May 21, 2014
Practice Groups:
Government
Enforcement;
Global Government
Solutions
Surviving in an Age of Individual Accountability:
How Much Protection Do Indemnification and D&O
Insurance Provide?
By: Jon Eisenberg
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.
I. The Age of Individual Accountability
Criticizing regulators for not prosecuting senior executives has become one of the great
American sports. Whether it’s Judge Jed Rakoff writing in The New York Review of Books,1
or Gretchen Morgenson and Louise Story writing in The New York Times, 2or Pro Publica
reporter Jesse Eisinger writing in The New York Times Magazine,3or countless others
making similar arguments in other publications,4 they sound a consistent theme: executives
should have been prosecuted more aggressively for their roles in the financial crisis.
However misguided, this is not surprising. John Kenneth Galbraith observed in his history of
financial bubbles going back to “Tulipmania” in the 1600s, “The final and common feature of
the speculative episode—in stock markets, real estate, art, or junk bonds—is what happens
after the inevitable crash. This, invariably, will be a time of anger and recrimination and also
of profoundly unsubtle introspection.”5 The anger “will fix upon the individuals who were
previously most admired for their financial imagination and acuity.”6 He could have added: it
will also fix upon the regulators who failed to prevent the crisis.
There are compelling reasons senior executives have not been charged in greater numbers.
For example, Roger Lowenstein, whose books and articles have often been critical of
financial institutions and their executives, nevertheless rejected the notion that the financial
crisis was caused by fraud. The assumption that the crisis was caused by fraud, he wrote,
“hinder[s] our understanding of the crisis” and “do[es] violence to our system of justice.” 7
The crash “was the result of a tendency in our financial culture, especially after a period of
buoyancy, to push leverage and risk-taking to the extreme.” But that is not fraud, and is not
a basis for either criminal or civil actions against CEOs and CFOs. “We should all be
Surviving in an Age of Individual Accountability: How Much
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thankful,” Lowenstein writes, that “people who contribute to a financial collapse aren’t guilty
of a crime absent specific violations that make them so.”8
Unfortunately for CEOs, CFOs, and other senior executives, the drumbeat of criticism has
stung the regulators and caused them to place targets on the backs of senior executives. No
matter what regulators do, armchair prosecutors will perceive it as too little, and for that
reason enforcement regulators are under great pressure to be as aggressive as possible.
That is why the SEC highlights the fact that as of the end of 2013, it had brought actions
against 70 CEOs, CFOs and other senior officers in connection with its financial crisis
enforcement actions.9 SEC Chair Mary Jo White has made targeting individuals a “core
principle” of the SEC’s enforcement program on the theory that “when people fear for their
own reputations, careers or pocketbooks, they tend to stay in line.” 10 Most SEC cases now
name individuals.
Other agencies are focused on individual accountability as well. In imposing a $10 million
fine on a bank executive and a $7.5 million fine on a CFO for a bank’s alleged disclosure
violations, New York Attorney General Eric Schneiderman said, “This settlement is one more
step in our effort to hold top financial executives accountable for their actions.”11 The
Federal Energy Regulatory Commission imposed a $30 million fine on an individual trader for
violating the Commission’s anti-manipulation rules.12 In a March 2014 speech, Benjamin
Lawsky, New York State’s Superintendent of Financial Services, focused almost exclusively
on his intent to punish Wall Street executives. 13 In testimony before Congress, David S.
Cohen, the U.S. Treasury Department’s Undersecretary for Terrorism and Financial
Intelligence, stated that the agency was focused on “employing all the tools at the agency’s
disposal to hold accountable those institutions and individuals who allow our financial
institutions to be vulnerable to terrorist financing, money laundering, proliferation finance,
and other illicit financial activity.”14 (emphasis added). In a May 9, 2014 speech, CFPB
Director Richard Cordray stated that issues of individual liability should be based on the
“concept of accountability,” and that the CFPB has taken action ranging from requiring
individuals to finance restitution to consumers to referring them to the Justice Department for
criminal prosecution.15
A recent survey by the American Association of Bank Directors found that over the prior five
years 24.5% of banks had directors or prospective directors resign, refuse to serve on a
committee, or refuse an offer to become a director because of fear of personal liability.16
Needless to say, it is even more important in the Age of Accountability for officers and
directors to understand what protection they have, and do not have, against having to pay
large fines out of their own pockets for conduct they undertake on behalf of their companies.
II. Mounting a Defense: Who Pays?
Regulatory investigations and proceedings often take years to bring to conclusion and may
involve millions of dollars, and occasionally tens of millions of dollars, in legal fees. The first
question for officers and directors is whether they are entitled to advancement of legal fees
incurred in defending against a regulatory investigation.
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A. Upon Receipt of an Undertaking, Delaware Law Permits but Does Not
Require Advancement of Legal Fees
We turn to Delaware law first because so many companies are incorporated in Delaware and
because other states often follow Delaware law and Delaware decisions on corporate
governance issues.17 Delaware law permits, but does not require, a company to advance
legal fees incurred in defending a civil, criminal, administrative, or investigative suit or
proceeding.18 Of course, the difference between permitting and requiring is potentially the
difference between fees being advanced or not advanced.
If a company chooses to advance, Delaware law requires the company first to obtain “an
undertaking by or on behalf of such director or officer to repay such amount if it shall
ultimately be determined that such person is not entitled to be indemnified….”19 A typical
undertaking provides that the officer or director undertakes to repay any amounts advanced
by the company to the extent it is ultimately determined that the officer or director is not
entitled to indemnification.20 With regard to former officers and directors, as well as
employees who are not officers or directors, Delaware law appears to permit but not require
an undertaking.21
Delaware law also allows the company to impose such “terms and conditions” as it deems
appropriate. For example, a company might require collateral, retain the right to select
counsel, determine the reasonableness of the fees, or demand to be kept informed regarding
developments in the investigation.
Because Delaware makes advancement permissive but not mandatory, it actually provides
very little protection to an executive. For example, what will happen if there is a change in
management, or if regulators pressure a company not to advance legal fees,22 or if a matter
has received publicity that makes directors uncomfortable in making a discretionary decision
to advance fees, or if the board becomes unsympathetic to the executive being investigated,
or if the executive has left and gone to a competitor at the time the investigation is
commenced? Unless executives have a high degree of confidence that they can predict the
future in a very challenging and often hostile environment, they should take virtually no
comfort from the fact that a company may advance legal fees. A company that may choose
to advance legal fees may also choose not to advance legal fees.23
B. Many Company By-Laws Require Advancement to the Maximum Extent
Permitted by Delaware Law
Many companies protect officers and directors by adopting by-laws that require the company
to provide advancement and indemnification to the maximum extent permitted by Delaware
law. The Delaware Supreme Court itself has observed, “[M]andatory advancement
provisions are set forth in a great many corporate charters, bylaws and indemnification
agreements.”24 For example, many companies have by-laws that provide that the company
“shall” advance legal fees “to the maximum extent permitted by Delaware law” upon receipt
of an undertaking to repay the amount advanced if it shall ultimately be determined that the
officer, director or employee is not entitled to indemnification. The by-laws may further
provide that the advancement is not intended to be a personal loan,25 that the fees will be
paid within a specific period of time (for example, 30 days), and that the officer or director
may seek mandatory injunctive relief if the company fails to pay the fees. The by-laws may
also provide that the officer, director, or employee will be entitled to advancement without
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regard to their ability to repay or ultimate entitlement to indemnification, until the final
determination of the proceeding. Of course, the added protection to the executives may
come at an unwelcome cost to the company of advancing fees to an unsympathetic
individual who will not be in a position to reimburse the company at the end of the
proceeding. 26 This irritation may be most acute when the same by-law provisions that apply
to third-party claims against an officer or director also apply to claims by the company itself,
as few things irritate companies more than having to advance legal fees for an individual that
the company itself has accused of wrongdoing.
When companies make the permissive advancement provisions of Delaware law mandatory
for the company, Delaware courts almost uniformly enforce the mandatory advancement
provisions – even when it appears that the officer or director may have engaged in
misconduct and the company resists advancement.27 They do so on the ground that the
issue of advancement is distinct from the issue of the ultimate merits,28 and that
advancement is required until the ultimate merits are determined, which may not be until
appeals have been exhausted.29 The proper remedy when a corporate executive has
engaged in misconduct is usually not to deny advancement before the matter is concluded
but to seek recovery of any funds advanced once the matter is concluded.
The first practice pointer here is simply that officers and directors (and employees) need to
know whether they work for a company that has made the Delaware advancement
provisions mandatory, or whether, instead, they work for a company that has preserved its
discretion to advance or not advance on any terms it sees fit. In the case of the former, the
officers, directors, and employees have a strong right to advancement; in the case of the
latter, their protection is entirely dependent on the company’s exercise of its discretion, which
may turn out to be no protection at all. The second point is that advancement is not
unconditional – it comes with an obligation to re-pay if it is ultimately determined that the
officer or director is not entitled to indemnification. We turn to that issue below.
III. Ready to Settle—Now Who Bears The Cost?
Delaware Vice Chancellor Sam Glasscock, III, recently explained the rationale for broad
indemnification as follows:
No corporation can be a success unless led by competent and energetic officers
and directors. Such individuals would be unwilling to serve if exposed to the
broad range of potential liability and legal costs inherent in such service despite
the most scrupulous regard for the interests of stockholders. This is the rationale
behind the indemnification and advancement provisions of Delaware corporate
law.30
While there are compelling reasons to protect officers and directors through broad
indemnification, there are also countervailing considerations. In particular, regulators often
disfavor indemnification because they believe it detracts from individual accountability and
reduces the incentives against misconduct. Since corporations act through individuals, the
argument goes, individuals should also be accountable when a company engages in
misconduct. Regulators also tend to believe that when an individual settles a regulatory
proceeding, the individual is guilty of the conduct the regulators have alleged whereas the
individual and corporation may believe the settlement was made for other reasons, such as
getting closure and avoiding the cost, distraction, and uncertainty associated with litigation.
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Surviving in an Age of Individual Accountability: How Much
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Beginning with the financial crisis, the individual accountability side of the argument has
received more attention than in the past.
Indemnification is more limited, and more complicated to analyze, than advancement.
Officers and directors seeking to understand their right to indemnification need to understand
state law restrictions on indemnification, their company’s indemnification policies, regulators’
restrictions on indemnification, and public policy limitations on indemnification.
A. Delaware Law Permits, but Does Not Require, Broad Indemnification for
Defendants Who Act in Good Faith
Delaware law broadly permits, but does not require, indemnification of persons who “acted in
good faith and in a manner the person reasonably believed to be in or not opposed to the
best interest of the corporation….”31 In other words, as far as Delaware law is concerned, in
most cases a corporation can choose to indemnify, or not indemnify, officers, directors (and
others) who acted in good faith and reasonably believed that their conduct was in or not
opposed to the best interests of the company. As we noted with respect to advancement,
there is a huge distinction between merely being permitted to indemnify and being required
to indemnify.
Delaware law allows a corporation to make the good-faith determination without regard to
whether the suit was terminated by settlement, judgment, or conviction. There is certainly no
presumption under Delaware law that a settlement implies guilt. It provides that the manner
in which the suit was terminated “shall not, of itself, create a presumption that the person did
not act in good faith and in a manner which the person reasonably believed to be in or not
opposed to the best interests of the corporation.”32 This makes sense because in many
cases the alleged violations do not require proof of bad faith and, further, the vast majority of
cases and regulatory proceedings are ultimately resolved through settlements in which there
is no final adjudication of the merits of the claims. Unless a court has made the
indemnification decision, Delaware law requires that it be made by 1) a majority vote of the
directors who are not themselves parties to such proceeding, or 2) a committee of such
directors designated by a majority vote, or 3) by independent legal counsel directed to make
such a determination by the directors, or 4) by the stockholders.
With regard to indemnification that is required as opposed to permitted, Delaware law
mandates indemnification in only one situation – when a present or former director or officer
of the corporation “has been successful on the merits or otherwise in defense of any action,
suit or proceeding,” and then for “expenses (including attorneys’ fees) actually and
reasonably incurred by such person in connection” with the successful defense.33 What
constitutes “success” is not always clear in a regulatory proceeding. For example, the
Delaware Chancery Court recently rejected a CEO’s argument that his guilty plea to two
strict liability misdemeanors constituted “success” because he convinced the U.S. Attorney
not to charge him with more serious offenses.34 The court said, “The proper analysis instead
considers the outcome achieved by the indemnitee in light of the formal charges or claims
against him” and that it would not judge the outcome “against the universe of crimes with
which the indemnitee could have been charged.”35 From a “success” perspective, the CEO
would have been better off if he had been charged with both the more serious and the strict
liability offenses, and then the more serious charges had been dropped.36 For similar
reasons, the court also rejected the argument that he had been successful in a regulatory
settlement that prohibited him from participating in federal healthcare programs because he
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had avoided a regulatory monetary penalty. On the other hand, it found that the CEO was
successful in connection with an FDA consent decree, but only because it did not impose a
fine or place any restrictions on him.
As with permissive advancement, it can quickly be seen that Delaware law itself provides
little protection to officers, directors, and other employees because it only permits, but does
not require, a corporation to indemnify employees who acted in good faith and with a
reasonable belief that their conduct was in the best interests of the corporation.37 A
company could condition indemnification on virtually anything–for example, the absence of
negligence, the absence of gross negligence, or the absence of any violation of a statute or
regulation. Moreover, absent a by-law or other provision making indemnification mandatory,
officers and directors would be subject to the same risks discussed above with regard to
advancement—what will happen if there is a change in management, or if regulators
pressure a company not to indemnify, or if a matter has received publicity that makes
directors uncomfortable in making a discretionary decision to indemnify, or if the board
becomes unsympathetic to the executive being investigated, or if the executive has left and
gone to a competitor at the time the investigation is commenced?
B. Many Companies Adopt By-Laws that Mandate Indemnification to the
Maximum Extent Permitted by Delaware Law
As with advancement, many companies adopt by-laws that require companies to indemnify
to the maximum extent permitted by Delaware law. For example, a company might
indemnify persons for “all expenses and liabilities of any type whatsoever (including, but not
limited to, losses, damages, judgments, fines, excise taxes and penalties, and amounts paid
in settlement) actually and reasonably incurred by the individual in connection with the
investigation, defense, settlement or appeal of such proceeding, provided the individual
acted in good faith and in a manner reasonably believed to be in or not opposed to the best
interests of the company.” It might provide that the company “shall” indemnify “to the fullest
extent permitted by law and that no determination shall be required in connection with such
indemnification unless specifically required by applicable law which cannot be waived.” An
agreement might further provide that if the indemnitee is deceased, the company will
indemnify the indemnitee’s spouse, heirs, executors, and administrators. It might further
provide that the termination of any proceeding by settlement or judgment shall not create a
presumption that the indemnitee did not act in good faith and in a manner in which the
indemnitee believed to be in or not opposed to the best interest of the company. It may also
provide that the agreement shall continue for as long as the indemnitee may be subject to
any possible claim, and that the company shall require any successor to the company to
assume and agree to perform the obligations to indemnify to the same extent as the
company would be required to perform if no such succession had taken place.
C. Bad News: Regulators May Prohibit Indemnification that a Company is
Otherwise Obligated to Pay
Unfortunately for directors and officers, there are circumstances in which indemnification of
regulatory fines may be prohibited even if permitted by state law and mandated by the
company’s by-laws.
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For example, FDIC rules provide that no insured depository institution or depository
institution holding company shall make any “prohibited indemnification payment.” The FDIC
defines a “prohibited indemnification payment” to mean
any payment (or any agreement or arrangement to make any payment) … to pay
or reimburse such person for any civil money penalty or judgment resulting from
any administrative or civil action instituted by any federal banking agency, or any
other liability or legal expense with regard to any administrative proceeding or
civil action instituted by any federal banking agency which results in a final order
or settlement pursuant to which such person i) is assessed a civil money penalty,
ii) is removed from office or prohibited from participating in the conduct of the
affairs of the insured institution, or iii) is required to cease and desist from or take
any affirmative action described in section 8(b) of the Act with respect to such
institution.38
The only exception is for partial reimbursement of expenses incurred in connection with
charges in which there is a specific adjudication or finding that the officer or director did not
violate banking laws or engage in unsafe or unsound banking practices or breaches of
fiduciary duty.39 In other words, officers or directors of an insured depository institution or
holding company will likely have to bear the cost of any penalty imposed by a federal
banking agency unless they prevail on the merits of the claims. Because they will not be
entitled to indemnification, they may also have to reimburse the corporation for any fees
advanced to defend against claims by a federal banking regulator. On the other hand, the
principal risk of significant penalties usually comes from the SEC, the Department of Justice,
and state attorneys general rather than federal banking regulators.
The Federal Reserve, in its Guidance Regarding Indemnification Agreements and
Payments,40 reminds bank holding companies and state member banks that these
restrictions apply to them and reinforce “the Federal Reserve’s longstanding policy that an
institution-affiliated party who engaged in misconduct should not be insulated from the
consequences of his or her misconduct.” Of course, the flaw in that reasoning is that it
assumes that a party who settles has necessarily engaged in misconduct. The Guidance
states, “Although state corporate laws may allow a company to adopt by-laws indemnifying
its institution-affiliated parties, any indemnification provisions or agreements adopted by a
state member bank or bank holding company must comply with federal law and the FDIC’s
regulations concerning indemnification.”
Federal savings associations have broader permissive indemnification authority but are
required to give the OCC at least 60 days’ notice of their intention to make an indemnification
payment.41 “No such indemnification shall be made if the OCC advises the association in
writing, within such notice period, the OCC’s objection thereto.” Moreover, if directors of a
federal savings association simply decline to provide permissive indemnification, the officer
or director may be without a remedy.42
SEC settlement orders sometimes include bars against seeking indemnification, 43but often
they do not. In SEC v. Conaway, 697 F. Supp. 2d 733 (E.D. Mich. 2010), a litigated case in
which the SEC prevailed, the court stated that the SEC had provided no authority for its
request that the court’s order prohibit the defendant from seeking reimbursement.
Nevertheless, the court went on to state, “I find that the remedial purpose of any such fine
would be highly diluted if it were borne by any third party,” and it ordered that the penalty be
doubled if the defendant received reimbursement from any third party.
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Whether or not the SEC includes a waiver provision in a settlement agreement, companies
and executives should be aware that the SEC has codified its position in item 512 of
Regulation S-K, 17 C.F.R. §229.512, that a prospectus include the following language:
“Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be
permitted to directors, officers, or persons controlling the registrant, the registrants has been
informed that in the opinion of the SEC such indemnification is against public policy as
expressed in the Act and is therefore unenforceable.”44
CFPB settlement orders often state that respondents “shall not … seek or accept, directly or
indirectly, reimbursement or indemnification from any source … with regard to any civil
money penalty that the Respondents pay under this Order.”45 To date, however, the CFPB
has not sought to impose penalties against executives of public companies.
One point of negotiation that officers and directors should carefully consider is that in some
cases an order in an enforcement action will impose joint liability on an individual defendant
and a company defendant.46 Joint liability means that each party can be required to make
the payment, but a payment of the entire amount by one party satisfies the obligation that the
other party has to pay. Thus, when a company and an individual are jointly liable to pay a
fine, the company may pay the entire fine. For that reason, in cases in which the company is
willing and able to pay the entire penalty, it may be in the interests of the individual defendant
that any penalty assessed against him or her be a joint obligation of the company as well.
On the other hand, in many settlements there may be no company defendant, or the order
will specify a separate penalty for the company and the individual, or the company may be
unwilling or unable to pay the entire amount.
The key practice pointers are the following: 1) permissive indemnification provides little
protection; 2) companies that make permissive indemnification mandatory provide a far
higher level of protection; 3) banks and bank holding companies will generally not be able to
indemnify individuals for fines and other sanctions assessed by federal banking regulators;
4) federal savings associations are not permitted to indemnify if, after notice, the OCC
objects to indemnification; and 5) other agencies sometimes restrict indemnification by
conditioning settlement on agreements not to seek indemnification.
IV. D&O Insurance: Protection or Minefield?
The limits on indemnification for regulatory penalties mean that officers and directors need to
carefully consider a corporation’s insurance policies. So-called “Side A” coverage potentially
protects officers and directors for economic loss arising from claims for wrongful acts made
against the individual insured when the corporation refuses or is unable to provide
indemnification. In contrast, Side B coverage is for claims by the entity for amounts paid to
indemnify an insured person, and Side C coverage is for claims by an entity for loss arising
from a claim against the entity itself.47
For example, Side A coverage might provide:
This policy shall pay the Loss of each and every Director or Officer of the
Company arising from a Claim first made against the Directors or Officers during
the Policy Period … for any actual or alleged Wrongful Act occurring on or prior
to the Effective Time in their respective capacities as Directors or Officers of the
Company, except when and to the extent that the Company … has indemnifed
the Directors or Officers. The Insurer shall … advance Defense Costs of such
Claim prior to its final disposition.48
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A. Ten Questions You Should Ask about Your Company’s D&O Coverage
D&O policies differ, sometimes significantly, from carrier to carrier and may themselves be
limited when it comes to regulatory penalties. Officers and directors may wish to consider
the following (in addition to whether their company even has Side A coverage):
First, does the policy cover regulatory investigations and proceedings? Not all policies purport to
cover regulatory investigations and proceedings. Some cover investigations, some cover
regulatory proceedings, and a few may cover neither. In many cases, insurers and policyholders
have litigated the availability of coverage for regulatory investigations.
Second, does the policy cover fines? Many D&O insurance policies exclude fines and penalties.
Other policies do cover at least certain fines and penalties and the nature of the fine, and the
underlying basis, may be important.
Third, what conduct does the policy exclude? D&O policies also contain conduct exclusions. For
example, an exclusion might provide:
The Policy shall not apply to any Claims made against the Insureds … based upon or
arising out of any deliberate, dishonest, fraudulent or criminal act or omission by such
Insureds. 49
Often such exclusions come with a proviso like the following, which requires a final
adjudication:
Provided, however, such Insureds shall be protected under the terms of this policy with
respect to any Claims made against them in which it is alleged that such Insureds
committed any deliberate, dishonest, fraudulent or criminal act or omission, unless
judgment or other final adjudication thereof adverse to such Insureds shall establish that
such Insureds were guilty of any deliberate, dishonest, fraudulent or criminal act or
omission.50
Fourth, does the policy exclude coverage for receipt of personal benefits? D&O policies also
typically exclude coverage for claims arising from an insured’s receipt of any personal profit or
advantage to which the insured was not legally entitled. These policies typically include some
sort of trigger, such as a requirement for a “final adjudication.”
Fifth, is the carrier likely to assert a public policy defense to coverage? In addition to relying on
specific policy exclusions related to fraud or improper profits, insurers often attempt to deny
coverage on public policy grounds that are not set forth in the policy itself, such as arguments that
policyholders should not be entitled to coverage for any type of disgorgement. The noncontractual public policy defense is a frequent source of litigation.
Sixth, does the policy exclude liability for money laundering violations? Some D&O policies
specifically exclude coverage for money laundering violations.
Seventh, under what circumstances does the policy require re-payment of defense costs that
have been advanced? Some insurers may seek repayment of previously advanced defense
costs if a settlement contains sufficiently specific allegations that, if true, would trigger exclusions
from coverage.
Eighth, what happens in bankruptcy? Depending on the nature of the policy (e.g., is it a Side A
only policy), it may become an asset of the bankruptcy estate, rather than of the director or
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officer, if the company files for bankruptcy. Some policies, however, include a bankruptcy
provision that generally provides that the primary purpose of the policy is to protect the insured
person; that in the event of bankruptcy the insurer shall first pay the claims of insured persons for
non-indemnified loss; and that no insured shall oppose a request for an insured person’s request
in the bankruptcy court for approval of the insurer’s advancement of defense costs. Case law, as
well as policy language, may be important.
Ninth, under what other circumstances may the carrier avoid coverage? Carriers sometimes
seek to avoid coverage because 1) the company’s financials, which typically form part of the
application it submits to the carrier, were misstated; 2) the company did not advise the carrier of
facts indicative of a claim at the time the policy holder applied for coverage; or 3) even that other
insureds engaged in conduct excluded by the policy. Officers and directors have enhanced
protection if the policy, for example, provides that no statements or knowledge possessed by any
insured person shall be imputed to another insured person for the purpose of determining if
coverage is available.51
Tenth, is the amount of the coverage adequate? Officers and directors need to be aware that
D&O policies are typically single-limit policies. That means that every dollar spent on defense
costs for one insured reduces the amount of insurance dollars available for another insured. In
addition, Side A coverage may be combined by the company with Side B and Side C coverage,
and the company and individuals may assert competing claims on the pool of insurance. Some
policies include priority provisions that state that the insurer must first pay the Side A claims of
individual insureds.
B. Insurance Coverage Litigation
Although not involving D&O coverage, the type of litigation that can arise in the context of
settlements of regulatory proceedings is seen in decisions involving a settlement between
the SEC and Bear Stearns, which resulted in findings of violations, an order to disgorge $160
million, and an order to pay a $90 million penalty. The order made findings that Bear
Stearns knowingly facilitated market timing by its clients.52
In litigation against the carrier to recover the $160 million in disgorgement and $40 million in
defense costs (the policyholder did not seek coverage for the $90 million penalty), the carrier
sought to avoid coverage on various grounds, including that 1) public policy prohibits an
insured from obtaining coverage for “disgorgement” of an ill-gotten gain, and 2) the D&O
policy’s profit exclusion was triggered by the SEC’s findings of wrongful conduct. SEC
administrative settlements, unlike settlements of SEC injunction actions, contain findings
rather than allegations.
On the public policy issue, the New York Court of Appeals acknowledged that other courts
have held that the risk of being ordered to return ill-gotten gains—disgorgement—is not
insurable because the wrongdoer would retain the proceeds of his illegal acts by shifting his
loss to an insurer.53 Bear Stearns did not dispute that general principle, but argued that the
principle should not be applied to disgorgement of profits made by its clients, rather than
obtained by Bear Stearns itself. The Court of Appeals agreed with Bear Stearns on this
issue, reversed the intermediate Court of Appeals, and reinstated the coverage action.
On remand, the carrier renewed its argument that coverage was also barred because the
SEC administrative order contained detailed findings of misconduct. The trial court
concluded, however, that the SEC’s order, even though it contained detailed findings of
violations, did not constitute a “final adjudication or judgment” required by the policy
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language because it was the product of a settlement rather than a contested proceeding. In
reaching that conclusion, it noted that the firm’s consent to the settlement was “solely for
purpose of these proceedings,” and that the factual findings were neither admitted nor
denied (except as to jurisdiction).54 Eight years after the SEC settlement, the litigation over
the carriers’ defenses to coverage is ongoing.
C. Regulatory Restrictions on Insurance Coverage
On October 10, 2013, the FDIC issued an advisory bulletin, titled “Director and Officer
Liability Insurance—Policies, Exclusions, and Indemnification for Civil Money Penalties.”55
While the advisory bulletin appears designed in part to encourage policyholders to purchase
broad protection (which may assist the FDIC when, as receiver for a failed bank, it sues
officers and directors), the advisory also states, “FDIC regulations prohibit an insured
depository institution or depository institution holding company from purchasing insurance
that would be used to pay or reimburse an [officer or director] for the cost of any [civil money
penalty] assessed against such person in an administrative proceeding or civil action
commenced by any federal banking agency.” In other words, the FDIC’s position appears to
be that officers and directors cannot be insured for civil money penalties assessed by a
federal banking regulator. On the other hand, the advisory: 1) does not prohibit insurance
coverage of legal expenses incurred in connection with such a proceeding, and 2) does not
prohibit insurance for penalties assessed by state and federal agencies other than federal
banking agencies. That is where most of the risk is.
The SEC does not usually address insurance of individuals in its consent decrees, but there
are exceptions. In the consent decree in SEC v. Falcone, et al.,56 which involved admissions
of wrongdoing, the consent provided:
The Harbinger Defendants agree that they shall not seek or accept, directly or
indirectly, reimbursement or indemnification from any source, including but
limited to, payment made pursuant to any insurance policy, with regard to any
civil penalty amounts that each Harbinger Defendant pays….
The CFPB often includes in its settlement orders a requirement that defendants “shall not
seek or accept, directly or indirectly, reimbursement or indemnification from any source,
including but not limited to payment made pursuant to any insurance policy, with regard to
any civil penalty amounts that Defendants pay pursuant to this Order,”57 although sometimes
the prohibition is limited to civil money penalties that “the company” pays under the order.58
V. Conclusion
The reader who has managed to get this far will have absorbed the following lessons.
1. Regulators are highly focused on individual accountability, and for that reason
there is greater risk than in the past that CEOs, CFOs and other executives will
be targeted.
2. State law advancement and indemnification provisions, at least under Delaware
law, are largely permissive rather than mandatory and thus, by themselves,
provide little protection to officers and directors unless they actually prevail on the
claims.
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Surviving in an Age of Individual Accountability: How Much
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3. Officers and directors enjoy significantly greater protection when their companies
adopt by-laws requiring the companies to advance fees and provide
indemnification to the maximum extent permitted by law. Many companies do
exactly that. Other companies, however, provide far less protection by retaining
discretion at the company level to provide, or not provide, advancement and
indemnification as the company deems appropriate.
4. Even when they have indemnification to the maximum extent permitted by law,
officers and directors need to understand the following limitations:
a. At least for current officers and directors, advancement of legal fees
comes with an undertaking to re-pay if it is ultimately determined that the
officer or director is not entitled to indemnification. The fact that legal
fees are advanced does not mean they will ultimately be indemnified,
which means they may have to be re-paid.
b. The FDIC prohibits insured depository institutions and their holding
companies from indemnifying officers and directors for civil money
penalties imposed by federal bank regulators. The FDIC takes the
position that this trumps more liberal state indemnification laws.
Fortunately, most of the risk to officers and directors of solvent institutions
does not usually come from federal bank regulators.
c. The OCC requires federal savings associations to provide 60 days notice
before providing indemnification to an officer or director, and requires the
federal savings association not to indemnify if the OCC objects.
d. SEC settlement orders sometimes prohibit indemnification and
sometimes are silent on the issue. The SEC takes the position, however,
that indemnification for liabilities arising under the Securities Act is
against public policy and unenforceable. There is no definitive authority
on what that means in the context of a settlement.
e. CFPB settlement orders often state that respondents may not seek
indemnification from any source with regard to a civil money penalty.
5. Because indemnification is often restricted, officers and directors also need to
understand their coverage under insurance policies—so-called Side A D&O
insurance. Insurance may provide coverage when indemnification does not.
Among the questions officers and directors should ask are:
a. Are regulatory investigations and proceedings covered by the policy?
b. Are regulatory fines covered by the policy?
c. What conduct exclusions are there?
d. Do the conduct exclusions apply only if there is a final adjudication of
misconduct or do they potentially apply to settlements as well?
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Surviving in an Age of Individual Accountability: How Much
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e. What is required to obtain advancement and in what circumstances do
the policies require re-payment of advanced defense costs?
f.
What happens to the policy proceeds in the event of bankruptcy?
g. Are misstatements or knowledge of another insured in an application for
insurance imputed to the officer or director?
h. Does misconduct by one insured trigger an exclusion for all insureds?
i.
Is the amount of coverage adequate considering it may be depleted by
other insureds?
j.
Does the policy include a priority provision that gives priority to claims by
an individual insured over a company insured?
6. As with indemnification, regulators may prohibit a director or officer from
transferring the loss to the carrier. In particular,
a. The FDIC prohibits insured banking institutions and their holding
companies from insuring officers and directors for civil money penalties
assessed by a federal banking agency.
b. The SEC sometimes prohibits a settling defendant from seeking recovery
from an insurance carrier.
c. The CFPB often prohibits a settling defendant from seeking recovery
from an insurance carrier.
d. Carriers may argue that public policy prohibits coverage of regulatory
penalties on the facts of a particular case.
The main point here is not that both indemnification and insurance may have significant
limitations (which they often do); it is that in the Age of Accountability, officers and directors
are well advised to understand the limitations of their corporation’s indemnification and
insurance policies well before they find themselves facing potential personal liability. For
executives in a hostile regulatory environment, the time to understand the extent of their
protection against individual liability is before the problems arise, and not after it’s far too late
to do anything about it.
Author:
Jon Eisenberg
jon.eisenberg@klgates.com
+1.202.778.9348
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Surviving in an Age of Individual Accountability: How Much
Protection Do Indemnification and D&O Insurance
Provide?
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1
Jed S. Rakoff, “The Financial Crisis: Why Have No High-Level Executives Been Prosecuted?”
The New York Review of Books (Jan. 9, 2014).
2
Gretchen Morgenson and Louise Story, “In Financial Crisis, No Prosecutions of Top Figures,”
The New York Times (Apr. 14, 2011).
3
Jesse Eisenger, “Why Only One Top Banker Went to Jail for the Financial Crisis,” The New
York Times Magazine (Apr. 30, 2014).
4
E.g., Robert Schmidt, “SEC Goldman Lawyer Says Agency Too Timid on Wall Street
Misdeeds,” Bloomberg (Apr. 8, 2014); Neil Irwin, “This is a Complete List of Wall Street CEOs
Prosecuted for Their Role in the Financial Crisis,” The Washington Post (Sept. 12, 2013); Glenn
Greenwald, “The Real Story of How ‘Untouchable’ Wall Street Execs Avoided Prosecution,”
Business Insider (Jan. 23, 2013); Ted Kaufman, “Why DOJ Deemed Bank Execs Too Big To
Jail,” Forbes (Jul. 29, 2013); Alison Frankel, “Sarbanes-Oxley’s Lost Promise: Why CEOs Haven’t
Been Prosecuted,” Reuters (July 27, 2012).
5
John Kenneth Galbraith, A Short History of Financial Euphoria at 27 (Viking Penguin 1990).
6
Id. at 29.
7
Roger Lowenstein, “Wall Street: Not Guilty,” BloombergBusinessweek Magazine (May 12,
2011).
8
Preet Bharara, the U.S. Attorney for the Southern District of New York, has aggressively
prosecuted high-level executives in the course of bringing 80 criminal insider trading
prosecutions. Explaining why he hasn’t charged executives in connection with the financial crisis,
he said, “You bring the cases you can based on the evidence you have.” Quoted in Nate
Raymond, “Judge Criticizes Lack of Prosecution Against Wall Street Executives for Fraud,”
Reuters (Nov. 12, 2013).
9
“SEC Enforcement Actions – Assessing Misconduct That Led to or Arose From the Financial
Crisis,” avail. at http://www.sec.gov/spotlight/enf-actions-fc.shtml.
10
Mary Jo White, “Deploying the Full Enforcement Arsenal,” (Sept. 26, 2013), avail. at
http://www.isidewith.com/poll/317926575. Andrew Ceresney, “Keynote Address at the
International Conference on the Foreign Corrupt Practices Act,” (Nov. 19, 2013), avail. at
http://www.sec.gov/News/Speech/Detail/Speech/1370540392284#.U1_OGihXHFl.
11
A.G. Schneiderman Announces Former Bank of America CFO Joe L. Price Barred for 18
Months from Serving as Officer or Director of Any Public Company,” (Apr. 25, 2014), avail. at
http://www.ag.ny.gov/press-release/ag-schneiderman-announces-former-bank-america-cfo-joe-lprice-barred-18-months-serving. .
12
“FERC Orders $30 Million Fine Against Former Amaranth Trader,” FERC News Release (Apr.
21, 2011), avail. at http://www.ferc.gov/media/news-releases/2011/2011-2/04-21-11-G-1.asp
14
Surviving in an Age of Individual Accountability: How Much
Protection Do Indemnification and D&O Insurance
Provide?
13
“Remarks of Superintendent Lawsky on Financial Regulatory Enforcement at the Exchequer
Club,” (Mar. 19, 2014), avail. at http://www.dfs.ny.gov/about/speeches_testimony/sp140319.pdf.
14
Testimony of David S. Cohen before the Senate Committee on Banking, Housing, and Urban
Affairs at 5 (Mar. 7, 2013), avail. at
http://www.dfs.ny.gov/about/speeches_testimony/sp140319.pdf
15
Prepared Remarks of CFPB Director Richard Cordray at the Federal Reserve Bank of Chicago
(May 9, 2014), avail. at http://www.consumerfinance.gov/newsroom/prepared-remarks-of-cfpbdirector-richard-cordray-at-the-federal-reserve-bank-of-chicago-2/
16
The American Association of Bank Directors, “AABD Survey Results on Measuring Bank
Director Fear of Personal Liability Are Not Good News,” (Apr. 9, 2014), avail. at
http://aabd.org/aabd-survey-results-measuring-bank-director-fear-personal-liability-good-news/.
17
Executives whose companies are incorporated in other states need to look to the law of those
states.
18
Delaware Code, §145(e).
19
Id.
20
For a sample form of undertaking, see Undertaking to Repay Advancement of Expenses, avail.
at http://us.practicallaw.com/7-520-5639.
21
Delaware Code, §145(e).
22
Until a court declared the practice unconstitutional, the Department of Justice often pressured
companies not to advance expenses to individuals under investigation. United States v. Stein,
435 F. Supp. 2d 330 (S.D.N.Y. 2006).
23
In Miller v. Palladium Industries, Inc., C.A. No. 7475 (Del. Ch. Dec. 31, 2012), aff’d, No.
36,2013 (Del. Sup. Jul. 19, 2013), the company’s by-laws made advancement mandatory “unless
otherwise determined by the Board of Directors in the specific case….” The Board rejected the
CEO’s request for advancement based on, among other factors, the company’s own financial
needs, its belief that the CEO had engaged in misconduct, and its conclusion that the CEO would
not be able to repay the amounts advanced. The Delaware Court of Chancery and the Delaware
Supreme Court rejected the CEO’s claim that the company’s by-laws made advancement
mandatory.
24
Homestores, Inc. v. Tafeen, 888 A.2d 204, 212 (Del. 2005).
25
Section 402 of the Sarbanes-Oxley Act prohibits public companies from extending, arranging,
or renewing personal loans to or for their directors and executive officers.
26
See Fillip v. Centerstone Linen Services, LLC, Civil Action No. 8712-ML (Del. Ch. Feb. 27,
2014) (“It is far from uncommon that an entity finds it useful to offer broad advancement rights
when encouraging an employee to enter a contract, and then finds it financially unpalatable, even
morally repugnant, to perform that contract once it alleges wrongdoing against the employee.”).
See also, e.g., Peter Lattman, “Goldman Stuck With a Defense Tab, and Awaiting a Payback,”
Dealbook (Jun. 18, 2012), avail. at http://us.practicallaw.com/7-520-5639.
27
E.g., Kaung v. Cole Nat’l Corp., 884 A.2d 500 (Del. 2005) (“[T]he scope of an advancement
proceeding under Section 145(k) of the DGCL is limited to determining ‘the issue of entitlement
according to the corporation’s advancement provisions and not to issues regarding the movant’s
alleged conduct in the underlying litigation”)”; Sergey Aleynikov v. The Goldman Sachs Group,
Inc., Civ. No. 12-5994 (D.N.J. Oct. 16, 2013) (granting summary judgment to former vice
president on claim for advancement of legal fees and on claim for fees in seeking the
advancement of legal fees).
28
E.g., Ridder v. CityFed Fin. Corp., 47 F.3d 85, 87 (3d Cir. 1995) (“Under Delaware law,
appellants’ right to receive the costs of defense in advance does not depend upon the merits of
the claims asserted against them, and is separate and distinct from any right of indemnification
they may later be able to establish.”)
29
Sun-Times Media Group, Inc. v. Black, 954 A.2d 380, 397 (Del. Ch. 2008).
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Surviving in an Age of Individual Accountability: How Much
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30
Herman v. K-V Pharmaceutical Co., 54 A.3d 1093, 1094 (Del. 2012). See also, e.g., Stifel
Financial Corp. v. Cochran, 809 A.2d 555, 561 (Del. 2002) (“The invariant policy of Delaware
legislation on indemnification is to ‘promote the desirable end that corporate officials will resist
that they consider unjustified suits and claims, secure in the knowledge that their reasonable
expenses will be borne by the corporation they have served if they are vindicated”)”.
31
In particular, Section 145(a) of the Delaware Code provides:
A corporation shall have power to indemnify any person who was or is a party or is
threatened to be made a party to any threatened, pending or completed action, suit or
proceeding, whether civil, criminal, administrative or investigative (other than an action by
or in the right of the corporation) by reason of the fact that the person is or was a director,
officer, employee or agent of the corporation, or is or was serving at the request of the
corporation as a director, officer, employee or agent of another corporation, partnership,
joint venture, trust or other enterprise, against expenses (including attorneys' fees),
judgments, fines and amounts paid in settlement actually and reasonably incurred by the
person in connection with such action, suit or proceeding if the person acted in good faith
and in a manner the person reasonably believed to be in or not opposed to the best
interests of the corporation, and, with respect to any criminal action or proceeding, had
no reasonable cause to believe the person's conduct was unlawful.
32
Delaware Code §145(a).
33
Delaware Code §145(c).
34
Hermelin v. K-V Pharmaceutical Co., 54 A.3d 1093 (Del. Ch. 2012).
35
Id. at 1109.
36
See Merritt-Chapman & Scott Corp. v. Wolfson, 321 A.2d 138 (Del. Super. 1974).
37
For companies incorporated in New York, the law is more favorable on this point. Section 724
of the New York Code largely mandates indemnification in circumstances in which Delaware law
only makes it permissive and provides a specific procedure for an individual to go to court when a
corporation fails to provide indemnification.
38
12 C.F.R. §359.1(l).
39
12 C.F.R. §359.1(2).
40
Board of Governors of the Federal Reserve, “Guidance Regarding Indemnification Agreements
and Payments,” SR 02-17 (Jul. 8, 2002), avail. at
http://www.federalreserve.gov/boarddocs/srletters/2002/sr0217.htm
41
12 C.F.R. §545.121(c)(2).
42
In Bender v. Jordan, 623 F.3d 1128 (2010), the D.C. Circuit held that 12 C.F.R. §545.121 “does
not require a board of directors to indemnify directors and officers in any circumstances in which
the officers or directors have not received final judgment on the merits in their favor” and that the
regulation “creates no general entitlement to indemnification … where the board of directors does
not consider the determinations necessary to create a permissive entitlement.” In that case, the
company had not adopted by-laws addressing indemnification and the company’s new board
declined to provide it.
43
See, e.g., Consent Order in SEC v. Philip A. Falcone, et al., 12 Civ 5027 (S.D.N.Y. August
2013) (“The Harbinger Defendants agree that they shall not seek or accept, directly or indirectly,
reimbursement or indemnification from any source, including, but not limited to, payment made
pursuant to any insurance policy, with regard to any civil penalty amounts that each Harbinger
Defendant pays pursuant to the Final Consent Judgment….”); In the Matter of Stephen A.
Odland, Securities Exchange Act Rel. No. 63153 (Oct. 21, 2010) (“Respondent agrees that he
shall not seek or accept, directly or indirectly, reimbursement or indemnification from any
source… with regard to any amounts that Respondent shall pay pursuant to this Order”); SEC v.
Richard M. Scrushy, SEC Lit. Rel. No. 20084 (Apr. 23, 2007) (Defendant has “agreed to refrain
from seeking indemnification or reimbursement from any third-party for any part of the $81 million
required by the Final Judgment”); Press Release 2003-56, “The SEC, NASD, and the NYSE
16
Surviving in an Age of Individual Accountability: How Much
Protection Do Indemnification and D&O Insurance
Provide?
Permanently Bar Henry Blodget from the Securities Industry and Require $4 Million Payment,”
(Apr. 28, 2003) (Respondent “has agreed that he will not seek reimbursement or indemnification
for the penalties he pays.”).
44
Globus v. Law Research Service, Inc., 418 F.2d 1276 (2d Cir. 1969), cert. denied, 397 U.S.
913 (1970) held, in the context of a finding of Securities Act violations based on alleged
knowledge of material misrepresentations, that indemnification against securities law liabilities
was void as a matter of public policy. Exactly how far Globus extends is not entirely clear.
Courts have held that a wrongdoer cannot enforce a contractual right to indemnification under the
federal securities laws. E.g., Eichenholtz v. Brennan, 52 F.3d 478, 483-85 (3d Cir. 1995);
Franklin v. Kaypro Corp., 884 F.2d 1222, 1232 (9th Cir. 1989); Baker, Watts & Co. v. Miles &
Stockbridge, 876 F.2d 1101, 1108 (4th Cir. 1989). On the other hand, courts have held that “one
who is not at fault may enforce a contractual agreement for the indemnification of expenses
incurred in the successful defense of securities laws claims.” Credit Suisse First Boston, LLC v.
Intershop Communications AG, 407 F. Supp.2d 541, 548 (S.D.N.Y. 2006). It is not clear how a
particular court would come out on a request for indemnification by an officer or director who
settled an SEC case without any adjudication of liability but was found by a committee of
disinterested directors or by independent counsel not to have engaged in conduct that violated
the securities laws or to have acted in good faith with a reasonable belief that his or her conduct
was in the best interests of the corporation.
45
E.g., In the Matter of Fidelity Mortgage Corp. and Mark Figert, CFPB File No. 2014-CFPB-0001
(Consent Order).
46
E.g., Consent Order in SEC v. Philip A. Falcone, et al., 12 Civ. 5027 (S.D.N.Y. Aug. 16, 2013);
Consent Order, In the Matter of Fidelity Mortgage Corp. and Mark Figert, CFPB Admin
Proceeding File No. 2014-CFPB-0001 (Jan. 16, 2014); Stipulated Final Judgment and Order,
CFPB v. Castle & Cooke Mortgage, LLC, et al., Case No. 2:13CV684DAK (Nov. 7, 2013);
Stipulated Final Judgment and Consent Order in CFPB v. Meracord LLC and Linda Remsberg,
Case No. 3:13-cv-05871 (W.D. Wash. Oct. 4, 2013).
47
For a more detailed discussion of issues that arise in connection with directors and officers
liability insurance, including issues related to coverage of regulatory investigations and
proceedings, see Section 6.01, “Directors and Officers Liability Insurance,” in Eisenberg (editor),
Litigating Securities Class Actions (Matthew Bender 2013). The publication is available online on
Lexis/Nexis.
48
See, e.g., In re Allied Digital Technologies Corp., 306 B.R. 505, 510 (Del. 2004).
49
See J.P. Morgan Sec. Inc. v. Vigilant Ins. Co., 2014 NY Slip Op. 50284(U) (N.Y. Sup., New
York County Feb. 28, 2014).
50
Id.
51
See In re HealthSouth Corp. Ins. Litigation, 308 F. Supp.2d 1253, 1261 (N.D. Ala. 2004).
52
In the Matter of Bear, Stearns & Co., Inc., Securities Act Rel. No. 8668 (Mar. 16, 2006).
53
J.P. Morgan Securities Inc. v. Vigilant Ins. Co., 21 N.Y.3d 324, 336, 992 N.E.2d 1076 (N.Y.
2013).
54
J.P. Morgan Sec. Inc. v. Vigilant Ins. Co., supra fn 49.
55
FDIC, FIL-47-2013, “Director and Officer Liability Insurance Policies, Exclusions, and
Indemnification for Civil Money Penalties,” (Oct. 10, 2013), avail. at
http://www.fdic.gov/news/news/financial/2013/fil13047.pdf.
56
Consent Order in SEC v. Falcone, et al., at§3, avail. at
http://www.sec.gov/litigation/litreleases/2013/consent-pr2013-159.pdf.
57
E.g., Stipulated Final Judgment and Order in CFPB v. American Debt Settlement Solutions,
Inc. and Michael Dipanni, Case No. 9:13-cv-80548 (S.D. Fla. June 7, 2013).
58
E.g., Stipulated Final Judgment and order in CFPB v. Castle & Cooke Mortgage, LLC., et al.,
No. 2:13CV684DAK (D. Utah. Nov. 7, 2013).
17