"Indemnification of Directors and Officers: A Different Side to the Problem of Corporate Corruption"
Alexander M. Szeto & J. David WashburnWall Street Lawyer
June 1, 2004
In order to attract and retain highly qualified individuals to serve as directors and officers, corporations must ensure that directors and officers can defend themselves if sued, and, if successful, can recover the costs of that defense. Indemnification of executives is a standard practice for both public and private corporations. But after the recent epidemic of scandals, corporations have often been forced to choose between remaining faithful to their indemnification obligations or challenging the demands of executives who appear to be undeserving.
Corporations have often been forced to choose between remaining faithful to their indemnification obligations or challenging the demands of executives who appear to be undeserving.
Because corporations typically provide broad indemnification rights, many former executives facing serious allegations of wrongdoing are demanding to have their former corporations pay their legal fees. These demands are causing corporations and their D&O insurance carriers to test the strength of their indemnification obligations in court. So far, the courts have been reluctant to set aside these obligations, leaving corporations and their insurers with substantial bills.
According to some reports, the average cost of defending a shareholder’s lawsuit is over $2 million. Tyco International went to court to force its insurance carrier to pay the defense costs of its former CEO, whose legal bills are estimated to be over $15 million. Adelphia Communications did the same with its insurance carrier to provide co-founder John Rigas and several former officers $300,000 each toward their civil defense fees. If insurance does not pay, the corporation must cover the executive’s legal bills. When you consider that insurance costs millions of dollars each year, and the fact that some of these former executives have already (in some cases, allegedly) looted millions of dollars from the company, an executive’s misdeeds can be quite expensive.
Along with legal expenses, many corporations are either directly reimbursing or seeking insurance coverage for settlements. For example, Xerox Corporation announced that it would indemnify several former executives that reached a $22 million settlement with the SEC regarding allegations that they fraudulently overstated the company’s financial position. Similarly, Qwest Communications announced its intention to have insurance pay a $25 million settlement reached in several shareholder lawsuits against its directors and officers. Under typical indemnification provisions, executives who settle their cases without admitting guilt or accepting responsibility for their actions remain eligible for, and in certain cases are entitled to, reimbursement from the corporation for legal fees. In most cases, settling executives also can be indemnified for amounts they agree to pay as part of the settlement.
While corporations and insurance carriers battle in court over their obligations, and former executives continue to ring up million dollar legal bills and structure settlements in ways that preserve their right to indemnification or insurance, the SEC is using its administrative enforcement powers to ensure that individual defendants remain primarily responsible for their misdeeds. Use of its administrative powers to advance public policy is hardly a new concept for the SEC. Consider, for example, the SEC’s innovative strategies in its proceedings against WorldCom and in reaching the landmark settlement with several Wall Street investment firms. But the SEC’s current strategy is groundbreaking in using settlements to make it difficult, if not impossible, for defendants to obtain indemnification.
No Help From the Courts
Corporations and insurance carriers are finding out that their indemnification obligations are not easily avoided. Insurance carriers, in particular, are pursuing several avenues in an attempt to avoid paying out on claims made by corporate executives. Despite the arguments favoring insurers and corporations, the courts have looked to the documents governing their obligations and generally have found the insurance policies, bylaws, and indemnification agreements to be too broad, too vague, or too restrictive to relieve the indemnitors.
[T]he SEC is using its administrative enforcement powers to ensure
that individual defendants remain primarily responsible for their misdeeds.
Tyco’s D&O insurance carrier, Federal Insurance Co., is among the most recent to discover that the courts are unable to protect them from their obligations. Tyco’s former CEO Dennis Kozlowski became the target of over thirty lawsuits after he was accused of stealing over $600 million from the company. Kozlowski demanded that Federal provide him with a defense or pay his legal bills.
Upon receiving notification from Kozlowski of his impending claim for coverage, Federal unilaterally rescinded the policy, claiming the policy was void because Kozlowski lied about the financial condition of the company and made misrepresentations on the insurance application. Tyco responded by suing to enforce Federal’s duty to defend. The Supreme Court in Manhattan sided with Tyco, holding that “until Federal’s rescission claims are litigated in its favor and the Policies are declared void ab initio, they remain in effect and bind the parties.”[1] The court offered Federal little remedy, stating that “if Federal ultimately prevails in this action and the Policies are declared to he void ab initio, Federal may be able to recover its costs for the defense it has provided Kozlowski.”[2] Federal admitted that it was unlikely to recover the monies given to Kozlowski should he be found liable for his actions.
Corporations and insurance carriers are finding out that
their indemnification obligations are not easily avoided.
Federal also argued that even if the policy was valid, the policy excluded Kozlowski’s claims. Specifically, Tyco’s policy with Federal contained an exclusion for acts from which Kozlowski personally profited. Despite that, the court held that Federal had a duty to defend: as long as Kozlowski’s claim for coverage contained acts that might be covered under the policy, Federal must continue to pay defense costs for all the acts for which coverage was sought. Because the policy covered “Wrongful Acts” (a phrase that includes any “misstatement, misleading statement, act, omission, neglect, or breach of duty” by Kozlowski in his capacity as an officer), the court held that Kozlowski’s claim contained at least some covered acts.
Similar facts involving Adelphia Communications and its D&O insurer, Associated Electric & Gas Insurance Services, Ltd. (“AEGIS”), produced similar results. AEGIS attempted to unilaterally rescind Adelphia’s policy and then sued to have it declared void when Adelphia cofounder, John Rigas, his sons, and several former officers demanded advancement of fees to defend themselves against charges of fraud and conspiracy. Adelphia’s policy continues to be the subject of several lawsuits, including actions in the Bankruptcy Court in Manhattan.[3] Ultimately, the Federal District Court in Philadelphia determined that AEGIS was obligated to advance legal fees to the Adelphia defendants until a court found the policy to be void.[4] This decision was particularly troublesome for AEGIS because a stay imposed by the Bankruptcy Court in a separate action prevented any court from determining the validity of the rescission.
[Courts] seem unwilling to provide any kind of “safety net” in the event
the executives are unable to satisfy [their repayment] obligations.
The district court also held that, although there were exclusions in the policy, AEGIS lacked the discretion to determine their applicability. AEGIS asserted that the policy excluded coverage under what the court defined as the “Prior Knowledge Exclusion.” Under this exclusion, coverage is not given when an executive has knowledge of a fact or circumstance that is likely to give rise to a claim and the executive fails to disclose or misrepresents such a fact or circumstance. The court held that the Prior Knowledge Exclusion did not contain language that empowered AEGIS to determine its applicability, concluding that it was unfair “to give an insurer the ability to escape its duty to advance payment merely because it asserts the Prior Knowledge Exclusion, without any judicial determination.”[5] Again, the court found that the Bankruptcy Court’s stay prevented it from making any kind of applicability determination.
For Rite Aid Corporation, even admission of guilt by its former CFO Frank Bergonzi would not persuade a court to allow Rite Aid to escape its indemnification obligations. Bergonzi pleaded guilty and admitted to conspiracy and fraud, prompting Rite Aid to declare him ineligible for indemnification. The Delaware Chancery Court, however, held that under Rite Aid’s bylaws, the company was required to advance the costs of Bergonzi’s legal defense until it was “ultimately determined” that he was ineligible for indemnification.[6] The court held that, although the guilt portion of Bergonzi’s criminal trial had concluded, entry of a guilty plea prior to sentencing was not a final disposition of the proceedings. Bergonzi had also executed a separate agreement with Rite Aid that required him to repay any advanced funds if it was ultimately determined that he was not eligible for indemnification—a fact the court considered in deciding that Rite Aid must advance Bergonzi’s legal defense costs until a court determined his eligibility for indemnification.
Rite Aid used particularly broad wording in its various indemnification provisions.[7] Because the court in Bergonzi’s criminal trial did not make any determination of eligibility (due to the plea) and Rite Aid’s bylaws prevented the Chancery Court from making any such determination (because the proceedings were not yet complete), the court had no choice but to enforce the indemnification obligation. The court inferred that it might have reached a different result if the governing provisions of Rite Aid’s bylaws and indemnification agreement had been drafted differently.
Although the courts acknowledge that executives bear a repayment obligation if the corporations or insurers prevail in their actions, they seem unwilling to provide any kind of “safety net” in the event the executives are unable to satisfy those obligations. In reality, these decisions will require corporations and insurers to pay millions of dollars in legal bills with little or no hope for repayment.
Settling a Problem
Settlements are another key area where indemnification is quickly becoming the subject of conflict. The SEC and other parties accusing executives of misconduct agree to settlements with the understanding that the defendant will pay an amount that resembles the penalty or damages that might have been imposed had the defendant lost at trial. In exchange, the executives admit no guilt or responsibility for their actions because most indemnification agreements allow reimbursement as long as guilt or liability is not found. Most defendants can obtain indemnification from their corporations and escape full financial responsibility for settlements.
Xerox Corporation used this reasoning when it announced it would indemnify several of its former executives in a settlement reached with the SEC. Xerox not only agreed to pay the executives’ legal expenses, but also approximately $19 million of the $22 million settlement. None of the settling executives admitted to any wrongdoing. “Since these individuals were not found guilty of any wrongdoing, under the bylaws of the company, Xerox is required to indemnify them for legal fees and disgorgement,” stated a Xerox spokesperson.[8]
Most defendants can obtain indemnification from their corporations
and escape full financial responsibility for settlements.
Xerox’s decision drew swift reaction from the SEC. In a speech following Xerox’s announcement, SEC Chairman William H. Donaldson reprimanded companies that “under permissive state laws, indemnify their officers and directors against disgorgement and penalties ordered in law enforcement actions, including those brought by the Commission.”[9] Chairman Donaldson also noted that such actions were, in his opinion, poor public policy and that this was an area where reform might be considered.
Xerox’s announcement closely followed a similar decision made by several Wall Street investment firms that also settled with the SEC. The SEC, NASD, New York Stock Exchange, and New York Attorney General’s Office joined together for a massive investigation into ten prominent Wall Street securities firms for serious conflicts of interest between their research and investment divisions. The Wall Street firms eventually entered into a “Global Settlement” costing them approximately $1.4 billion. However, soon after the SEC announced the settlement, four of the settling firms indicated their intention to have insurance pay for part of the settlement.
Corporations also indemnify their executives in settlements reached in civil lawsuits. In February, Qwest Communications settled one of the many shareholder suits against it. (Qwest is the subject of numerous lawsuits, including one by the SEC, regarding overstatement of its financial position by billions of dollars.) Qwest settled the suit for $25 million—all of which will be paid by D&O insurance. Qwest reported it had an insurance reserve of several hundred million dollars that will be used to cover the costs of settlements reached in suits involving the overstatement. The company estimates that the reserved insurance fund should cover all but $100 million of the costs of settling all the claims against it. While that is no small amount—even for Qwest—it allows the company to let its directors and officers avoid having to dig too deeply in their own pockets.
The SEC’s New Initiative
The SEC relies heavily on settlements because it tends to bring more enforcement actions than it can handle. However, the SEC no longer wants to see executives receiving insurance coverage for settlement amounts. The SEC is now using settlements to advance reform in the area of indemnification—something that may result in an increased number of cases being tried. Thus, instead of widely publicizing a campaign to change the nature of settlements, the SEC is quietly reforming its settlement agreements to include provisions that make it difficult, if not impossible, for directors and officers to escape liability for their actions.
The SEC is now using settlements to advance reform in the area of indemnification.
The SEC’s new initiative includes reaching agreements with defendants prohibiting them from seeking indemnification for civil fines. Specifically, settling defendants agree not to take tax deductions for penalties imposed against them, not to seek reimbursement under a D&O or other insurance policy, and not to seek indemnification from anyone—Including the defendant’s corporation. The SEC obtained such provisions in settlement agreements with former Citigroup analyst Jack Grubman and with former Merrill Lynch analyst Henry Blodget.[10] The SEC continues to include language in its settlement agreements that expands the scope of the prohibition to prevent defendants from seeking indemnification for any civil fines, even those handed down outside the SEC’s enforcement actions.
The SEC’s reforms also change the historical practice of not admitting guilt in the settlement. Specifically, the SEC will “construe the ‘neither admit nor deny’ language as precluding a person who has consented to an injunction in a Commission enforcement action from denying the factual allegations of the injunctive complaint in a follow-on proceeding:”[11] This is, at least in part, to deter defendants from committing further transgressions that may subject them to future SEC enforcement actions. However, this policy may have the additional effect of preventing an executive from obtaining indemnification since the Commission also will not accept a settlement in which the defendant denies the allegations. Under the circumstances, executives may be ineligible to receive indemnification under their corporation’s indemnity provisions or insurer’s policy. A settlement with the SEC also may affect the outcome of lawsuits in other courts in which the executive is involved. Should the settlement contribute to a finding of guilt, the executive may likewise be unable to procure indemnification or insurance.
The SEC understands that its new settlement policies may create more litigation. Commissioner Harvey Goldschmid publicly acknowledged that the SEC “may have to take meaningfully more cases to trial because we’re asking for more than we’ve ever asked before.”[12] Defense attorneys agree that the result will be more cases being tried than settled. Increased litigation is not a viable option for the SEC since the agency brings more enforcement actions than it has the resources to try, but the new settlement policy may make it more difficult to reach settlements if defendants resist the new provisions.
As a solution, the SEC may be looking to the same cooperative effort that produced the Global Settlement. Last September, Chairman Donaldson publicly announced a joint effort between the SEC and the North American Securities Administrators Association (“NASAA”) to study how best to effect the concept of a single national market in collective and individual enforcement activities.[13] While the SEC did not explicitly mention the new settlement policy as the reason for seeking a global settlement framework, the SEC recognizes that it cannot achieve ideal results in its enforcement actions, including optimal settlement, without a cooperative effort among state and federal authorities.
The Consequences of Noncompliance
Those entering into settlements with the SEC are now being warned that failure to cooperate will result in severe consequences. Lucent Technologies recently entered into a settlement with the SEC after an investigation into possible improper recognition of over $1 billion in revenue. Lucent originally agreed in principle with the SEC on terms of a settlement that did not include any fines. However, when Lucent agreed to indemnify several former employees involved in the accounting misconduct, the SEC added a $25 million fine—the largest ever imposed by the SEC. In the SEC’s view, Lucent’s decision to indemnify the employees was directly contrary to public policy.[14]
Lucent’s case indicates that the SEC is no longer quietly bringing about reform to its settlement process. The SEC hopes to make an example out of Lucent and send a clear message to those considering indemnifying employees who settle with the SEC. A significant fine may be the language that defendants can truly comprehend.
Conclusion
Change in indemnification of corporate executives seems inevitable, though it is not clear what will inspire that change. Corporations may want to draft narrower indemnity provisions in their charters, bylaws, and indemnification agreements, but will struggle with the desire to guarantee their directors and officers broad protection. Insurance carriers may increase premiums and deductibles, add more exclusions, and give themselves the necessary discretion to determine eligibility, but must consider whether doing so will drive away customers. The SEC will continue to develop its enforcement system, but must risk exhausting its resources should it result in an abundance of litigation. Ideally, the effect of any of these decisions will be to deter individuals from any engaging in (or perhaps just failing to report) misconduct for fear that they will be stuck paying their own legal bills in addition to facing whatever punishment comes their way.
[1] Fed. Ins. Co. v. Tyco Int’l Ltd., Index No. 600507/03 (N.Y. Sup. Ct. March 5, 2004).
[3] See In re Adelphia Communications Corp., 285 B.R. 580 (Bankr. S.D.N.Y. 2002).
[6] Bergonzi v. Rite Aid Corp., 2003 Del. Ch. LEXIS 117 (Del. Ch. October 20, 2003).
