities fraud” suits, which as used in the report refers to actions brought by regulatory and enforcement authorities, as well as private securities suits that are not brought as class actions. The category of “securities fraud” suits does not include securities class action lawsuits, which have their own separate category of “securities class action” suits, which part of the larger category of “securities suits.” Readers will want to be very attentive to the report’s usage of these terms.

 

According to the Advisen report, there was a 41 percent decline in new corporate and securities lawsuit filings in the second quarter of 2013 compared to 2013’s first quarter. This quarter to quarter decline – from 352 new corporate and securities lawsuits in the first quarter to 234 new corporate and securities lawsuits in the second quarter – represents the “largest quarterly decline since before the financial meltdowns of 2007/08.” The year over year quarterly drop was even sharper, as the number of new corporate and securities lawsuits declined 55 percent comparing the second quarter 2013 filings to the filings in the second quarter of 2013. The 234 new corporate and securities lawsuits during 2Q13 is the lowest number of quarterly filings since before 2009.

 

Several categories of corporate and securities lawsuits contributed to this decline, with corporate and securities lawsuits that the report characterizes as breach of fiduciary duty lawsuits, derivative shareholder lawsuits and securities fraud lawsuits all declining in the quarter. What the report calls securities fraud lawsuits (which again, as noted above, includes regulatory and enforcement actions but does not include securities class action lawsuits) fell by 59 percent from the first quarter of 2013 to the second quarter of 2013.

 

The report notes that this decline in the number of what the report calls “securities fraud” lawsuits dates back to the first quarter of 2012 and “is due in part to a chance of emphasis in SEC enforcement.” Although this downward trend “had been apparent,” It has “never been as drastic as it was this past quarter.”

 

Merger objection lawsuits have contributed significantly to the growth in corporate and securities lawsuit filings in recent years. Though the numbers of these suits increased dramatically in the years through 2011, the numbers of these lawsuits began to decline in 2012, compared to 2011, and “are on pace to do so again in 2013.” The report does not examine the question whether the decline in the absolute number of merger objection lawsuits in 2012 and YTD in 2013 reflects a decline in merger activity.

 

The report notes that securities class action lawsuits as a percentage of all corporate and securities lawsuit filings have been on a downward trend since 2007 (from 22 percent of all corporate and securities lawsuits in 2007 to 10 percent in 2012). However, with the decline in the filing of other types of corporate and securities lawsuits in the second quarter of 2013, second quarter securities class action lawsuits represented 13 percent of all corporate and securities lawsuits.

 

Absolute numbers of securities class action lawsuit filings have also been declining for the past two years. The report states that there were 74 securities class action lawsuit filings during the first half of 2013, putting the annualized filings on a pace for another decline in 2013 from the 184 filings that Advisen reported in 2012. The report does note an uptick in the number of securities class action lawsuits alleging accounting allegations. (My own analysis of first half 2013 securities class action lawsuit filings can be found here.)

 

Companies in the financial services sector remained as the leading target of corporate and securities lawsuits in the second quarter of 2013. A quarter of all corporate and securities lawsuit filings in the second quarter involved companies in the financial sector. The report notes that “the downward trend in new financial services filing” which has developed as the credit crisis has receded into the past “continued in the second quarter.”

 

The quarterly Advisen report also includes a separate section on the cyber liability exposures of corporate directors and officers. The report states that directors and officers “are faced with an ominous new threat landscape comprised of an evolving set of exposures.” Readers interested in this topic will want to review the guest post on this blog of D&O maven Dan Bailey, in which Dan discusses directors’ cyber liability exposures. A recent post in which I discussed the question whether or not cyber breaches could become the next wave of securities litigation can be found here. Finally, a more recent post in which I discussed the questions corporate directors will want to be asking about cyber risk and cyber liability insurance can be found here.

 

Speakers’ Corner: On Tuesday, July 16, 2013, I will be participating in Advisen’s Quarterly D&O Claims Trends Webinar, in which, among other things, the latest Advisen report will be discussed. In this free hour-long webinar, which will take place at 11:00 am EDT, I will be participating on a panel with Kieran Hughes of AIG, Carl Metzger of the Goodwin Proctor law firm and Jim Blinn of Advisen. The panel will discuss claims trends and developments during the first quarter of 2013. Registration information for the webinar can be found here.

 

On July 15, 2013, the FDIC provided the latest update on the web page on which the agency is tracking the litigation it has filed and that has been authorized against the directors and offices of failed banks. According to the latest update, the FDIC has now filed a total of 69 lawsuits against failed bank directors and officers, including a total of 25 so far during 2013. By way of contrast, the FDIC filed 26 lawsuits against failed bank directors and officers during all of 2012.

 

Though the agency has now filed 69 lawsuits, it has not filed any since mid-June — roughly a month-long period where there have been no new failed bank lawsuit filings. During the current bank failure litigation wave, there have been other periods where the pace of new filings dropped off (refer for example here). Given the ebb and flow of filing activity, it would unwarranted to try to read anything into the fact that there have been any filings in about a month – particularly given that there was an intervening federal holiday during that period.

 

The latest update also reflects an increase in the number of lawsuits against failed bank directors and officers that the agency has authorized. As of the prior update (dated June 7, 2013) the agency had authorized lawsuits involving 114 failed banks and involving 921 former directors and officers. Now with the latest update, the agency has now authorized lawsuits in connection with 120 failed banks, and involving 962 individuals. In other words, since the last update the agency, the agency has authorized lawsuits in connection with only six additional banks, but the lawsuits authorized in connection with those six banks apparently involve 41 individuals.

 

The number of authorized lawsuits is inclusive of the 69 lawsuits the agency has filed so far, involving 530 former directors and officers. In other words, in addition to the 530 individuals who have been named as defendants in failed bank lawsuits, the FDIC has authorized lawsuits involving another 432 former directors in connection with the 51 authorized but as yet unfiled lawsuits.

 

Just as there have been no lawsuits in about one month, there have been no new bank failures  during that period either. Actually, it has been more than a month since the last bank failure on June 7, 2013. There have been a total of 484 bank failures since January 1, 2007. With the recently increased number of authorized lawsuits, the agency has now authorized lawsuits in about 24 percent of bank closures during the current bank failure wave. This implied rate of litigation activity is roughly equivalent to the litigation rate during the S&L crisis, when banking regulators filed lawsuit against the former directors and officers of failed bank in connection with about 24% of failed institutions.

 

To be sure,  the agency has at this point only authorized lawsuits in connection with about 24% of banks that failed during the current bank failure wave; what percentage of those authorizations result in actual lawsuits remains to be seen. On the other hand the number of lawsuits authorized also seems likely to increase in the months ahead.

 

The 69 lawsuits that have been filed so far have been filed in 19 different states and Puerto Rico. The state with the largest number of lawsuits against former directors and officers of failed banks is Georgia, which now has had 16 lawsuits filed against former directors and officers of banks that were located in the state prior to their closure. This is hardly surprising since Georgia has experienced the highest number of bank failures. But with about 23% of all failed bank lawsuits involving failed Georgia banks, but with the state representing only about 17% of bank failures, the lawsuits are falling disproportionately against Georgia’s banks. Of course, that could simply be a matter of timing; many of the closed Georgia banks were among the first banks to fail, so it arguably is unsurprising that the earliest lawsuits would be concentrated against failed Georgia banks.

 

After Georgia, the states with the largest numbers of failed bank lawsuits are California (9); Illinois (9); Florida (7); Washington (5); and Nevada (4). This roster of states corresponds roughly with the list of states that have experienced the highest numbers of bank failures.

 

Largely as a result of the pre-dismissal motion discovery bar and the heighted pleading standard Congress and the courts have imposed, the plaintiffs in these cases increasingly have come to rely on the statements of confidential witnesses in attempting to plead securities fraud cases, a development that has become the target of extensive criticism.

 

In an unusual July 9, 2013 post-settlement order in the Lockheed Martin securities class action lawsuit, Southern District of New York Jed Rakoff examines the role of confidential witness-based allegations, both in the Lockheed case itself and in securities cases in general. As is clear from Judge Rakoff’s memorandum, the plaintiffs’ reliance on confidential witness testimony to try to meet heightened pleading standards presents a problem for both plaintiffs and for defendants, as well as for the courts. A copy of Judge Rakoff’s July 9 opinion can be found here.

 

Background

As discussed here, in July 2011, shareholder plaintiffs filed a securities class action lawsuit against Lockheed Martin and certain of its directors and officers. Among other things, the plaintiffs alleged that the defendants had misrepresented the company’s prospects and financial results. In support of their allegations, the plaintiffs’ complaint relied in part on the supposed testimony of certain confidential witnesses, who were current or former company employees and who provided testimony substantiating that the individual defendants were aware of certain facts or had knowledge of certain issues. The defendants moved to dismiss the plaintiffs’ complaint.

 

In a February 14, 2012 ruling explained in a July 13, 2012 order, Judge Rakoff denied the defendants’ motion to dismiss – as he later noted, the dismissal denial was “partly in reliance on the statements attributable to the [confidential witnesses].” After the dismissal motion was denied, the parties commenced discovery. Defense counsel used discovery processes to obtain the names of the confidential witnesses and then took their depositions.

 

The defendants then filed a motion for partial summary judgment, arguing that in their depositions, the confidential witnesses had recanted their testimony or denied having made the statements attributed to them. The plaintiffs countered that the witnesses had changed their stories because of financial or other pressure Lockheed had brought to bear on them but that their investigator’s notes largely confirmed what had been attributed to the witnesses in the complaint.

 

As Judge Rakoff later explained in his recent memorandum, because “the parties competing assertions raise serious questions” that “implicated the integrity of the adversary process itself, he ordered five of the confidential witnesses to appear in court, along with the plaintiffs’ investigator. The transcript of the October 2012 hearing, which can be found here, makes for some interesting reading

 

On December 14, 2012, Judge Rakoff issued an order denying the defendants’ motion for summary judgment, with an opinion to follow. That same day, the parties informed the court that they had settled the case. Judge Rakoff preliminarily approved the settlement in March 2013. Even though the case has settled and it was, as Rakoff noted in his recent memorandum opinion, “no longer necessary to issue a full opinion” explaining his reasons for denying the defendants’ motion for summary judgment, Judge Rakoff nevertheless issued his July 9 memorandum because, he noted, “a few comments may be helpful in light of certain issues presented by [the summary judgment] motion that are likely to recur in future cases.”

 

The July 9 Memorandum

Judge Rakoff opened his July 9 memorandum by noting that “the recent attempts by Congress and the Supreme Court to curtail what they perceive as vexatious, even extortionate class action filings have spawned innovative but problematic reactions—as this case illustrates.” He added that the procedural hurdles that Congress and the courts had created, while designed to give the courts a “gatekeeper” function to weed out “dubious class action lawsuits at the outset,” have produced “an unintended consequence” – that is, that plaintiffs’ counsel “undertake surreptitious pre-pleading investigations designed to obtain ‘dirt’ from dissatisfied employees.” The amended complaint in this case, “as in many others,” relied on information attributed to confidential witnesses.

 

After reviewing the cases’ procedural history and the reasons why he convened the unusual October 2012 hearing at which he heard the live testimony of the previously confidential witnesses and the plaintiffs’ investigator, he summarized his conclusions about the testimony. Judge Rakoff stated that the testimony

 

bore witness to the competing pressures this process has placed on the confidential witnesses and the impact such pressures had had on their ability to tell the truth. In a nutshell, it appeared to the Court that some, though not all of the [confidential witnesses] had been lured by the investigator into stating as ‘facts’ what often were mere surmises, but then, when their indiscretions were revealed, felt pressured into denying outright statements they had actually made.

 

With respect to three of the witnesses who had backpedaled rather too far from what they had told the plaintiffs’ investigator, Rakoff said that “while the court was not unsympathetic to the difficult position in which these witnesses found themselves, their disrespect for their obligation to tell the truth hardly redounded to their credit.” Rakoff contrasted these witnesses from two others who “provided welcome evidence that some witnesses can still place the value of truth above their self-interest.”

 

Judge Rakoff found with respect to the plaintiffs’ investigator that “his report of his findings to plaintiff’s counsel was accurate in all material respects.” The only statement attributed to a confidential witness that was not accurately stated in the amended complaint was not the result of mis-reporting by the investigator “but of mis-drafting by counsel.” The amended complaint, in a misstament Judge Rakoff described as “improper,” characterized a witness’s surmise as actual knowledge, “an error made more egregious by the fact that the Court had relied, in part, on the statement” in denying the motion to dismiss. However he noted that had had relied on other evidence as well, and the plaintiff’s counsel had subsequently amended the complaint to correct the error.

 

Strictly speaking, there was no reason for Judge Rakoff to have issued his July 9 memorandum. With the case settled, no issues remained before him except as pertains to procedures surrounding the pending settlement. In his concluding paragraph, Judge Rakoff explained why he nevertheless released the Memorandum:

 

The sole purpose of this memorandum … is to focus attention on the way in which the PSLRA and decisions like Tellabs have led plaintiffs’ counsel to rely heavily on private inquiries of confidential witnesses, and the problems this approach tends to generate for both plaintiffs and defendants. It seems highly unlikely that Congress or the Supreme Court, in demanding a fair amount of evidentiary detail in securities class action complaints, intended to turn plaintiffs’ counsel into corporate ‘private eyes’ who would entice naïve or disgruntled employees into gossip sessions that might help support a federal lawsuit. Nor did they likely intend to place such employees in the unenviable position of having to account to their employers for such indiscretions, whether or not their statements were accurate. Bat as it is, the combined effect of the PSLRA and cases like Tellabs are likely to make such problems endemic

 

Discussion

Judge Rakoff is far from the first observer to note the problems involved with plaintiffs’ reliance on confidential witnesses and the abuses that can sometimes result. Indeed he is far from the first member of the judiciary to raise a red flag about the problems associated with confidential witness testimony in securities cases.

 

For example, in a February 5, 2013 order in the SunTrust Banks securities suit, in which Northern District of Georgia Judge William S. Duffey, Jr.,   in a post-dismissal proceeding in which he denied the defendants’ motion for sanctions, noted that the plaintiffs’ conduct with respect to a confidential witness was “not in keeping with the conduct expected of attorneys practicing before the Court.” While counsel’s actions “did not constitute an actionable violation,” the Court “remains troubled by the conduct of Plaintiffs’ counsel.”

 

By the same token, in a March 26, 2013 decision of the Seventh Circuit in an opinion by Judge Richard Posner in the Boeing securities class action lawsuit, the appellate court remanded a case to the district court to address the plaintiffs’ counsel’s compliance with Fed. R. Civ. Proc. 11, noting that the plaintiff’s counsel’s failure to inquire about apparent concerns with a confidential witness’s testimony “puts one in mind of ostrich tactics – of failing to inquire for fear that the inquiry might reveal stronger evidence of their scienter regarding the authenticity of the confidential source that the flimsy evidence of scienter they were able to marshal against Boeing.” The Court noted that the law firm involved had been criticized in other cases for “misleading allegations concerning confidential witnesses” and added that “recidivism is relevant in assessing sanctions.”

 

What makes Judge Rakoff’s observations about the ills associated with the plaintiffs’ reliance on confidential witnesses noteworthy (other than the fact that he went way out of his way to issue an entirely non-required statement) is that he emphasized that the problem is an issue for both plaintiffs and for defendants and, more importantly, he focused on the cause of the problem. Rakoff sees the problem as the unintended result of the pleading constraints that Congress and the Supreme Court have put on plaintiff shareholders in securities class action lawsuits. In his view, the problem appears almost unavoidable, or at least highly likely to recur, making these kinds of problems “endemic.”

 

Judge Rakoff stated that he was issuing his memorandum, despite the absence any case-specific reason to do so, because he wanted to “focus attention” on the problem. He does not specify whose attention he wants to focus. Certainly, he got my attention, as well as that of other bloggers. But although I am sure Judge Rakoff is quite attentive to opinion in the blogosphere, I recognize that his primary motivation was trying to attract the attention of Congress and appellate courts, to show them how the unintended consequences of their actions were producing a serious problem of all concerned.

 

Though Judge Rakoff can try to focus attention on the problem, that effort alone does not address the obvious next question, which is – what can be done about it?

 

In an April 4, 2013 post on his D&O Discourse blog (here), securities litigator Doug Greene of the Lane Powell lays out his proposal of what to do about the confidential witness problem. Among other things, Greene suggests requiring plaintiffs’ lawyers to include sworn declaration from confidential witnesses and to provide employment related information to substantiate that their employment provided them the actual opportunity to observe the events about which they were testifying. Greene also proposes allowing defense counsel limited discovery of confidential witnesses prior to the motion to dismiss, to avoid situations where dismissal motions are granted based on the testimony of witnesses that later recant. (I should emphasize that I am summarizing Greene’s proposals ; his analysis and discussion of these issues is extensive and warrants a full reading, rather than my mere summary description here).

 

Certainly, one of the issues causing the confidential witness problem is that they are, well, confidential. The pattern recurs often that after the dismissal motion is denied, and the witnesses’ identities are known and their testimony is questioned, the witnesses recant. In that respect, Greene’s suggestion that plaintiffs must provide greater corroborating and identifying information appears to have a substantial basis.

 

On the other hand, as Judge Rakoff noted, once the identities of confidential witnesses are known, they are then “pressured into denying outright the statements they had actually made.” As one leading plaintiffs’ lawyer has said to me, confidential witnesses always recant, because of the financial and other pressure their employer can bring to bear on them, regardless of how precise, specific and detailed their prior testimony had been. The introduction of procedural steps that would accelerate the process of forcing witnesses to recant their testimony – even where, as Judge Rakoff noted, they had actually made the statements they were now denying – will not necessarily and in every case represent a guarantee of greater integrity in the process.

 

The one thing that is clear is that we have a problem. Judge Rakoff is right to try to draw attention to this problem. Whether or not the problem is, as Judge Rakoff state, “endemic,” it clearly is a recurring problem. While greater scrutiny of plaintiffs’ use of confidential witness testimony is one step to try to address this problem, that alone will not be sufficient. As Judge Rakoff’s memorandum highlights, the focus should be on the cause of the problem, which he regards as the unintended result of the specific steps taking by Congress and the courts to rein in abusive securities litigation.

 

I have no brilliant proposals to address this problem, but I think Judge Rakoff is on the right track. It is more important to look at causes, rather than effects. The focus should be on the causes. More importantly, there must be a focus. This is a problem that is not going away.

 

More About the Supreme Court: When the founding fathers in their ageless wisdom set up our tripartite system of government, they virtually guaranteed that there would be tension between the three branches. A recent essay in the Lexington column in the Economist magazine taking a look at the just-completed Supreme Court term comments on how this tension – particularly the tension between the Court and Congress – characterizes much of the Court’s late term activities.

 

In the essay, entitled “Above the Fray, but Part of It,” the column’s author notes that

 

A single instinct binds together several big and seemingly incompatible rulings handed down by the Supreme Court at the end of its term. That instinct touches on traditional arguments about the competing rights of the federal government versus the 50 states, but is larger than a discussion of states’ rights. Put simply, the court showed a deep suspicion of attempts to use the law to place a particular group or institution on a pedestal, granting it special privileges to shield it from attack or competition. To give the instinct a single label, the court rejected paternalism as a way of organizing American society.

 

After noting that the court had rejected one kind of paternalism in the Voting Rights Act and affirmative action cases, “in striking down the Defense of Marriage Act, the majority was – in effect — taking issue with a paternalism of the right.” The Supreme Court’s suspicion of paternalism “belongs to a long national tradition, to be sure: America was born of revolution and built around self-government.”

 

Just the same, the court’s end-of-term rulings “defy easy partisan labeling.” Both from the right and the left there is a distinct sense of “what is at stake, politically.” As the column’s author notes, “This is a Supreme Court which does not hide its disdain for Congress.” It is a “supremely confident court.” As a result, “this has been a term of unusual confrontation and drama. Expect more to follow.”

 

Back in 2009, one of the prominent securities litigation filing trends was the prevalence of “belated” securities class action lawsuit – that is, cases filed at the very end of the limitations period rather than in immediate aftermath of a stock price decline

 

And then in 2011, perhaps the most significant securities lawsuit filings trend at the time was the massive upsurge in the filings of securities class action lawsuits against U.S.-listed Chinese companies.

 

More recently, both of these trends appeared to have subsided. But a securities class action lawsuit filed this past week appears to bring both of these past trends together again in a single new case. It should be noted that, in an interesting variation of the past trends, the most recent case involves a company based not in the People’s Republic of China, but rather in Taiwan, Republic of China.

 

As reflected in their July 10, 2013 press release (here), plaintiffs’ lawyers filed a securities class action lawsuit in the Southern District of New York against SemiLEDs Corp. and certain of its directors and officers. According to the plaintiffs’ complaint, though the company was headquartered in Boise, Idaho, at the time of its December 8, 2010 IPO, the company has its principal operational, administrative and manufacturing facilities in Taiwan. SemiLEDs is a holding company for wholly-and majority-owned subsidiaries and joint ventures that manufacture and sell light emitting diode (“LED”) chips and components used in general lighting applications.

 

According to the press release, the Complaint alleges that the defendants failed to disclose that:

 

 (i) that the Company was experiencing known, but undisclosed, pricing pressures for its products which were reasonably likely to have a material adverse effect on SemiLEDs’ future revenues and operating income; (ii) that known events or uncertainties, including the reduction in demand for the Company’s products, the likely (and ultimate) loss of a large customer, and the decline in the value of the Company’s inventory, were reasonably likely to cause SemiLED’s financial information not to be indicative of future operating results; (iii) that the Company’s disclosure controls were materially deficient and its representations concerning them were materially false and misleading; (iv) that the certifications issued by defendants associated with the Company’s disclosure controls were materially false and misleading; and (v) that, based on the foregoing, defendants lacked a reasonable basis for their positive statements about the Company, and its then current business and future financial prospects.

 

The complaint further alleges that on July 10, 2011, SemiLEDs issued a press release announcing its financial results for the quarter ended May 31, 2011. For the quarter, the Company reported a revenue decline of 43% from the previous year’s third quarter, and a net loss of $5.1 million. The Company’s results for the quarter were adversely impacted by a $1.1 million inventory charge during the quarter, an amount equal to more than 7% of the value of the Company’s total inventory at February 28, 2011. SemiLEDs’ stock price fell nearly 11% on July 12, 2011

 

The announcement and stock price decline took place two years ago, but the plaintiffs did not file their complaint until July 10, 2013. In their complaint, the plaintiffs purport to represent a class of the company’s shareholders who purchased their shares between December 9, 2010 and July 12, 2011 – that is, who purchased their shares between the day after the company’s registration statement was declared effective and the first trading day after the company’s July 10, 2011 earnings announcement.

 

Though the complaint references the company’s December 2010 IPO, the complaint does not assert claims under the Securities Act of 1933. Rather, the two substantive claims in the complaint are both asserted under the Securities Exchange Act of 1934. The apparent explanation for the omission of ’33 Act claims is the statute’s one-year limitations period. By asserting their action exclusively under the ’34 Act, the plaintiffs clearly hope to rely on that statutes two-year limitations period.

 

But while the way that the plaintiffs have plead their case can be understood by reference to the various limitations periods, that still does not explain why the plaintiffs did not get around to filing their suit until the very end of the limitations period.

 

Back a few years ago when there was a rash of belated securities suit filings — where the complaint was not filed until the very end of the limitations period — one of the explanations proposed was that the leading plaintiffs’ firms were buried under the vast numbers of credit crisis related lawsuits they were filing at the time. There may be something like that going on here as well, but the fact is that credit crisis litigation wave peaked some time ago. At least in absolute numbers, securities class action lawsuit filings overall are down compared to historical norms (about which refer here).. It isn’t apparent why this case would have been filed so belatedly.

 

By the same token, the surge of lawsuits filed against U.S.-listed Chinese companies also peaked some time ago. Of course this case involves a Taiwanese company rather than a Mainland company. But still the train left the station on the Chinese company securities suit filing trend some time ago.

 

In the end, of course, every case is filed for its own reasons and not merely because it represents an example of then-current filing trends. Each case also has its own dynamic and internal logic. All of which argues against trying to make too much out of a single case. Just the same, you just can’t help noticing the resemblance between the characteristics of this case and recent years’ filing trends. What was old is new again.

 

A recurring issue in the litigation the FDIC has filed against the directors and officers of failed banks is the question of whether or not officers – as opposed to directors – can rely on the business judgment rule as a defense under applicable state law. A July 8, 2013 decision by Judge Dean Pregerson applying California law concluded (as have other courts in failed bank cases) that the California’s statutorily codified Business Judgment Rule protects only directors, not offices. But, as Judge Pregerson found, there are also ircumstances when directors cannot rely on the Business Judgment rule as the basis for a motion to dismiss, either. A copy of Judge Pregerson’s July 8, 2013 opinion can be found here.

 

Background

The First Bank of Beverly Hills failed on April 24, 2009. On April 20, 2012, the FDIC in its capacity as receiver for the failed bank filed a lawsuit against ten former directors and officers of bank. In its complaint (here), the FDIC seeks to recover losses of at least $100.6 million the bank allegedly suffered on nine poorly underwritten acquisition, development and construction loans and commercial real estate loans from March 2006 through July 2007.

 

The FDIC asserts claims against the ten defendants for negligence, gross negligence and breach of fiduciary duties. The complaint alleges that the defendants approved or allowed the loans in question in willful disregard of the bank’s own loan policies and with “willful blindness” to the risks and imprudence of the loan decisions. The complaint alleges that at the same time the defendants were approving these risky strategies, they were “weakening the Bank’s capital position by approving large quarterly dividend payments to the Bank’s parent company,” of which several defendants were shareholders. The complaint alleges that the individual defendants “lined their own pockets” with these dividends.

 

The defendants moved to dismiss arguing, among other things that they are protected by California’s business judgment rule from the claims of breach of fiduciary duty.

 

The July 8 Order

In his July 8 order, Judge Pregerson denied the defendants’ motions to dismiss. He considered the motions of the director defendants and of the officer defendants separately.

 

First, with respect to the director defendants, Judge Pregerson concluded that “the FDIC had pleaded facts sufficient to overcome the business judgment rule.” He concluded that the FDIC “has stated a claim for the directors receiving improper personal benefits, which, if true may deprive them of the protection of the business judgment rule.” He also noted that the FDIC “has stated a claim for the directors’ abdication of corporate responsibility,” adding that “the FDIC alleges that the directors approved loans so facially deficient that the made reliance [on information provided by others] unwarranted.”

 

Judge Pregerson also concluded that the director defendants were not entitled to dismissal of the breach of fiduciary duty claims based m the exculpatory clause in the bank’s articles of incorporation. The inclusion of an exculpatory clause in corporate charters is permitted under California law, but the exculpation available under these provisions is limited by exceptions. Judge Pregerson found that the FDIC’s allegations here come within the exceptions. Among other things, Judge Pregerson found, quoting the language of the statutory limitations on exculpatory clauses, that  the complaint alleges that the director defendants “received an improper personal benefit” and also that the FDIC had “pleaded facts amount to ‘reckless disregard’” and that “state a claim for an ‘unexcused pattern of inattention that amounts to an abdication of duty.

 

With respect to the officer defendants, Judge Pregerson, following several other courts applying California law, concluded that corporate officers, as opposed to directors, are not entitled to rely on the business judgment rule.

 

Discussion

It is worth noting that Judge Pregerson did not definitively rule that the director defendants cannot rely on the protection of the business judgment rule, only that – based on the FDIC’s allegations, which must be take as true for purposes of the dismissal motion – the business judgment rule cannot serve as a basis for dismissing the FDIC’s claims in against the director defendants at the dismissal motion stage.

 

Many of the directors and officers named as defendants in the FDIC’s failed bank lawsuits have raised the business judgment rule as a defense and sought to rely on the rule as the basis of a motion to dismiss. Judge Pregerson’s rulings here, based on the FDIC”s allegations, that the director defendants cannot rely on the rule as the basis for dismissal of the agency’s claims, is a reminder that the business judgment rule is not a defense to certain kinds of allegations. Specifically Judge Pregerson’s ruling show that director defendants may not be able to rely on the rule as a defense against allegations of self-interested conduct or of abdication of duties.

 

Judge Pregerson’s decision that the California Business Judgment Rule does not protect officers is consistent with prior federal court rulings applying California law in FDIC failed bank cases where officers of the failed banks have sought to invoke the rule. Refer, for example, here.

 

In several jurisdictions, individual defendants have successfully argued that their conduct is protected by the business judgment rule and accordingly, that they cannot be held liable for ordinary negligence. The most significant holding is the August 14, 2012 decision in the Northern District of Georgia in the Haven Trust case, in which Judge Steve C. Jones dismissed the claims against both the director and officer defendants, because of his determination that under Georgia law the directors’ and officers’ conduct is protected by the business judgment rule. The Haven Trust case is discussed here. Earlier in August, a judge in the Middle District of Florida, ruled in the FDIC’s failed bank lawsuit relating to the failed Florida Community Bank of Immokalee, Florida, that under Florida law directors cannot be held liable for ordinary negligence, as discussed here. The ruling in that case did not reach the question of whether or not officers can be held liable for ordinary negligence under Florida law.

 

 

In a recent post about the latest U.S. Supreme Court decision supporting arbitration, I speculated that the next step might be arbitration clauses in corporate bylaws, requiring shareholders to arbitrate shareholder claims. In response to my post, several readers alerted me that these issues had already been raised in a case involving CommonWealth REIT, though I had not been able to track the case down. Fortunately a recent law firm memo details the case and discusses its implications. Though it only involves a trial court decision in Maryland state court, the CommonWealth REIT decision could have important implications for those interested in pursuing the notion of arbitration clauses in corporate by-laws.

 

In a July 8. 2013 Law 360 article entitled “A Template for Tamping Down Corporate Activism” (here, subscription required), Andrew Stern, Alex J. Kaplan and Jon W. Muenz of the Sidley Austin law firm discuss the May 8, 2013 Maryland Circuit Court decision in the case involving CommonWealth REIT. According to the authors, the case is the first to squarely address the issue whether a company can enforce a by-law clause requiring shareholders to arbitrate their claims. As discussed in the memo, the Maryland court ruled that the company could enforce the clause.

 

Commonweath REIT is a publicly traded real estate investment trust organized under the laws of Maryland. Two investment funds acquired nearly 10% of Commonwealth shares and then launched a lawsuit against the company and its trustees seeking declaratory and injunctive relief to prevent alleged “value-destroying” and “self-interested” conduct by the defendants.

 

The company immediately initiated arbitration proceedings, in reliance on a provision in the company’s bylaws requiring that “any disputes, claims or controversies brought by or on behalf of any shareholder … be resolved through binding and final arbitration.” The plaintiff funds sought to stay the arbitration, arguing that they had never “assented” to the arbitration clause (which they said had been “unilaterally foisted upon them”) and that no consideration had been exchanged and therefore no binding arbitration agreement had been formed.

 

The Maryland court rejected the funds’ objections and held the bylaw arbitration clause to be enforceable. In finding that the funds had assented to the clause, the court noted that each share certificate of CommonWealth stock bore a legend stating that “the holder of this certificate…agrees to be bound by all of the provisions of the …Bylaws.” Based on this legend, the court concluded that the funds had “constructive knowledge” of the arbitration provision and that it was “enough to constitute mutual assent of the parties to the arbitration provision.” The court also noted that the funds were “sophisticated parties” who had “actual knowledge” of the arbitration clause as they had “investigated” the company’s bylaws prior to purchasing Commonwealth stock.

 

The court also found that there had been sufficient consideration for the arbitration clause to be binding. The court found that the arbitration clause could be enforced by either party which the court found to constitute adequate consideration.

 

The article notes that the funds had filed a notice of appeal of the lower court’s ruling, but that the funds then dismissed their appeal to pursue arbitration.

 

The article’s authors comment that though it remains to be seen how other courts will address the question of the enforceability of arbitration clauses in corporate bylaws, the Maryland decision “should be seen as, at the very least, a significant incremental victory for boards and trustees who view arbitration as an effective means to manage the typically highly public nature of corporate activism.” At a minimum, the authors note, the decision could be seen – at least for Maryland companies — as “a green light for boards … to include broad arbitration clauses in their bylaws without seeking shareholder approval.”

 

Among other issues that other courts may interpret differently than the Maryland court is the question of whether or not shareholders can, like the plaintiffs in the Maryland case, be said to have “constructive knowledge” of the bylaw provisions or to have “assented” to the provisions. The article’s authors noted that the Maryland court did not discuss Delaware court decisions on which the funds sought to rely in arguing that Delaware’s courts have rejected the principle that “stockholders somehow assent to provisions contained in company bylaws simply by virtue of being stockholders.”

 

I find this entire topic very interesting. After I published my prior post about arbitration clauses in corporate by laws, I had several discussions with various lawyers about whether or not courts would ever enforce such a clause against shareholders, particularly where the clause was adopted without shareholder consent. Several plaintiffs’ lawyers scoffed at the notion that courts would ever enforce such a clause. Nevertheless, here is one case where the court enforced the clause.

 

To be sure, this is only the decision of a trial level state court. It has no precedential value and may or may not be followed by other courts. Other courts may be less willing to conclude as the court did here that the plaintiffs have “constructive knowledge” of the bylaw clauses or have assented to the provisions. Other courts may be less willing to conclude that there was adequate consideration to support enforcement of the clauses. Nevertheless, at least this one court did enforce the arbitration clause. As the law firm memo’s authors state, this decision does represent an “incremental victory” for those who advocate for the inclusion of these types of provisions in corporate bylaws as a way to forestall costly and burdensome shareholder litigation.

 

With the U.S. Supreme Court’s willingness to enforce arbitration agreements in commercial and consumer contracts, and with case law developments like the one in Maryland, more companies may be encouraged to attempt to use their bylaws as a way to control shareholder litigation. I suspect we will see more – both from companies and from the courts – on the arbitration clauses in corporate bylaws.

 

Alison Frankel has an interesting column on this topic on her On the Case blog (here).

 

Time to Nominate Blogs for the American Bar Association Blawg 100: Each year, the American Bar Association publishes its list of the top 100 legal blogs. The ABA calls its list the Blawg 100. The ABA is calling for nominations for this year’s list. The group would like to know about blogs that you read regularly and that you think other lawyers should know about. They ask that you send a separate nomination for each blog that you would like the group to consider. The group may include some of the best comments from the nominations in their Blawg 100 coverage. Nomination must be submitted no later than 7 p.m. on Friday, August 9, 2013. Nominations can be submitted here.

 

Quarterly D&O Claims Trends Webinar: On Tuesday, July 16, 2013 at 11 am EDT, I will be participating in a webinar sponsored by Advisen to discuss Quarterly D&O Claims Trends. This hour-long webinar is free. The other particpants in the call will include Kieran Hughes of AIG and Carl Metzger of the Goodwin Proctor law firm. For further information about the seminar and to register, refer here.

 

An important accessory to the indemnification rights of directors and officers is their right to have their defense expenses advanced while the claims against them are pending, before their ultimate right to indemnification has been determined.  A frequently recurring issue is the question of when the company may withhold advancement. This issue often arises when new management has asserted claims against former managers they blame for problems at the company.

 

A recent decision by the Ontario Court of Appeal, applying Ontario and Canadian federal law, affirmed the holding of the lower court that Look Communications, the company involved, did not have to advance the costs certain former directors and officers incurred in defending claims the company had filed against them. Though the decision will be of greatest interest to directors and officers of companies in Canada, it nevertheless provides an interesting perspective on the rights of advancement here in the U.S. as well. A copy of the Ontario Court of Appeal’s July 4, 2013 opinion can be found here.

 

Background

Look Communications is a technology company organized under the Canadian Business Corporations Act (CBCA). Its business fortunes faltered and its board ultimately approved a sale of its assets through a court-supervised process. Following the sale, the board authorized the payment of bonuses to certain officers and directors and also allowed corporate officials to receive compensation for the cancellation of certain stock option and other equity rights. Altogether the company paid over $20 million in bonus compensation and in compensation for the options and equity rights, representing about 32% of the asset sale proceeds.

 

After the award of the bonuses and other compensation was disclosed, shareholders filed significant objections. The board authorized the payment of $1.5 million in retainers to law firms acting on behalf of the directors and officers, who then resigned once the retainers had been paid.

 

In July 2011, after an investigation by Look’s new management, Look commenced an action against the former directors and officers alleging that the individuals had breached their fiduciary duties and seeking repayment of the bonuses and equity cancellation payments. The individual defendants, in reliance on the company’s by-laws as well as a written indemnification agreement, demanded that the company advance their expenses incurred in defending against the company’s lawsuit. The company refused and the individuals filed separate actions seeking judicial declarations of their advancement and indemnification rights.

 

Under Section 124 of the CBCA, a company may indemnify its directors and officers for legal proceedings in which the individuals become involved as a result of their association with the company, as long as the individual seeking indemnification “acted in good faith and with a view of the best interests of the corporation.” Look’s by-laws made these permissive indemnification rights mandatory. A separate indemnification agreement required Look to advance legal costs in any proceeding, including one brought by Luck itself, subject only to an obligation to repay if a court determined that the individual was not entitled to indemnification.

 

The former directors and officers argued in reliance on the by-laws and indemnification agreement that they were entitled to automatic advancement of their defense fees; that they were also entitled to a presumption that they had acted in good faith; and that their ultimate entitlement to indemnification could only be determined after a full evidentiary trial.

 

Look relied on Section 124(4) which provides that a corporation is permitted to advance defense fees only “with the approval of the court.” Look argued that this provision required the court to preliminarily assess the parties’ conduct to determine whether the persons seeking advancement had acted in good faith. Look further argued that the individuals had not acted in good faith and were not entitled to advancement and submitted affidavits and other materials in support of this position.

 

As discussed here, in a September 28, 2012 decision, Justice Lawrence A. Pattillo of the Ontario Superior Court of Justice held that the individual directors and officers were not entitled to advancement. Among other things, Justice Pattillo held that under Section 124(4) court approval was required for advancement and that approval can be granted only if the officer or director claiming advancement “acted honestly and in good faith with a view to the best interests of the corporations.”

 

Justice Pattillo concluded that the company had made out a strong prima facie case that the former directors and officers had acted in bad faith by awarding themselves over 30% of the assets sales value, and authorizing the payment of the legal retainer on their own behalf before resigning. 

 

The individuals appealed. On appeal, the individuals urged the appeals court to avoid imposing a merits-based threshold on advancement, arguing that were the court to impose such a threshold directors and officers would be required to litigate the merits of the underlying case in the separate action to determine whether or not they were entitled to advancement.

 

The July 4 Opinion

In a July 4, 2013 opinion written by Justice Robert J. Sharpe for a unanimous three-judge panel, the Ontario Court of Appeal dismissed the individuals’ appeal and affirmed the lower court’s ruling, holding that the statute “imposes a judicial filter on advance funding and the strong prima facie test for determining whether advancement should be denied is apt.” The Court added that the “test comports with the statutory requirement for court approval but also is sufficiently stringent to ensure that advance funding is ordinarily available to those claiming it unless there is strong evidence of bad faith.”

 

The individuals had attempted to argue, in reliance on Delaware law, that their defense expenses ought to be advanced without scrutiny of their conduct, subject only to an undertaking to repay if it is later determined based on the outcome of the underlying proceeding that they are not entitled to indemnification. Justice Sharpe wrote:

 

In my view, apart from demonstrating that it is motivated by a very different underlying policy than adopted by Parliament in Section 124(4), Delaware law does not assist us in resolving the issue on this appeal. Unlike the CBCA, the Delaware General Corporation Law does not require court approval of the advancement of legal expenses. (Citations omitted). By enacting Section 124 (4), Parliament has determined that whatever corporate by-laws or agreements promise, by statute, advancement of legal costs requires court approval and court approval should be withheld if the officer or director has not acted in good faith and in the best interests of the corporation. That represents a fundamentally different policy choice that that prevailing in Delaware, a policy choice that this court must respect.

 

Justice Sharpe went on to conclude that the individuals’ indemnification agreements did not alter the statutory requirement for judicial supervision. Justice Sharpe agreed that if the agreements’ wording alone controlled, advance funding could only be denied on the basis of a final and conclusive judicial determination. However, the court concluded, the “issue must be decided on the basis of the overriding language of Section 124(4)” which provides that the right of advancement is “subject to court approval before trial.”

 

The Court of Appeal concluded based on the evidentiary record presented to the court below that the lower court had not erred in concluding that the company had made out a strong prima facie case of bad faith, and properly concluded that the individuals were not entitled to advancement of their costs in defending the claims the company had filed against them.

 

Discussion

In the Ontario appellate court’s view, the indemnification provisions in the Canada Business Corporations Act represent “a fundamentally different policy choice than that prevailing in Delaware.” Section 124(4) “imposes a pre-trial good conduct filter,” while under the Delaware statutes “advance costs are awarded without any scrutiny of the conduct.”

 

Section 124(4) does indeed provide for indemnification under the related statutory provisions “with the approval of the court.” In that respect, the appellate court’s conclusions are unremarkable – they are simply a reflection of the statutory language specifying a requirement for judicial supervision for the implementation of statutory indemnification rights. However, the Ontario Court not only held that the “judicial filter” requirement applied to the individuals’ statutory indemnification rights, but it also held that the requirement for judicial supervision applied to the interpretation of the individuals’ contractual indemnification rights.

 

It is not at all uncommon for new management to pursue claims against a company’s former management. New managers often blame the former managers for problems besetting the company. One very good reason that well-advised managers will seek to put contractual indemnification agreements in place is so that if the managers are the target of claims after they have left the company, they can claim their rights of indemnification notwithstanding the arrival of new management. The contractual indemnification provides them an extra measure of protection and some level of assurance that their rights will be protected if claims later arise.

 

The Ontario court’s interpretation of the statutory provision to require judicial supervision not only of statutory indemnification rights but also of contractual indemnification rights at a minimum adds an additional procedural layer for individuals seeking to rely on their indemnity rights to defend themselves. This result is not necessarily compelled by the statutory language, and even the appellate court agreed that if indemnification issue were determined solely on the basis of the language of the agreement, “advance funding could only be denied on the basis of a final and conclusive judicial determination.” However, the Ontario appellate court nevertheless found that the statute’s “overriding language” imposed requirement of preliminary judicial supervision even on the individuals’ contractual rights.

 

In addition to the additional procedural burdens these requirements put on the individuals seeking indemnification, there is the additional concern of the impact of a “finding of a strong prima facie case of bad faith” on any D&O insurance that may be available to these individuals. There are at least two potential impacts, one having to do with the applicable retention and the other having to do with the possible operation of policy exclusions.

 

The judicial determination that the individuals are not entitled to advance funding means as a practical indemnification is not available to them. The individuals would then seem to have an argument that the Side A retention is applicable to their claim for policy benefits. In most instances, the Side A retention is zero, meaning that — if coverage is otherwise available under the policy — the individuals would have a basis on which to argue that they are entitled to first dollar coverage under the policy.

 

Which of course begs the question of whether coverage is otherwise available under the policy. One issue an insurer undoubtedly would explore in these circumstances is whether or not the judicial determination would trigger the preclusive effect of the conduct exclusions. The individuals would argue that even a judicial finding of “a strong prima facie case of bad faith” is not enough to trigger the conduct exclusion, which typically will provide that it applies only after a “final adjudication” The court’s prima facie determination is an interim, interlocutory determination; it is by no means a final adjudication. Moreover, the finding of bad faith arguably represents something other then a determination of criminal, fraudulent or even dishonest conduct. The individuals would appear to have a substantial basis on which to argue that this type of judicial determination would not implicate the typical conduct exclusion wording.

 

It is worth observing as a final note that though this case represents the rare case where individual directors and officers were denied their rights to advancement of their defense expenses, the outcome is a direct reflection of the specific statutory language involved and of the unusual circumstances presented. But even though the result if the outcome of very jurisdiction-specific and case-specific factors, it nevertheless provides an interesting example from which to consider the rights of individual directors and officers to have their costs of defending claims advanced on their behalf. 

 

Special thanks to loyal reader James Camp for providing me with a copy of the Canadian appellate court’s opinion.

 

In my former days on the carrier side, our D&O insurance group advocated for our policyholders a program of securities litigation loss prevention, on the theory that there are steps companies can take to make themselves less likely to be a securities suit target or better able to defend themselves if they are hit with a suit. The concept of securities litigation loss prevention remains a worthy idea although not always as frequently discussed as perhaps it should be. 

 

Because of my past interest in this topic, I was particularly pleased to see the recent memo from the Latham & Watkins law firm entitled “Giving Good Guidance: What Every Public Company Should Know” (here). The memo provides a good overview of the issues public companies should consider in developing their approach to earnings guidance, and it also sets out practical steps companies can take to try to reduce the possibility of guidance-related liability.

 

The memo begins with a review of the legal context, noting with respect to earnings guidance that “the legal landscape should be carefully understood before management takes the plunge.” The memo provides a cautionary note with the observation that it is possible “to make critical mistakes that can have significant economic consequences under the federal securities laws and in the financial markets.” At the same time, however, “it is possible to give guidance in a deliberate and careful way without incurring undue liability.”

 

After reviewing the basic liability landscape, as well as critical considerations arising from the statutory safe harbor provisions and regulatory provisions such as Regulation FD, the memo reviews two basic questions – that is, how far to go and what to say in giving guidance – and provides critical guidelines. In particular, the memo emphasizes the importance of having a carefully considered company-specific plan for giving guidance that takes advantage of opportunities to accompany disclosure with meaningful cautionary statements.

 

In a particularly useful section, the memo lays out ten rules for “giving good guidance,” all of which are built around having a controlled process involving designated spokespersons delivering carefully considered message accompanied by meaningful cautionary statements. The memo concludes with an appendix of frequently asked questions.

 

I am pleased to be able to link to the law firm’s memo here and to recommend it for company management interested in taking steps to try to reduce the securities litigation exposures arising from providing earnings guidance. It is a favored indoor pastime these days to bemoan the fact that we have a hyperactive litigation system that can impose enormous costs on operating companies. But the fact is that there are steps companies can take to reduce their risk of becoming involved in a securities suit. While there may be much to lament about our litigious system, there are steps companies can take to try to do something about it, and that is a much more positive and practical way for companies to deal with the litigation threat.

 

In an earlier post (here), I discussed the question of the role of D&O insurers in the securities litigation loss prevention process. To see a recent post discussing M&A-related litigation loss prevention, refer here.

 

The SEC’s New Policy to Require Liability Admissions in Certain Cases: Following on Judge Jed Rakoff’s concerns in the Citigroup SEC enforcement action in connection with the proposed settlement that the company had neither admitted nor denied wrongdoing, the SEC, under new leadership, has reconsidered its longstanding policy and now will no longer allow defendants to settle cases without also admitting liability.

 

Though the new policy has yet to be applied in a specific case, commentators have already raised a number of concerns with the SEC’s proposed new approach. In a July 2, 2013 New York Times Deal Book column (here), Wharton School professor David Zaring raises the concern that the new approach could prove very costly for the SEC, as defendant companies will be very reluctant to make admissions that could be used against them in related civil litigation. These disincentives will make it that much harder for the SEC to resolve cases and in the end require the agency to take more cases to trial, a prospect that could drain the agency’s already strained resources.

 

In addition to the concern that admissions could be used against them in related civil litigation, the companies face yet another problem with the possibility of admissions. That is, the admissions could potentially serve as a basis for a company’s D&O insurer to deny coverage based on the policy’s misconduct exclusion. The possibility that an admission might cost the company its D&O insurance protection would provide yet another deterrent for companies from entering into admissions as part of an SEC enforcement action settlement.

 

Can the Countrywide Derivative Suit Survive the BofA Acquisition?: When does a derivative lawsuit survive a merger? That was the question before the Delaware Supreme Court earlier this week in connection with the derivative suit filed against the management of Countrywide Mortgage prior to the company’s acquisition by Bank of America. The case came to Delaware’s highest court by way of a certified question from the Ninth Circuit, which had asked whether under Delaware law the shareholder plaintiffs could maintain the suit notwithstanding the merger in light of the “fraud exception” to Delaware principles about post-merger shareholder standing.

 

In a July 3, 2013 post on her Reuters blog (here), Alison Frankel has an interesting summary of the issues as well as of the parties’ arguments. As Frankel explains, under Delaware law, derivative suit plaintiffs lose their standing to pursue claims on behalf of the company when they lose their ownership interest as a result of a merger. The one exception is when the merger was a itself a fraud intended only to protect the board, which the BofA acquisition was not. The question was whether the Delaware Supreme Court might recognize other circumstances, such as those involved here, where the derivative suit might survive the merger, given Countrywide’s alleged misconduct. The plaintiffs’ arguments in that regard relied heavily on various statements the Delaware Supreme Court had made in prior cases about Countrywide’s conduct.

 

Frankel’s column summarizes the parties’ arguments on these issues and the question of whether or not the court would have to recognize a new exception to the general rules in order to recognize the right of the plaintiffs to pursue their claims. This will be very interesting case to watch — it will be interesting to see what the Delaware Supreme Court does.