We consider below how advancement of legal fees, indemnification, and insurance operate when officers and directors become involved in regulatory investigations and proceedings. Part I addresses the enhanced risk officers and directors face today in an Age of Accountability. Part II addresses advancement of legal fees, which may be discretionary or mandatory depending on a company’s by-laws. Part III covers indemnification, which generally requires at least a conclusion that the officers and directors acted in good faith and reasonably believed that their conduct was in, or at least not contrary to, the best interests of the corporation. Part IV examines insurance coverage, which varies from carrier to carrier and may or may not provide meaningful protection. Finally, Part V summarizes the principal lessons from the analysis. Although there is significant overlap with similar principles that apply to private litigation, we limit our discussion here to advancement, indemnification, and insurance for regulatory investigations and proceedings.
Posts Tagged ‘Director liability’
Federal Deposit Insurance Corporation (FDIC) litigation activity associated with failed financial institutions increased significantly in 2013, according to Characteristics of FDIC Lawsuits against Directors and Officers of Failed Financial Institutions—February 2014, a new report by Cornerstone Research. The FDIC filed 40 director and officer (D&O) lawsuits in 2013, compared with 26 in 2012, a 54 percent increase.
The surge in FDIC D&O lawsuits stems from the high number of financial institution failures in 2009 and 2010. Of the 140 financial institutions that failed in 2009, the directors and officers of 64 (or 46 percent) either have been the subject of an FDIC lawsuit or settled claims with the FDIC prior to the filing of a lawsuit. Of the 157 institutions that failed in 2010, 53 (or 34 percent) have either been the subject of a lawsuit or have settled with the FDIC.
The FDIC last week issued a Financial Institution Letter advising financial institutions and their directors and officers of the increased use of exclusionary terms or provisions in D&O policies, and the resulting increased risk of uninsured personal civil liability for directors and officers. (FIL-47-2013, October 10, 2013).
The FDIC Letter urges the directors of financial institutions to make well-informed choices about D&O coverage, including consideration of costs and benefits, exclusions and other restrictive terms in proposed policies, and the implications for personal financial liability for directors and officers.
D&O insurance is a critical asset for financial institutions and their directors and officers, and the FDIC Letter expressly affirms that the purchase of D&O insurance serves a valid business purpose. The FDIC’s Letter is also a timely reminder that the D&O insurance market is in constant flux and that—in addition to seeking advice from insurance brokers—directors should consider seeking advice from experienced coverage counsel to gain a better understanding of the potential impact of restrictive provisions in proposed policies.
On February 6, 2013, Chancellor Strine of the Delaware Chancery Court issued a bench ruling addressing the duty of independent directors of a Delaware corporation with significant operations or assets outside the United States. In re Puda Coal, Inc. Stockholders Litigation, C.A. No. 6476-CS (Del. Ch. Feb. 6, 2013). In a short but important bench ruling, Chancellor Strine refused to dismiss a breach of fiduciary duty claim against independent directors of a Delaware corporation who had failed to discover the unauthorized sale of assets located in China by the company’s chairman. Importantly, Chancellor Strine’s remarks implicated the duty of loyalty, which creates a risk of personal liability for directors and, potentially, the absence of corporate indemnification. While the facts in the case were somewhat extreme, the ruling in Puda Coal highlights the risks and challenges that may exist for directors of Delaware corporations with significant foreign assets or operations. Although Chancellor Strine recognized that each situation is undoubtedly dependent on its facts and will turn on the nature of the foreign operations, his ruling did include the following remarks:
On September 25, 2012, Vice Chancellor Travis Laster of the Court of Chancery of the State of Delaware dismissed the derivative complaint in South v. Baker, C.A. No. 7294-VCL, with prejudice. This decision reaffirms the Chancery Court’s low tolerance for hastily filed shareholder derivative lawsuits brought under the In re Caremark International Inc. Derivative Litigation, 698 A.2d 959 (Del. Ch. 1996), line of cases where the plaintiff makes little effort to plead any connection between a “corporate trauma” and the conduct of a board of directors. At the same time, the South decision also finds that shareholders are entitled to, and should seek, books and records from Delaware corporations before bringing derivative lawsuits in Delaware. Accordingly, Delaware corporations should anticipate an increase in shareholder demands for books and records under Section 220 of the Delaware General Corporation Law in the wake of any “corporate trauma.” In addition, the South decision found that dismissal of the South complaint did not preclude other Hecla shareholders from filing future derivative suits because the South plaintiffs did not use Section 220 and, therefore, did not adequately represent Hecla’s interests.
The following are our observations on the second year of mandatory “say on pay” votes for U.S. public companies under Dodd-Frank thus far this proxy season.
Results of Vote. As of June 25, 2012, of the companies that have reported results for 2012, 54 have failed their say on pay votes. This is an increase from 2011 and there remain a number of companies left to report. Four companies have failed two years in a row. 396 companies in the S&P 500 have reported say on pay results as of June 22, 2012, of which 384 received majority shareholder support (97%). Similar to last year, the mean level of shareholder approval is 89% and the median level of shareholder approval is 95%.
Influence of ISS. The recommendation of ISS continues to have a measurable impact on voting results. ISS has recommended against say on pay proposals at approximately 14% of the S&P 500 companies as of June 22, 2012. Of companies receiving unfavorable vote recommendations from ISS, 21% of those that had reported results as of June 22, 2012 failed to receive majority support. Companies receiving negative ISS recommendations that have nonetheless received majority support have generally done so with considerably lower margins than those receiving a favorable ISS recommendation. According to a recent study by Pay Governance, a negative ISS recommendation results in an average shareholder support level of 65% versus 95% for those receiving a positive ISS recommendation (for S&P 500 companies, the difference in support levels based on such recommendations is 59% versus 94%). According to the same study, this is a 10% increase over last year’s correlation. During the approximately two years of mandatory say on pay proposals under Dodd-Frank, only one company that received a positive ISS recommendation failed to receive majority shareholder support. The median change in voting results following a year-over-year change in ISS recommendation is approximately 27%.
On March 26, 2012, in Credit Suisse Securities (USA) LLC v. Simmonds, the U.S. Supreme Court held 8-0 that the two-year statute of limitations for suits under the short-swing liability rules of Section 16(b) of the Securities Exchange Act of 1934 is not tolled (i.e., suspended) until an insider files a Section 16(a) disclosure statement; the limitations period can begin running even if the disclosure statement is filed at a later date or never filed at all. The Court’s decision provides insiders of U.S. public companies with better protection and more certainty against time-barred claims.
The Supreme Court reversed the Ninth Circuit, which had held, citing to its precedent, that the limitations period is tolled until an insider files the Section 16(a) disclosure statement “regardless of whether the plaintiff knew or should have known of the conduct at issue”. In dicta, the Supreme Court also rejected the Second Circuit’s rule that the limitations period is tolled until the plaintiff “gets actual notice that a person subject to Section 16(a) has realized specific short-swing profits that are worth pursuing”.
The Supreme Court did indicate some willingness to permit equitable tolling of the Section 16(b) limitations period, but under circumstances more limited than the “disclosure” rule of the Ninth Circuit or the “actual notice” rule of the Second Circuit.
Earlier this summer, the Federal Court of Australia handed down an important corporate law decision that would appear to have a substantial impact on the way that the statutorily defined responsibilities of directors are understood in Australia.  In Australian Securities and Investments Commission v. Healey, the entire board of directors (consisting of seven non-executive directors and the chief executive officer) was found to have breached its duty in failing to notice a significant error in the financial statements, an error that also went uncorrected by the outside auditors and internal employees. The directors were subject to possible financial penalties and bans as a result of the decision, though in the penalty phase of the case, the court determined that the liability judgment itself, with its associated embarrassment and reputational damage, was adequate punishment and deterrence.  Though the case involved interpretation of an Australian corporation law statute and was necessarily fact-specific, nonetheless it is worth careful scrutiny, as it serves as a powerful reminder to directors that their role is an active one and, further, may signal the direction in which the understanding of the role of directors generally could be headed.
The Delaware Court of Chancery last week provided fresh guidance on the standards of director conduct applicable to part-cash, part-stock mergers and reaffirmed the rules of the road for board process and deal protection provisions in strategic mergers. In re Smurfit-Stone Container Corp. S’holder Litig., C.A. 6164-VCP (May 20, 2011).
In a merger agreement announced on January 23, Smurfit-Stone, a leading containerboard manufacturer, agreed to merge with Rock-Tenn Corporation. The agreement provides that Smurfit-Stone stockholders will receive consideration valued at $35.00 per share as of the date of the merger agreement, representing a 27 percent premium over the stock’s pre-announcement trading price, with 50 percent of the consideration payable in cash and the other 50 percent payable in Rock-Tenn common stock. Shareholder plaintiffs sought to enjoin the deal, alleging that the Smurfit-Stone board had improperly failed to conduct an auction and that the deal protection provisions in the merger agreement were impermissible as a matter of Delaware law.
In CDX Liquidating Trust v. Venrock Assocs., et al., 2011 U.S. App. LEXIS 6390 (7th Cir. March 29, 2011), the United States Court of Appeals for the Seventh Circuit, reversing the District Court’s ruling, held under Delaware law that a director’s disclosure of a conflict, in and of itself, is insufficient to protect that director from liability for breach of the fiduciary duty of loyalty arising from that conflict. Similarly, the other party to whom the conflicted director owes loyalty (under the right circumstances) can be held liable for aiding and abetting a breach of fiduciary duty. Nor does the mere existence of independent directors shield these parties from liability.
In Venrock, the debtor (“Debtor”) was a company which manufactured internet modems. The founders received common stock. Two venture capital firms (the “VCs”) received preferred stock in exchange for an investment made at the beginning of 2000. A principal of one of the venture capital firms (the “VC Principal”) became a member of Debtor’s five-member board of directors (the “Board”) upon the firm’s investment. In April 2000, the Board rebuffed a tentative offer to buy Debtor’s assets for $300 million.