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To Indemnify or Not to Indemnify
Have You Asked The Relevant Corporate Bylaw and D&O Insurance Questions?
By Rebecca M. Lamberth and John C. Tanner
When was the last time someone took a look at your company’s corporate bylaw provisions governing the scope and extent of its indemnification obligations to current and former directors and officers? What about related indemnity policies with your directors, or indemnification provisions in the employment agreements with senior officers?
In the case of public companies, someone may have done so fairly recently in light of renewed concerns about whether and how today’s public corporations can continue to attract qualified candidates for vacant board of director and senior management positions. In the wake of stunning corporate scandals and a seemingly unprecedented level of governmental regulation and enforcement scrutiny, such concerns have certainly been widely discussed. Thus, in-house counsel may have revisited provisions governing the company’s indemnification obligations to ensure that they are drafted as broadly as is legally permissible.
In so doing, however, was a review also performed of the company’s current D&O insurance policy? And did anyone consider the interplay between the two? If not, perhaps someone should. Consider the following scenario.
Advancement May Be Legally Required for Guilty Parties
A securities lawsuit has been filed against your company and against various of the company’s current and former directors and officers. In response, the company notifies its insurance carrier of the lawsuit, and the carrier agrees to provide coverage subject to a fairly standard reservation of rights letter. In the course of defending against the lawsuit, the company then advances defense costs on behalf of the individual defendants pursuant to broad and fairly typical indemnification provisions in the corporate bylaws and elsewhere. At the same time or shortly thereafter, one or more governmental agencies begin an investigation of the same events at issue in the civil action.
One of the named individual defendants - the former CFO - ultimately strikes a deal with the investigating enforcement agency, agreeing to plead guilty to one count of securities fraud and to cooperate with the government’s on-going investigation of the company and the events in litigation. Immediately thereafter, the company notifies the former CFO that it will no longer advance defense costs on her behalf. Likewise, the insurance carrier (perhaps with full support from the current directors and officers who would prefer not to share the limited pool of insurance proceeds with someone who has just pled guilty) notifies the former CFO that it is denying coverage based on the D&O policy’s fraud exclusion.
Additional litigation ensues in which the former CFO seeks, in the first instance, to force the company to continue advancing defense costs on her behalf, and secondly, to force the company’s D&O carrier to continue funding those defense costs because no final judgment has yet been entered in the criminal proceedings against the former CFO - and will not be until her testimony has been given and its effect on her sentencing has been determined.
Broad Indemnification and Insurance Provisions May Inadvertently Protect Culpable Parties
Typical D&O policy language requires the carrier to advance, “excess of any applicable retention amount, covered Defense Costs” prior to the final disposition of any claim. It is also typical that such a policy will contain a fraud exclusion-excluding liability by the carrier for the advancement of defense costs-in the event that “a judgment or final adjudication” establishes in fact that fraudulent conduct has occurred.
Recent court rulings indicate that a D&O carrier’s obligation to advance defense costs may continue despite the entry of a formal guilty plea by a corporate defendant. See Great American Insurance Co. v. Gross, 2005 WL 1048752 (E.D. Va. May 3, 2005). As a result, many carriers are moving away from “final adjudication” fraud exclusion wording-in some cases with the blessing of their insureds-to arm the carriers with the ability to exclude bad actors while preserving coverage for other, innocent parties.
While a desire to prevent erosion of coverage by guilty parties is appealing, give careful consideration to how your corporate indemnification and advancement obligations may interact with your D&O insurance. In many cases, the corporate bylaws mandate advancement of defense expenses prior to a final adjudication that indemnification is improper. Broad advancement provisions thus may dictate continued advancement of defense costs by your company even in the face of criminal guilty pleas. See Bergonzi v. Rite Aid Corp., 2003 WL 22407303 (Del. Ch. Oct. 20, 2003). In other words, your company’s advancement obligations to its former and current directors and officers may be broader than the negotiated fraud exclusion wording in your D&O policy.
The above example is merely one of several ways your corporate indemnification and advancement provisions may interact with your company’s D&O insurance. In the current legal environment, prudent counsel should undertake a fresh review of both in order to avoid surprise once litigation ensues.
Rebecca Lamberth is a partner of the law firm Alston & Bird, LLP and member of the firm’s Securities Litigation Group. She may be contacted at (404) 881-7000 or at firstname.lastname@example.org.
John Tanner is vice president & claims counsel for the Financial Services Division of insurance broker McGriff, Seibels & Williams, Inc., a wholly owned subsidiary of BB&T. He may be contacted at (404) 847-1607 or at email@example.com.