INDEMNIFICATION, EXCULPATION AND D&O INSURANCE … · Indemnification, Exculpation and D&O Insurance Protection of Governing Persons 1 I. Introduction Corporate directors, officers

INDEMNIFICATION, EXCULPATION AND D&O INSURANCE PROTECTION OF GOVERNING PERSONS

TOM D. HARRIS Haynes and Boone, LLP

901 Main Street, Suite 3100 Dallas, Texas 75202

214.651.5630 [email protected]

ERNEST MARTIN, JR. Haynes and Boone, LLP



State Bar of Texas 4TH ANNUAL ADVANCED BUSINESS LAW COURSE

October 26 - 27, 2006 Houston

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Partner Corporate/Securities Mergers and Acquisitions Dallas Office 901 Main Street Suite 3100 Dallas, TX 75202 Ph: 214.651.5630 Fax: 214.200.0464 Areas of Experience: Private Equity Mergers and Acquisitions Securities Transactions

Tom D. Harris [email protected] Tom has over 16 years’ experience in acquisitions, divestitures, securities transactions and other corporate matters. He has represented both buyers and sellers in public and private sale-of-business transactions and has represented both issuers and underwriters in securities transactions. He also has represented independent committees of boards of directors. Example transactions in which Tom has participated include his representation of: Affordable Residential Communities, Inc., in its pending acquisition of NLASCO,

Inc., and related financings.

The Special Transaction Committee of the Board of Directors of Texas Genco Holdings, Inc. in connection with the sale of the publicly-held interests in Texas Genco to GC Power Acquisition LLC, an entity owned by investment funds affiliated with The Blackstone Group, Hellman & Friedman LLC, Kohlberg Kravis Roberts & Co. L.P. and Texas Pacific Group.

The independent directors of two publicly-held companies in connection with each company’s recruitment and hiring of a new CEO.

Cardinal Investment Company, a private equity firm, in its leveraged acquisition of the assets of Furr’s Cafeterias out of bankruptcy, and its leveraged acquisition, and subsequent sale, of the steel drum reconditioning business of IFCO Industrial Container Systems.

Kennerly Capital L.L.C., a private equity firm, in its leveraged buyout and eventual sale of a plastic computer parts manufacturer, and its leveraged buyout and eventual sale of a leading manufacturer of hydraulic cranes for offshore use.

United Rentals, Inc., in more than 70 acquisitions.

Hitachi Consulting Corporation in its acquisition of Navigator Systems, Inc., Tactica Holdings, Inc. and WaveBend Solutions, L.L.C.

RadioShack Corporation in its entry into a joint venture with Microsoft Corporation.

The Dallas Center for the Performing Arts Foundation, Inc., in its public/private venture to design, finance and construct the Winspear Opera House, the Wyly Theatre, a parking garage and other improvements on City-owned property in the downtown Dallas Arts District.

The owners of the Dallas Stars hockey franchise in their creation of a venture involving the City of Dallas for the financing, construction and operation of American Airlines Center, the downtown Dallas hockey and basketball arena.

Education J.D., cum laude, Baylor University School of Law, 1989; Baylor Law Review, Executive Editor; B.B.A., Economics and Finance, cum laude, Baylor University, 1986 Memberships State Bar of Texas; Dallas Bar Association Judicial Clerkship Judge Jerre S. Williams, U. S. Court of Appeals for the Fifth Circuit, 1989-1990

Partner Insurance Coverage Dallas Office 901 Main Street Suite 3100 Dallas, TX 75202 Ph: 214.651.5641 Fax: 214.200.0519 Areas of Experience: Complex Insurance Coverage Litigation Environmental Coverage Claims Directors’ and Officers’ Liability Coverage Claims Property Damage and Business Interruption Claims General Liability Coverage Claims Bad Faith Claims

Ernest Martin, Jr. [email protected] Mr. Martin concentrates his practice in the areas of complex insurance coverage litigation, including environmental coverage claims, directors' and officers' liability coverage claims, securities coverage claims, property damage and business interruption claims, general liability coverage claims, and bad faith claims. His experience includes:

• Representing clients in multi-million dollar coverage litigation involving coverage related to:

o Directors and officers litigation o Environmental superfund clean-up and property damage claims o Toxic tort and lead poisoning claims o Construction defect claims o Product liability claims o Intellectual property claims o Business interruption claims o Employment-related claims o Sexual abuse claims o Nursing home wrongful death claims o Securities claims o Malicious prosecution claims

• Representing clients in disputes concerning coverage for major property damage claims.

• Representing clients in connection with claims for coverage for professional liability claims, including

legal malpractice.

• Representing clients in connection with bad faith claims related to alleged mishandling of coverage disputes.

Selected Professional and Business Activities:

• Co-founder of the Insurance Law Section of the State Bar of Texas, 1998. • Chair of the Insurance Law Section of the State Bar of Texas, 1998 to 2000.

• Chair of the Tort and Insurance Practice Section of the Dallas Bar Association, 2003.

• Council Member, Secretary, and Chair-Elect of the Tort and Insurance Practice Section of the Dallas Bar

Association, 1998-2003.

• Serving as the 2003 Chair and the 1999, 2000 and 2001 Co-Chair of the University of Texas Insurance Law Symposium.

• Serving as the 2004 Course Director of the Texas State Bar’s Advanced Insurance Law Seminar.

• Serving on various committees of the American Bar Association regarding insurance coverage, including Chair of the D&O Insurance Subcommittee, 2002-2004.

• Adjunct Professor of Law (Insurance) at Southern Methodist University (Dedman) School of Law, Fall 2000, Spring 2002, Spring 2003, Spring 2004, Spring 2005, and Fall 2005

Education J.D. University of California - Berkeley, 1987, Associate Editor, International Tax & Business Lawyer B.A. in Psychology and Legal Studies, Rice University, 1984 Memberships State Bar of Texas; Dallas Bar Association; American Bar Association; College of the State Bar of Texas; W.M. "Mac" Taylor, Jr. American Inn of Court

Honors

• Named Top Notch Lawyer in Insurance in Texas Lawyer’s Go-To-Guide, 2002 • Named in The Best Lawyers in America, 2005-2006 • Named Texas Super Lawyer in Texas Monthly, 2003, 2004, 2005 and 2006 • Named in Best Lawyers in America Guide, 2005 and 2006 • Named in Texas by Chambers USA Client’s Guide to America’s Leading Lawyers for Business as one of

the top insurance lawyers, 2004, 2005 and 2006 Online Publications

• A Corporate Counsel's Guide to the Basics and Trends in D&O Insurance • A KINGLY DECISION: Insurance Coverage Is in the Eye of the Insured Beholder • A New Frontier: Article 21.55 and the Duty to Defend • A Policyholder’s Paradise Lost? An Insured’s Perspective on the Insurability of Punitive Damages • ADR With Coverage in Mind: Making the Most of Your Policy Dollars • An Attorney’s Guide to the Basics and Trends in D&O Insurance • Article 21.21 and Other Statutory Claims: Staying on Top of New Developments • CGL Policies: Exploring the Battlefields of Coverage • Coverage for Vicarious and Derivative Liability Under Texas Law • D&O Insurance Coverage: Surviving the Turmoil (Lessons We Are Learning from Enron) • Exploring the Battlefields of Statutory Claims Against Insurers • HOT CGL TOPICS - Can Insurers Get Their Settlement Dollars Back? • Insurance: The Basics for Directors and Officers of Non-Profit Organizations • Remedies for an Insurer’s Breach of the Duty to Defend: A Policyholder’s Perspective • The Relationship Between Primary and Excess Insurers • What Every Corporate Counsel Needs to Know About Insurance Coverage • What Every Franchise Lawyer Needs to Know About Insurance • Finding Leverage Against the Insurer: Article 21.55 • “Hi, I’m Your Lawyer: We Haven’t Met”: When May an Insured Select its Own Counsel? • Insurance Coverage for the New Breed of Internet-Related Trademark Infringement Claims • Extra-Contractual Claims After Traver and Rocor: A Policyholder’s Perspective • Recent Texas Insurance Developments: What Every In-House Counsel Should Know • Hot Tips on Managing the Liability Crisis Through Insurance • D&O Top Ten Checklist • An Examination of Whether a Fiduciary Relationship Exists Between an Insured and its Broker • Texas Supreme Court Recognizes Insurance Company’s Right to Recoup Settlement Payments from

Policyholders • Surviving the D&O Turmoil; Maximizing Protection for the Non-Profit and its Directors and Officers • In the Wake of Spitzer: An Examination of Whether a Fiduciary Relationship Exists Between an Insured

and its Broker Under Texas Law • Fallout From Disasters: Recovering Business Losses

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TABLE OF CONTENTS

I. Introduction.......................................................................................................................1

II. Indemnification and Advancement of Expenses ............................................................1 A. Statutory Provisions; Constituent Documents.........................................................1

1. Mandatory Indemnification...............................................................................1 2. Permissive Indemnification...............................................................................2

a. Standard for Indemnifiable Conduct..........................................................2 b. Additional Standard for Derivative Actions ..............................................2

3. Persons Covered................................................................................................3 4. Determination of Eligibility ..............................................................................3 5. Effect of Judgment, Settlement, Etc..................................................................3 6. Advancement of Expenses ................................................................................3

B. Indemnification Agreements ...................................................................................4

C. Drafting Effective Indemnification Agreements.....................................................5 1. Terms.................................................................................................................5 2. Proceedings .......................................................................................................5 3. Standard of Conduct..........................................................................................6 4. Determination that the Standard Has Been Met................................................6 5. Indemnification Agreement Mandatory Payment .............................................6 6. Indemnification Agreement Advancement of Expenses ...................................6 7. Fees on Fees ......................................................................................................7 8. Indemnification Procedure ................................................................................7 9. Exclusivity.........................................................................................................7 10. Enforcing the Agreement ..................................................................................7 11. Limitations on Indemnification.........................................................................7 12. Selection of Counsel..........................................................................................7 13. Potential Shareholder Approval ........................................................................8

III. Exculpation........................................................................................................................8

IV. D&O Insurance .................................................................................................................9

V. Understanding the Basics of D&O Insurance ................................................................9 A. The Insuring Clause of the Policy: The Heart of the Policy ...................................9

1. Individual Director and Officer Coverage ........................................................9 2. Corporate Indemnity Reimbursement Coverage...............................................9 3. Corporate Entity Coverage................................................................................9

B. The Important Distinction Between “Claims-Made” Policies and “Occurrence” Policies .................................................................................................................10

C. What Is A “Claim” and How Broadly Is It Defined Under the D&O Policy?......11

D. Other Important Definitions in the D&O Policy...................................................11 1. The Definition of the Individual Insured.........................................................11 2. The Definition of “Insured” ............................................................................12 3. The Definition of “Loss”.................................................................................12

E. Defense Provisions of the D&O Policy.................................................................12

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1. No Duty to Defend ..........................................................................................12 2. Defense Costs Are Included Within the Policy Limit.....................................12 3. Advancement of Defense Costs ......................................................................12

F. Identifying Key Exclusions and Reducing Their Impact ......................................13 1. The “Bad Conduct” Type Exclusions .............................................................13

a. “Final adjudication” language..................................................................13 b. “Illegal profit” exclusions ........................................................................13

2. The “Insured v. Insured” Exclusion ................................................................14

G. The Insured’s Key Responsibilities: Notification and Cooperation......................15 1. Reporting the Claim ........................................................................................15

H. The Policy Application: An Integral Part of the Policy ........................................16

VI. Understanding Emerging Issues Under the D&O Policy............................................16 A. Bankruptcy’s Effect on D&O Coverage ...............................................................16

1. Purchase a Policy With No “Entity” Coverage...............................................17 2. Insist on a “Priority of Payments” Provision in the Policy .............................17 3. Insist on a “Bankruptcy” Clause in the D&O Policy ......................................18 4. Make Sure the Policy Contains a Modified “Insured v. Insured” Exclusion ..18

B. Misrepresentation in the Application ....................................................................19 1. In Order to Prevail on a Misrepresentation Defense in Texas, an Insurer Must

Prove That the Insured Intended to Deceive ...................................................19 2. Will an Innocent Director be Entitled to Coverage When Another Director Makes

a Material Misrepresentation in the Application? ...........................................19 a. Cutter & Buck Inc. v. Genesis Ins. Co., 2005 WL 1799397 (9th Cir. Aug. 1,

2005). .......................................................................................................20 b. In re HealthSouth Corp. Ins. Litig., 308 F. Supp. 2d 1253 (N.D. Ala. 2004).

..................................................................................................................20 c. Federal Ins. Co. v. Tyco International Ltd., 2004 WL 583829 (N.Y. Sup. Ct.

2004). .......................................................................................................20

C. The Impact of the Sarbanes-Oxley Act on D&O Insurance..................................21 1. Sarbanes-Oxley Act Requirements. ................................................................21

a. Certification Requirements. .....................................................................21 b. Increased Audit Committee Duties..........................................................21 c. Corporate Governance Issues. .................................................................21 d. Criminal Penalties....................................................................................22

2. Increased Liability Exposure...........................................................................22 a. Breach of Fiduciary Duty Claims. ...........................................................22 b. Securities Fraud Claims. ..........................................................................22 c. Unfitness Claims......................................................................................22 d. Compensation Forfeiture. ........................................................................23 e. Certification Violations............................................................................23

3. Potential Implications of the Sarbanes-Oxley Act on D&O Insurance Coverage. 23 a. Will A Claim for Violation of the Sarbanes-Oxley Act Satisfy the Policy

Definition of “Loss.”................................................................................23 b. Coverage for Criminal Proceedings.........................................................23 c. The Fraud/Dishonesty Exclusion.............................................................23

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d. The Personal Profit Exclusion. ................................................................23 e. Insured v. Insured Exclusion....................................................................23 f. Rescission of Policies. .............................................................................24

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Indemnification, Exculpation and D&O Insurance Protection of Governing Persons 1

I. Introduction

Corporate directors, officers and other governing persons can incur substantial liability in performing their obligations to the companies they serve. As fiduciaries, corporate directors and officers owe two primary duties—the duty of loyalty (perhaps coupled with the duty of good faith) and the duty of care. The duty of loyalty, stated broadly, obligates governing persons to put the interests of the company ahead of their personal interests—to refrain from self-dealing. The duty of care generally obligates governing persons to act with the care that a reasonable person in a like position would believe to be appropriate. Violation of either the duty of loyalty or the duty of ordinary care can expose governing persons to personal liability. Governing Persons also can incur personal liability other than through breaches of fiduciary duties—for example, as a result of violations of federal or state laws such as securities statutes and regulations.

As a counter-weight to potential liability for breaches of the duty of care, the business judgment rule generally will preclude liability in circumstances where a business judgment, not involving self-dealing, turns out to be a mistake. Moreover, a company may be able to further limit claims against its directors and officers for breach of the duty of due care by adopting optional exculpatory language to the extent permitted under the applicable State statute.

Notwithstanding the apparent protections afforded by the business judgment rule and by exculpation provisions, however, derivative and class action suits asserting claims against directors and officers have produced large judgments and settlements in recent years. The year 2005 was particularly notable for securities case settlements. First, the year included announcements of two of the largest securities case settlements in history. The total settlement in the WorldCom case exceeded $6.1 billion, while the total settlement fund in the Enron matter reached approximately $7.1 billion. Moreover, both settlements included payments from outside directors’ personal assets. Even excluding these two case settlements, the total value of cases settled during the year grew to an all-time high of $2.5 billion. In addition, median and average settlement amounts reached unprecedented

1 Special thanks to Charles C. Keeble, Jr., Stett Matthew Jacoby, Micah Skidmore and Tom Tippetts for their contributions to this paper.

levels. Cornerstone Research, Post-Reform Act Securities Settlements (2006), available at http://securities.stanford.edu/Settlements/ REVIEW_1995-2005/Settlements_Through_12_2005_ PR.pdf.

Against this backdrop of potential liability, however, governing persons have important protections that, in practice, serve to assure these individuals that they can serve their business organizations without undue concern about personal liability. These protections include indemnification, advancement of expenses, exculpation and directors and officers (“D&O”) liability insurance.

II. Indemnification and Advancement of Expenses

A. Statutory Provisions; Constituent Documents

All States have adopted statutory provisions that provide for (sometimes expansive) indemnification rights for directors and officers. The following overview of the Texas and Delaware statutes illustrates the issues involved in indemnification of corporate directors and officers and may facilitate interpretation of indemnification provisions in other States. It is important, however, to consult the specific statutory language of the State of incorporation as there often are subtle but substantial variations from State to State. 1. Mandatory Indemnification

The Delaware indemnification statute mandates that the corporation indemnify directors and officers against expenses if the director or officer has been successful “on the merits or otherwise” in defending the action against him or her. DEL. CODE ANN. tit. 8, § 145(c) (2006). The Texas statute mandates that the corporation indemnify on the same basis, with the exception that it extends protection to “a governing person, former governing person, or delegate.” TEX. BUS. ORG. CODE § 8.051(a) (West 2006). The Texas Business Corporation Act, however, limits mandatory protection to directors and officers. TEX. BUS. CORP. ACT art. 2.02-1(H) & (O) (West 2006).

The “on the merits or otherwise” language means that if an action is dismissed with prejudice on procedural grounds, such as by application of a statute of limitations, the governing person will be entitled to indemnification. This language also contemplates dismissal in connection with a negotiated settlement, when dismissal is with prejudice and no payment or admission of liability is made. Dismissal without prejudice generally will not trigger mandatory indemnification.

The Texas and Delaware statutes differ, however, regarding what constitutes “success.” Delaware’s statute requires indemnification “[t]o the extent that a .

Indemnification, Exculpation and D&O Insurance Protection of Governing Persons Chapter 7

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. . director or officer . . . has been successful on the merits or otherwise.” DEL. CODE ANN. § 145(c). “To the extent . . . successful” has been construed to mean that partial success justifies partial indemnification. Merritt-Chapman & Scott Corp v. Wolfson, 321 A.2d 138, 141 (Del. 1974). In contrast, the Texas statute follows the Model Business Corporation Act in requiring the governing person to be “wholly successful.” Compare TEX. BUS. ORG. CODE § 8.051(a) and MODEL BUS. CORP ACT. § 8.52. The official comment to the Model Act states that “wholly” was added to preclude the result reached in Delaware, with the intent that the entire proceeding must be decided on a basis or ground involving a finding of nonliability. Id. If any claims or charges remain, mandatory indemnification will not be triggered. Cf. Bayliss v. Cernock, 773 S.W.2d 384, 386-87 (Tex. Ct. App. 1989) (finding a director to be “wholly successful” when his name had been deleted from an amended petition before trial thereby dismissing him from suit).

Another difference between the Texas and Delaware statutes involves the power a company has to opt out of mandatory indemnification. Under the Texas statute, a company may, through its articles of incorporation, “restrict the circumstances under which [it] must or may indemnify … a person” under the statute. TEX. BUS. ORG. CODE § 8.003(a). Delaware, on the other hand, does not allow a company to opt out of mandatory indemnification through its articles of incorporation or otherwise. DEL. CODE ANN. § 145(c); Witco Corp. v. Beekuis, 38 F.3d 682 (3rd Cir. 1994). 2. Permissive Indemnification

As discussed above, the Delaware and Texas statutes generally require indemnification when a governing person is exonerated of wrongdoing. However, when a governing person has not been exonerated, the governing person may nonetheless be entitled to indemnification based on the terms of the corporation’s constituent documents (articles, bylaws, limited liability company agreement or comparable document). Both the Texas and Delaware statutes allow a corporation to establish standards for determining when indemnification will be made available to its governing persons (in situations other than the mandatory instances discussed above). DEL. CODE ANN. § 145(c); TEX. BUS. ORG. CODE § 8.101(a). Because the Texas statute allows a corporation to restrict mandatory indemnification, however, the Texas statute actually provides corporations more control over indemnification in all circumstances—because a corporation’s articles could provide that indemnification would not be available even to a director who had been wholly successful on the merits of a matter.

a. Standard for Indemnifiable Conduct. A corporation has discretion to honor a commitment to permissive indemnification only when it properly determines that the governing person’s actions satisfied a baseline statutory standard for indemnification. To be eligible for indemnification under Delaware’s permission provisions, the person seeking indemnification must have 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, and, with respect to any criminal action or proceeding, had no reasonable cause to believe the person’s conduct was unlawful.” DEL. CODE ANN. § 145(a). Similarly, in Texas, the person seeking indemnification must have “(A) acted in good faith; (B) reasonably believed: (i) in the case of conduct in the person’s official capacity, that the person’s conduct was in the enterprise’s best interests; and in any other case, that the person’s conduct was not opposed to the enterprise’s best interests and in the case of a criminal proceeding, did not have a reasonable cause to believe the person’s conduct was unlawful.” TEX BUS. ORG. CODE § 8.101. b. Additional Standard for Derivative Actions. Shareholder derivative actions represent another limit to the discretionary latitude afforded corporations under the statutory permissive indemnification rules. Shareholder derivative actions are actions brought by a shareholder on behalf of a corporation. The Delaware statute, however, prohibits indemnification where the officer or director is unsuccessful in defending a derivative action and is adjudged liable to the corporation. DEL. CODE ANN. § 145(b). Notwithstanding the prohibition, courts are given discretionary authority to allow indemnification in such a situation where the court determines, in view of all the circumstances, that the officer or director is fairly and reasonably entitled to indemnity. Id.

The shareholder derivative action is also a special case in Texas. Under the Texas statute, indemnification of a person who is found liable to the corporation (or is found liable because the person improperly received a personal benefit) is limited to reasonable expenses incurred by the person in connection with the proceeding. TEX BUS. ORG. CODE § 8.102. Moreover, this exception of allowing indemnification for reasonable expenses is applicable only where the person has not been found liable for willful or intentional misconduct, a breach of the duty of loyalty owed by the person to the corporation, or an act or omission not committed in good faith that constitutes a duty owed to the corporation. Id. Thus, in both Delaware and Texas, a separate statutory standard applies with respect to permissive indeminification for derivate actions.

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3. Persons Covered The Delaware statute allows corporations to

extend permissive indemnity protection to a broad range of corporate actors—including any present or past director, officer, employee, or agent of the company involved in a proceeding by reason of the fact that such person is or was serving in such capacity. DEL. CODE ANN. § 145(a). In addition, the statute reaches any person who serves at the request of the company as a director, officer, employee, or agent of another company. The statute also encompasses service for an employee benefit plan and provides that the protections of the statue will extend to the covered person’s heirs, executors, and administrators. § 145(i)-(j). The Texas statute contains substantially similar provisions. See TEX. BUS. ORG. CODE §§ 8.001, 8.051, 8.101, 8.105. 4. Determination of Eligibility

Under both the Delaware and Texas statutes, the permissive indemnification must be triggered by an affirmative determination that the governing person has met the required standard of conduct.

Under the Delaware statute, a governing person may be determined to be eligible for indemnification by any of the following mechanisms:

• By a majority vote of the directors who are not named parties in the proceeding at issue, even if less than a quorum;

• By a committee of such directors designated by majority vote of such directors even though less than a quorum; or

• If there are not such directors, or if such directors so direct, by independent legal counsel in a written opinion; or

• By a majority vote of the stockholders. Del. Code Ann. § 145(d). Under the Texas statute, this determination may

be made by any of the following: • By a majority of directors, who at the time

are disinterested and independent; • By a majority vote of a committee that is

designated by a majority vote of directors who at the time are disinterested and independent, regardless of whether the directors who are disinterested and independent constitute a quorum, so long as at least one member of the committee is disinterested and independent;

• By special legal counsel selected by the board of directors or selected by a committee of the board of directors in accordance with the foregoing items;

• By a majority vote of the shareholders in a vote that excludes the shares held by

directors who are not disinterested and independent; or

• By a unanimous vote of shareholders. Tex. Bus. Org. Code § 8.103(a). The Delaware statute and the Texas statute are

substantially similar, with the exception that the Delaware statute refers to directors who are not named parties to the action, as opposed to the Texas statute, which refers to disinterested and independent directors. Thus, the Texas statute would appear to be more restrictive about when a director can participate in a determination regarding permissive indemnification. Please note, however, that the former Texas Business Corporation Act, under which many companies still operate, continues to refer to directors who are not named parties. TEX. BUS. CORP. ACT art. 2.02-1(F). 5. Effect of Judgment, Settlement, Etc.

Under both Delaware and Texas law, eligibility for indemnification is not foreclosed by a judgment or order against the defendant, by settlement of the case, by conviction or be a plea of nolo contendere. DEL. CODE ANN. § 145(a); TEX. BUS. ORG. CODE § 8.101(d). Moreover, both statutes permit a court to order indemnification. DEL. CODE ANN. § 145(d); TEX. BUS. ORG. CODE § 8.052. 6. Advancement of Expenses

Indemnification generally is understood to mean payment for judgments, settlements and expenses incurred in defending claims. Advancement of expenses, however, generally refers to payments made by an indemnitor prior to the ultimate resolution of the matter by judgment or settlement. As a practical matter, advancement of expenses often is more important to governing persons than ultimate indemnification. This is because the on-going cost to conduct a robust defense against claims of malfeasance or misfeasance typically is substantial. Many governing persons simply cannot afford to effectively defend a complicated matter without accessing the company’s resources. Indemnifying organizations often perceive advancement of expenses (and the resulting effective defense of underlying claims) as benefiting the organization, because the defense may prevent a governing person from suffering a substantial adverse judgment or seeking a settlement that would be adverse to the organization’s interests.

Under Delaware and Texas law, advancement of expenses typically is deemed to be independent from ultimate indemnification for legal fees. This is true even if repayment of advanced expenses may ultimately turn on a determination whether the governing person actually was entitled to indemnification. Indeed, advancement of expenses is a summary matter that will often be decided by a court


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before the determination of a party’s indemnification rights on the merits.

Delaware law permits a corporation to advance expenses upon receipt of an undertaking by the officer to repay if it is later determined that the officer is not entitled to indemnification. DEL. CODE ANN. § 145(e). A corporation’s constituent documents may provide for automatic, mandatory advancement of expenses upon receipt of such an undertaking. Alternatively, the constituent documents may outline specific procedures and circumstances (for example, the furnishing of securities for repayment), in addition to the receipt of an undertaking. If the constituent documents are silent regarding advancement of expenses, the corporation, when faced with an undertaking and a demand for advancement, is required to determine whether the proffered undertaking is sufficient to protect the corporation’s interest in repaying and whether the advancement would promote the corporations interests. See Haven v. Attar, C.A. No. 15134, 1997 WL 55957, at *34 (Del Ch. Jan. 30, 1997).

Texas law is substantially similar. The statute allows a corporation to provide in its constituent documents for the advancement of expenses upon receipt of a written affirmation by the director. TEX. BUS. ORG.CODE § 8.104. The director or officer must affirm his good faith belief that he has met the standard of conduct necessary for indemnification. The director or officer, or someone on his behalf, must provide a written undertaking to repay the advanced amounts if it is ultimately determined that: (1) he has not met the applicable standard for indemnification, or (2) he is ineligible for indemnification because he has been found liable for willful or intentional misconduct in his performance of his duty to the corporation. Id. The undertaking to repay need not be secured, and may be accepted without reference to any financial ability to make repayment. Id.

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RECENT DEVELOPMENTS: Advancement of Expenses and

Sarbanes-Oxley’s Prohibition on Personal Loans to Directors and Officers

Until recently, there has been concern that

advancement of expenses could be an issue under the Sarbanes-Oxley Act of 2002. At least one recent federal court decision, however, appears to have settled this issue. See Envirokare Tech, Inc. v. Pappas, No. 05 Civ. 5515 (S.D.N.Y. March 10, 2006). The question was whether advancement of expenses (in this case under an indemnification agreement) could constitute the type of personal loan that is prohibited under Section 402 of the Sarbanes-Oxley Act. The

Envirokare court determined that § 402 of the Act does not prohibit a company from advancing defense costs to its directors or officers as those costs are incurred even though the advances are repayable if indemnification were ultimately held to be unavailable. Id. The court did not attempt to define what a “personal loan” under § 402 means, but it held that the advancement of defense costs in this context did not fall within the term. The court reasoned that nothing within the legislative history of Sarbanes-Oxley indicated that the advancement of indemnifiable defense costs under State law was one of the abuses Congress intended to address.

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B. Indemnification Agreements In addition to the statutory provisions outlining

indemnification and advancement of expenses, States generally permit corporations to supplement and extend indemnification rights through indemnification agreements, as well as through provisions in their constituent documents. A company may utilize indemnification agreements to affirm statutory benefits, to clarify certain procedural issues that may not be dealt with specifically through the applicable statute, and to provide its governing persons with greater certainty about their rights to indemnification and advancement of expenses.

The Delaware statute includes a nonexclusivity provision, which provides that the indemnification and advancement of expenses provisions “shall not be deemed exclusive of any other rights to which those seeking indemnification or advancement of expense may be entitled under any bylaw, agreement, vote of stockholders or disinterested directors or otherwise.” DEL. CODE ANN. § 145(f). A somewhat narrower provision in Texas provides that indemnification provisions contained in constituent documents, or an indemnification agreement that satisfies the standard of conduct provided by statute, should be enforced even though the provision may not have or been authorized in the manner required by statute. TEX. BUS. ORG. CODE § 8.103(c).

Governing persons often view additional indemnification rights as having greater or lesser value, primarily based on the vehicle through which the additional rights are granted. For example, amendments to articles of incorporation typically require shareholder approval (which often is a burdensome or uncertain process), while bylaws generally may be more easily adopted, modified or appealed through a resolution adopted by the corporation’s Board. Some corporations include indemnification language in both their articles of incorporation and their bylaws. In some cases, this


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approach is used to enshrine fundamental indemnification terms in the articles of incorporation (which are more difficult to amend) and procedural or other specific indemnification terms in the bylaws (which are easier to modify). Governing person uncertainty about the permanence of indemnification and advancement of expenses provisions in constituent documents can be addressed in part by providing that any modification, amendment or repeal of any such provision—in a way that would limit or reduce the rights previously granted—will have only prospective (and not retrospective) effect.

An individual indemnification agreement often is viewed by governing persons as providing the greatest certainty of indemnification and advancement of expenses for a governing person. An individual indemnification agreement creates individually-enforceable contractual rights that normally cannot be modified without the indemnitee’s consent. In addition, individual indemnification agreements typically provide greater detail regarding the means through which an individual can obtain indemnification and advancement of expenses. For these reasons, governing persons often view individual indemnification agreements as being superior to general indemnification rights under statute or constituent documents. This is especially true where the indemnifying organization is considered a likely candidate for a change of control.

Considerations in determining the appropriateness of an indemnification agreement include the following:

• The financial position of the company; • Whether the applicable indemnity statute is

“non-exclusive;” • Company or industry exposure to litigation

risk; • Whether an indemnification agreement

would serve to better attract and retain qualified persons;

• The probability of a change of control; and • The possibility of a bankruptcy by the

indemnifying organization (in which case there may be a procedural advantage in having a separate indemnification agreement rather than relying on the company’s constituent documents).

Texas courts will interpret indemnification agreements in accordance with the normal rules of contract construction. See, e.g., Gulf Ins. Co. v. Burns Motors, Inc., 22 S.W.3d 417, 423 (Tex. 2000); Assoc. Indem. Corp. v. Cat Contracting, Inc., 964 S.W.2d 276, 284 (Tex. 1998). If any ambiguity remains as to the parties’ intent, Texas courts will strictly construe the indemnification agreement in favor of the indemnitor to prevent any liability from being extended

beyond the terms of the agreement. Ohio Oil Co. v. Smith, 375 S.W.2d 621, 627 (Tex. 1963), overruled on other grounds by Ethyl Corp. v. Daniel Construction Co., 490 S.W.2d 818 (Tex. 1972). Moreover, drafters should note that specific contract provisions may be a better indication of the parties’ intent than general provisions, and therefore may be more likely to be enforced. C. Drafting Effective Indemnification Agreements

In addition to the normal rules of contract construction, drafters of indemnification agreements should carefully consider a number of specific terms and provisions. At the outset, the agreement should recite the consideration to be provided by the director or officer in exchange for the indemnification rights created in the agreement. This consideration typically is the service or continuing service of the officer or director. 1. Terms. The agreement should clearly state who will be the indemnitor (and care should be given by the governing person to determine whether the indemnitor is the appropriate entity—for example, a parent of a subsidiary if the subsidiary does not have substantial assets). The governing person also should take care to ensure there is appropriate indemnification for service as a fiduciary of an employee benefit plan or trust—either through a separate indemnification agreement for such benefit plan or trust or through the base indemnification agreement for the governing person’s service to the sponsoring company. 2. Proceedings. The agreement should specify the types of claims/matters the indemnitee will be indemnified against and the types of damages and expenses that will be covered. Indemnification can cover suits, actions, or proceeding by reasons of present and/or former status. In addition, various types of proceedings may be covered (for example, matters that are administrative, civil, criminal, investigative, legislative, as well as matters that are pending at the time of the agreement and/or matters arising in the future). It is also important to identify the types of damages, costs, fines, fees and expenses that will be covered in the indemnification (for example judgments and penalties, settlement costs, expenses reasonably and/or actually incurred, attorneys’ fees or excise taxes (for example, if employee benefit plan actions are indemnified)).

The agreement should specify the actions, if any, for which indemnification is prohibited (for example, a matter in which a court determines the indemnitee is not entitled to indemnification, or an action by or on behalf of the corporation). In addition it is advisable to provide the circumstances in which a settlement must be approved in advance by the company. The effect of termination of an action should also be stipulated and






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“termination” should be defined (for example by judgment, order, settlement, conviction, or plea of nolo contendere or its equivalent). 3. Standard of Conduct. A provision requiring that the indemnitee meet a specified standard of conduct should also be included. The language of the provision should closely track that of the statutory baseline—that is, it should require, at a minimum, that the indemnitee act in good faith and in a manner the indemnitee reasonably believed to be in (or not opposed to) the best interest of the corporation. Many indemnification agreements provide that the indemnitee is conclusively presumed to have met the required standard—and thus is deemed to be entitled to indemnification—unless the indemnitor demonstrates by clear and convincing evidence that the indemnitee failed to meet the standard. This shifts the burden of proof from the governing person to the company and creates a presumption that the governing person is entitled to indemnification unless the company meets the burden of proof.

With respect to the standard of conduct that will entitle a governing person to indemnification, the Securities and Exchange Commission has opposed indemnification on public policy grounds for damages incurred as a result of a violation of federal securities laws—without regard for whether the governing person’s conduct satisfied any test for good faith or reasonable belief about the actions being in (or not opposed to) the company’s best interests. The indemnifying party may wish to include a carve-out in the indemnification agreement for any matter in which the Securities and Exchange Commission (or any other governmental agency with jurisdiction) has advised the indemnifying party that such governmental authority views indemnification in such matter as inappropriate or illegal.

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RECENT DEVELOPMENTS: The Thompson Memo and Governmental

Pressure to Not Indemnify

In this context, it is also important to note a recent decision that appears to limit the government’s power to influence corporate indemnification policy by threats of indictment. In Stein v. United States, a federal court struck down the portion of a Department of Justice Memorandum (commonly referred to the “Thompson Memo”) that requires consideration of whether a company is paying for the attorney’s fees for its employees in determining whether the corporation was cooperating with the government. No. S1 05 Crim. 0888 (SDNY June 26, 2006) (slip op.). The court held that the provision violated the employee’s rights to a

fair trial and effective assistance of counsel under the 5th and 6th Amendment of the U.S. Constitution. The record showed that Department of Justice attorneys had warned the company’s counsel that advancement of legal fees for employees being investigated would be viewed as rewarding their misconduct and that if the company had any discretion in not paying fees, it’s action would be placed “under a microscope.”

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4. Determination that the Standard Has Been Met. The indemnification agreement should provide who determines whether the standard has been met. The indemnified party may request that if a change of control has occurred, this determination always be made by an independent party (for example, a law firm with no relationship with the indemnifying party, an independent arbitrator or a court). 5. Indemnification Agreement Mandatory Payment. Both the Delaware and Texas statutes mandate payments to directors and officers if a suit is defended successfully—on the merits or otherwise. Not all state statutes, however, include this broad mandatory indemnification for matters resolved on a procedural basis. See, e.g., CAL CORP CODE § 317(d) (2006). An indemnification agreement, however, generally may provide for indemnification for dismissals based on procedural grounds, (for example, due to the application of a statute of limitations). The company may wish to encourage the governing person to seek early resolution on procedural grounds, rather than incurring additional time and expense to obtain a decision on the merits. Also, recall that the “wholly successful” language (as included in the Texas statute) may preclude partial indemnification in instances where the indemnitee achieves only partial success on the merits; whereas “to the extent successful” may afford partial indemnification where there was partial success (as Delaware courts have determined). The indemnification agreement also can provide whether settlement of a claim against a director or officer constitutes “success on the merits or otherwise.” 6. Indemnification Agreement Advancement of Expenses. The indemnification agreement should provide whether expenses will be paid in advance and, if so, how often they must be paid and what documentation or other steps are required to trigger the advancement obligation. If the indemnitee has engaged his own counsel (under circumstances permitted by the indemnification agreement), the submission to the indemnitor of legal invoices (with detailed narratives of the actions being taken by the indemnitee’s counsel) could put the indemnitee’s attorney-client privilege at risk. Accordingly, the indemnification agreement occasionally will address


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this by providing the indemnitee can submit only summary invoices or invoices that state only “for legal services rendered” as the narrative. This may be coupled with a right of the indemnitee to inspect full invoices/narratives at the conclusion of the matter to determine if the indemnitor wishes to object to any items as unreasonable. 7. Fees on Fees. Drafters should understand the effect of provisions that obligate corporations to indemnify persons to the fullest extent permitted by the law of the State of incorporation. The Delaware Supreme Court held, in Stifel Financial Corp. v. Cochran, that fees incurred by a former director in successfully enforcing a right to indemnification were required to be paid by the corporation pursuant to such a provision, interpreting the provision to provide indemnification for anything not otherwise prohibited under Delaware law 809 A.2d 555 (Del. 2002). The court concluded that mandatory indemnification for “fees for fees” was permissible, because a corporation may indemnify directors for “fees for fees” under Delaware law. DEL. CODE ANN. § 145(a). The Court emphasize that a corporation must expressly exclude “fees for fees” if it does not intend for them to be covered. See also Weaver v. Zenimax Media, Inc., C.A. No. 20439-NC, 2004 WL 243163 (Del Ch. Jan. 30, 2004) (following Stifel and holding that plaintiff is entitled to fees on fees because the bylaws do not expressly exclude them). The Stifel Court holding overruled a line of cases taking the opposite position that if a corporation wanted to cover fees on fees, it must expressly state it in its bylaws.

Governing persons often negotiate to ensure they can be indemnified for fees on fees to ensure that after a change of control (when the company may wish to take a narrow view of its indemnification and advancement of expenses obligations to former governing persons), the company/indemnitor will be obligated for fees on fees if the company improperly denies indemnification/advancement, and the governing person then is forced to take action (funded by the governing person’s own resources) to enforce his rights under the indemnification agreement. 8. Indemnification Procedure. The agreement should require notification to the company by the Indemnitee of commencement of any proceeding. Moreover, the indemnification agreement should address whether a failure to notify will relieve the company of liability, and whether that result occurs only if the company loses significant, substantive, or procedural rights in defending the claim as a result of such failure. 9. Exclusivity. The indemnification agreement typically will provide that the rights granted thereunder are not exclusive of other rights under statutes, bylaws,

future agreement, or vote of stockholders or disinterested directors. This may benefit a governing person if it later were determined that for some reason the indemnification agreement was unenforceable. In this case, the governing person would want to receive the benefit of the other potential indemnification-authorizing alternatives (for example, provisions in constituent documents). 10. Enforcing the Agreement. Well crafted enforcement provisions also serve to eliminate uncertainties and reduce conflict. An enforcement mechanism should fix a time limit for payment of claims and authorize the indmenitee to bring suit against the company for expenses, if the claim remains unpaid. Also, the indemnification agreement should provide whether the company must provide security to the indemnitee for the company’s obligations under the agreement by means of a irrevocable bank line of credit, funded trust or other collateral. Any such provision of security, however, should first be approved by the company’s board of directors. Governing persons may negotiate for the right to require the indemnitor to furnish such security upon a change of control. 11. Limitations on Indemnification. The parties may wish to address in the indemnification agreement the following potential circumstances:

• Proceedings brought voluntarily by the Indemnitee, whether with or without prior board approval;

• Expenses of serving as a witness in connection with a threatened or commenced change in control;

• Profits made in violation of § 16(b) of the Securities Exchange Act;

• Expenses with respect to any employee benefit or welfare plan, for which the Indemnitee is otherwise indemnified by the company;

• Proceedings where the Indemnitee’s conduct is finally adjudged to be (knowingly) fraudulent, (deliberately) dishonest, or to constitute (willful) misconduct;

• Breach of the Indemnitee’s duty of loyalty; and

• Court or other governmental determinations that indemnification is unlawful in any particular circumstance.

12. Selection of Counsel. The indemnification agreement should address the circumstances in which the company would be entitled to assume the defense of a matter for which the company is providing indemnification. Indemnification agreements often provide that if the Indemnitee engages his own counsel after the company has engaged counsel for him, the



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company is not liable for the expenses of the indemnitee’s separate counsel, unless the Indemnitee has reasonably concluded that there is a conflict of interest between the indemnitee and the indemnifying company. 13. Potential Shareholder Approval. Although State law typically does not require that a corporation obtain shareholder approval of an indemnification agreement, some corporations seek shareholder approval where possible to guard against potential shareholder challenges.

III. Exculpation

Many States have augmented their broad statutory indemnification provisions by also adopting charter-option provisions that permit a company to eliminate or reduce personal liability of directors to the corporation. The Delaware statute authorizes a company to include in its certificate of incorporation a “provision eliminating or limiting the personal liability of a director to the corporation or its stockholders for monetary damages for breach of fiduciary duty as a director.” DEL. CODE ANN. § 102(b)(7). The statute, however, disallows exculpation provisions that attempt to eliminate or limit a director’s liability for a breach of the duty of loyalty; for acts or omissions not in good faith or involving intentional misconduct or knowing violation of the law; for willful or negligent conduct in paying dividends or repurchasing stock where legally available funds are insufficient; or for improper personal benefit. Id. In substance, the Texas statute mirrors the Delaware statute. TEX. BUS. ORG. CODE § 7.001. Because these provisions do not apply where there has been a breach of duty of loyalty, exculpation provisions generally are understood to provide exculpation where a director has been found to have breached the duty of care.

An exculpation provision may be set out in the charter or articles at the creation of the corporation, or may be added later by shareholder approval. If the provision is added later, it generally will apply only prospectively. The provision permits the company to eliminate (or, in rare cases, limit to a certain dollar amount) money damages that otherwise would be recoverable from a governing person based on a duty of care violation.

Governing person exculpation statutes were adopted largely in response to the decision by the Delaware Supreme Court in Smith v. Van Gorkom. 488 A.2d 858 (Del. 1985). In that case, experienced directors were held liable for damages resulting from their gross negligence in hastily approving a friendly acquisition, notwithstanding the fact that there were no allegations or evidence of fraud, bad faith, or self dealing. Id. at 873. In the current statutory climate, a

corporation that had adopted an exculpation provision likely would effectively shield its directors from a similar claim. For example, in Malpiede v. Townson, the Delaware Supreme Court held that where a corporation has an exculpation provision and the plaintiffs file a complaint that contains only a duty of care claim, the court will dismiss the complaint because the plaintiffs cannot recover monetary damages from the defendants. 780 A.2d 1075 (Del. 2001). In other words, to survive a motion to dismiss, a complaint must allege a breach of the duty of loyalty or the duty of good faith.

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RECENT DEVELOPMENTS: Exculpation; The Duty of Good Faith; Disney

The recent Disney decisions involving the hiring

of Michael Ovitz and his subsequent termination without cause (resulting in a severance package valued at approximately $140 million) have created some uncertainty as to the level of protection that an exculpation provision can provide. Like most corporations today, Disney has an exculpatory provision in its charter. In its May 2003 decision, however, the Delaware court concluded that the plaintiff’s complaint alleged facts sufficient to rebut the business judgment rule under the duty of good faith and that such claims would not be exculpated under a Delaware-type exculpation provision. In re The Walt Disney Company Deriv. Litig. 825 A.2d 275 (Del. Ch. 2003).

According to the court, “[w]here a director consciously ignores his or her duties to the corporation, thereby causing economic injury to its stockholders, the director's actions are either ‘not in good faith’ or ‘involve intentional misconduct.’ [citing DEL. CODE § 102(b)(7)(ii)].” The court, therefore, concluded that the “plaintiffs’ allegations support claims that fall outside the liability waiver provided under Disney's certificate of incorporation.” On that basis, it held that the plaintiffs’ pleadings were sufficient to withstand a motion to dismiss. Id. Later, in its August 9, 2005 decision, the court, after analyzing the evidence and arguments in detail, reached the conclusion that the Disney directors did not breach their fiduciary duties or commit waste in connection with the hiring and termination of Michael Ovitz. In re The Walt Disney Company Deriv. Litg., C.A. no. 15452 (Del Ch. August 9, 2005).

In light of the Disney decisions, it is important to ensure that articles of incorporation include an exculpation provision. Although evidence of “gross” negligence may render the business judgment rule inapplicable, a shareholder plaintiff who proves that a






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director has been “grossly negligent” still cannot recover money damages against that director if the corporation’s charter includes a “director exculpation” provision as permitted by Delaware statute.

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IV. D&O Insurance Even if a governing person is entitled to

indemnification or advancement of expenses from the entity he or she serves, that entitlement will not be of much benefit to the governing person unless the entity is ready, willing and able to pay the indemnification or advancement of expenses. To ensure that their rights to indemnification and advancement of expenses ultimately prove to be meaningful, many governing persons insist (often as a condition before the individual will agree to serve) that the entity purchase appropriate D&O liability insurance.

The following discussion is not an exhaustive or technical treatment of D&O insurance. Instead, the following is a intended to equip counsel with a basic understanding of D&O insurance while discussing certain policy provisions that may be negotiated to the benefit of the policyholder.

V. Understanding the Basics of D&O Insurance A. The Insuring Clause of the Policy: The Heart of the Policy

In every policy, the “insuring clause” or “insuring agreement” is the heart of the policy. It sets forth the insurer’s agreement about coverage. Generally, there are, at least, two “insuring clauses” or “insuring agreements” in a D&O policy: (1) individual director and officer coverage and (2) corporate indemnity reimbursement coverage. A third type of insuring agreement, corporate entity coverage, is optional but often limited to securities and employment claims. Each of these clauses is addressed below. 1. Individual Director and Officer Coverage

Most companies indemnify their directors and officers through corporate bylaws or board resolutions. While there are certain limitations, this type of corporate indemnification is normally quite broad. A D&O policy, under this type of coverage, will provide individual director and officer coverage only in those instances where the company does not indemnify the director or officer. Here is an example of this type of insuring agreement:

Coverage A: Directors and Officers Insurance

This policy shall pay the Loss of each and every Director or Officer of the Company arising from any claim or claims first made against the Directors or Officers and reported to the insurer during the policy period . . . for any alleged Wrongful Act in their respective capacity as Directors or Officers of the Company, except for and to the extent that the Company has indemnified the Directors or Officers.

2. Corporate Indemnity Reimbursement Coverage

This coverage generally applies to the extent that the company has indemnified the director or officers pursuant to common law, statutory law, contract, company charter, or company bylaws. In this instance, the insurer is obligated to reimburse the company for the amount indemnified by the company. Here is an example of this type of insuring agreement:

Coverage B: Company Reimbursement Insurance

This policy shall reimburse the Company for loss arising from any claim or claims which are first made against the Directors or Officers and reported to the insurer during the policy period . . for any alleged Wrongful Act in their respective capacities as Directors or Officers of the Company, but only when and to the extent the Company has indemnified the Directors or Officers for such loss pursuant to law, common or statutory, or contract, or the charter or bylaws of the Company duly effective under such law which determines and defines such right of indemnity.

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3. Corporate Entity Coverage The original intent of D&O insurance was to

protect the personal assets of the directors and officers of a company. Originally, D&O insurance was not intended to protect the company. Thus, when a director or officer was sued along with the company, the D&O insurer would often take the position that, since the company was not covered under the policy, it was responsible for only a portion of the defense costs and indemnity amounts paid in the litigation. This inevitably resulted in major “allocation” debates between D&O insurers and their insureds. Insurers would argue for an allocation that minimized the covered loss (i.e., placing most of the cost toward the company). In contrast, the insureds would argue for an allocation that maximized the covered loss (i.e.,


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placing most of the cost toward the directors and/or officers).

The “allocation debate” became less important when insurers introduced “entity” coverage. This type of coverage provides coverage directly to the company. However, in most policies, it is limited to securities claims and employment claims made against the company. This type of supplemental coverage is provided to the insured at a higher premium. Here is an example of this type of insuring agreement:

Coverage C: Entity Insurance

The insurer shall pay on behalf of the Company Loss resulting solely from any Securities Claim first made against the Company during the Policy Period or, if applicable, the Optional Extension Period, for a Company’s Wrongful Act.

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RECENT DEVELOPMENTS: Corporate Entity Coverage

Entity coverage for securities lawsuits has

accounted for a significant portion of the recent settlements and damages for which the insurance industry has indemnified its insureds in Enron-like corporate scandals. As a result, insurers are increasingly hesitant to offer entity coverage as part of their D&O liability insurance policies. While this may be an attempt by insurers to narrow the coverage they offer, businesses should carefully evaluate the strengths and weaknesses of entity coverage before insisting on the inclusion of such coverage in their D&O program.

Strengths: • Provides additional protection to the insured

corporation • Eliminates the “allocation debate” common

in years past Weaknesses: • The corporate entity may “consume” all the

available limits of the policy and leave no funds for the benefit of the directors and officers whom the D&O policy was originally intended to protect.

• Policies with entity coverage may be held as assets of the estate of bankrupt corporations, a circumstance that may prevent directors and officers from accessing policy funds. See § III(A), infra (discussing the effects of bankruptcy on D&O coverage).

In lieu of entity coverage, a business may wish to request a “pre-set” allocation provision. Such a provision states what percentage of a claim an insurer will allocate to covered claims in the event that covered claims against directors and officers coexist with non-covered claims against the company itself. Although this option does not afford entity coverage for the company, it does abolish the “allocation debate” and the threat of bankruptcy-imposed limitations on indemnification for directors and officers. Corporations considering their D&O options should take into consideration which of these options would best suit their needs.

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B. The Important Distinction Between “Claims-Made” Policies and “Occurrence” Policies

Most D&O policies are “claims-made” policies, and it is important to understand the distinction between this type of policy and an “occurrence” policy.

• Occurrence-based policy • This type of policy is triggered if the

occurrence, accident, or event takes place within the policy period, regardless of when the claim is made.

• Claims made policy • This type of policy is triggered if the “claim”

is made within the policy period, regardless of when the occurrence, accident, or event took place.

Under a D&O policy (which is often a claims-made policy), the claim against the director, officer and/or company must be made during the policy period and must be for an alleged “Wrongful Act.” While the “Wrongful Act” need not be committed during the policy period under most policies, many D&O policies provide a “retroactive date,” which is the earliest date a “Wrongful Act” can take place and be covered under the D&O policy. It is therefore important for the policyholder to understand whether the D&O policy has a retroactive date and how early that date is. Policyholders should also be aware of “related acts” provisions which designate all Loss or all Claims arising from separate but related “Wrongful Acts” as, respectively, one Loss occurring at the time the first Wrongful Act is committed or one Claim made when the Claim was first made. To the extent that related Wrongful Acts occur both before and after a policy’s “retroactive date,” a “related acts” provision may operate to exclude all loss arising therefrom. See, e.g., Highwoods Props., Inc. v. Executive Risk Indem., Inc., 407 F.3d 917 (8th Cir. 2005); Medical Care Am. v. Nat’l Union Fire Ins. Co. of Pittsburgh, Pa., 341 F.3d 415 (5th Cir. 2003).





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There are also variations of the “claims-made” policy form. The more restrictive form is called a “claims-made and reported” policy form. Under this form, not only does the claim have to be made during the policy period, but it also must be reported by the insured to the insurer during the policy period. The more policyholder-friendly form does not require that the insured report the claim during the policy period. Instead, it simply requires that the reporting take place “as soon as practicable” or similar language. C. What Is A “Claim” and How Broadly Is It Defined Under the D&O Policy?

Since most D&O policies are “claims-made” policies and since the “claim” must be made within the policy period, it is therefore critical for the policyholder to understand how the policy defines the term “claim.” Surprisingly, some D&O policies fail to define the term “claim.” This often leads to confusion and litigation battles between policyholders and their insurers. Most policies, at a minimum, define the term “claim” to include a “written demand for money” and a “civil proceeding.” It goes without saying that the broader the definition of the term “claim,” the broader the coverage that is afforded by the policy. Policyholders should seek the broadest possible definition of the term “claim.” Here are some definitions that will broaden coverage:

• Written demands for monetary, nonmonetary and injunctive relief

• Civil proceedings for monetary, nonmonetary and injunctive relief

• Criminal proceedings • Administrative/regulatory proceedings • Arbitration proceedings • Civil, criminal, administrative or regulatory

investigations of insured persons post “target letter” (including SEC, grand jury, EEOC and Department of Justice)

• Securities investigations of insured persons after the service of a subpoena

• Administrative and regulatory proceedings against the entity on a co-defendant basis

As a practical matter, if the definition of “claim” is broadened (as is desirable), then corporate policyholders must be diligent to report those “claims” to their insurers once they are made. While most corporate policyholders would consider civil litigation to be a “claim,” most corporate policyholders would not consider a written demand for money, investigation, or subpoena to be a “claim,” which requires reporting to the D&O insurer.

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RECENT DEVELOPMENTS: Scope of “Claim”

In In re Enron Corp. Sec., Derivative & ERISA

Litig., 391 F. Supp. 2d 541, (S.D. Tex. Aug. 1, 2005), Judge Harmon considered whether defense costs incurred in criminal actions against Mark Koenig and Andrew Fastow were covered by various excess D&O policies. Because coverage for “Ultimate Net Loss,” including Defense Costs, was predicated on the existence of a “Claim,” the Court was tasked with deciding whether a criminal action constituted a “demand, suit or proceeding . . . which seeks actual monetary damages or other relief .” Id. at 557, 570-572. The Court ultimately interpreted “Claim” and “Ultimate Net Loss” in the context of the entire policy, including two exclusions. Specifically, the Court observed that the policy excludes both fines or penalties imposed in a criminal suit, as well as Claims for which “a final adjudication establishes that acts of active and deliberate dishonesty were committed or attempted . . . and were materials to the cause of action so adjudicated.” Id. at 572. According to Judge Harmon, these exclusions “would not be necessary if the policy did not cover defense costs for criminal actions.” Id. Moreover, to the extent that a criminal defendant is found not guilty and no fines or penalties are imposed, the policies ostensibly provide coverage for related defense expense. Id. Therefore, reasoned the Court, “there is sufficient ambiguity” in the definitions of “Claim,” “Wrongful Act,” “Ultimate Net Loss” and in the policy’s Exclusions “to construe the policy against the insurer in favor of the insured, as providing coverage for attorney’s fees in defending against criminal proceedings through a final adjudication, but only where the insured is ultimately found not guilty of having committed or attempted to commit acts of dishonest, fraud or criminality.” Id. at 573.

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D. Other Important Definitions in the D&O Policy 1. The Definition of the Individual Insured

The individuals insured under a D&O policy are, of course, the directors and officers. The terms “insured person” or “executive” are often used to reference the directors and officers intended to be covered under the policy. These terms, or similar ones, can be broadened to include individuals other than just the company’s directors and officers. The corporate policyholder should request a broadening of these terms by an inclusion of the following in the definition:

• Trustees and governors of the corporate entity



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• Management committee members of joint ventures

• Members of the Board of Managers of limited liability companies affiliated with the corporate entities

• Executives of the company serving as executives on specifically covered “outside entity” companies

• The General Counsel • The Risk Manager • Foreign equivalent executives of foreign

entities affiliated with the company • Employees for securities claims

2. The Definition of “Insured” The definition of “insured” is often broader than

the definition of “insured person” or “executive.” Most often, the definition of “insured” will not only include individual insureds, but also corporate insureds. At a minimum, the corporate policyholder should request that the definition include the following:

• The corporate entity in connection with securities claims and, if desired, employment claims

• Subsidiaries of the corporate entity in connection with securities claims and, if desired, employment claims

• The debtor-in-possession of the corporate entity in the event the company files bankruptcy.

3. The Definition of “Loss” In the insuring agreement, the insurer promises to

pay the “Loss” arising from a claim. The term “Loss” is a defined term.

Usually the definition of “Loss” will include the following:

• Damages • Judgments • Settlements • Defense Costs • It often explicitly excludes the following: • Civil or criminal fines or penalties • Punitive or exemplary damages • The multiplied portion of multiplied damages • Taxes • Any amount deemed uninsurable under the

law pursuant to which the policy is construed • The policyholder should seek a modification

of “Loss” as follows: • Loss should include punitive, exemplary and

multiple damages of an insured regarding securities claims

• Loss should include civil fines under Section 2(g)(2)(C) of the Foreign Corrupt Practices Act

• It should include punitive/exemplary/ multiple damages of all claims if they are insurable by law

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E. Defense Provisions of the D&O Policy Here are some of the typical characteristics of a

D&O policy with respect to the provision of a defense to the insureds: 1. No Duty to Defend

Unlike traditional commercial general liability policies, the typical D&O policy does not obligate the insurer to defend the insured in connection with potentially covered litigation. Instead, it is often the duty of the insured to retain competent counsel to defend the litigation. Some policies require the insured to select counsel from a “panel counsel” list provided by the insurer when the insured is involved in complex claims, such as securities claims. Sometimes the insurer is flexible in allowing the insured to retain counsel not included on the panel counsel list. However, it is best to negotiate this item before purchasing the policy. In other words, policyholders should determine if the insurance policy requires use of “panel counsel” for certain types of litigation. If so, the corporate policyholder may be able to negotiate with the insurer to add the insured’s preferred firm.

Although the insurer typically does not have a duty to defend the insured under a D&O policy, the insurer does have the “right” to associate in the defense. This means that the insurer may be allowed to retain its own counsel and assist in the defense of the litigation. 2. Defense Costs Are Included Within the Policy Limit

Under most D&O policies, every dollar incurred in defense of the litigation is a dollar that reduces the policy limit or, said another way, the defense costs are within the policy limits. This makes the policy a “wasting asset” policy. 3. Advancement of Defense Costs

As noted above, under a typical D&O policy, the insurer does not have a duty to defend the insured. It has no obligation to hire defense counsel or to pay counsel directly. As a result, it is the responsibility of the insured to retain and pay defense counsel. Most policies, however, require the insured to first obtain the insurer’s consent before hiring defense counsel. The insurer is then obligated to reimburse the insured for those defense costs.

Early forms of the D&O policy fail to address when the insurer is obligated to reimburse the insured for payment of defense costs. In some cases, this means that the D&O insurer may not be required to reimburse those defense costs until the end of the case.


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Recent forms of the D&O policy, however, now provide for “advancement” of defense costs. This means that the D&O insurer will pay defense costs before the end of the litigation. The policyholder must be careful to understand what kind of “advancement” clause is in the policy. Some clauses require the insured to make a written request for advancement of defense costs. Other policies require a written request by the insured but provide that the “advancement” will be made 90 days after receipt of the invoices. Still other clauses provide that “advancement” will take place on a “current” basis. The best “advancement” clause for the policy might look something like this:

The insurer shall, upon receipt, advance on a current basis covered defense expenses prior to the final disposition of a claim.

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RECENT DEVELOPMENTS: Advancement of Defense Costs

The majority of jurisdictions, including Texas,

adhere to the rule that, absent a provision requiring the current advancement of defense costs, D&O Insurers must nonetheless reimburse defense expenses as they are incurred. See In re Enron Corp. Sec., Derivative & ERISA Litig., ___ F. Supp. 2d ___, 2005 WL 2230250, at *23–24 (S.D. Tex. Aug. 1, 2005) (collecting cases) (Notwithstanding provisions excluding coverage where a final adjudication establishes fraud or dishonesty, an Insurer’s duty to pay “arises at the time the insured becomes ‘legally obligated to pay.’ To infer any other . . . time for the insurer’s duty to pay would be arbitrary because nothing in the definition gives any guidance to when this later time might be.” (quoting Little v. MGIC Indem. Corp., 836 F.2d 789, 793 (3d Cir. 1987)).

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F. Identifying Key Exclusions and Reducing Their Impact

The exclusions in a D&O policy vary from form to form. Some of the typical exclusions to review closely, however, include the following: 1. The “Bad Conduct” Type Exclusions

Most, if not all, D&O policies contain various exclusions barring coverage for certain “bad conduct” by the directors and/or officers. Generally, they include the following:

• Intentionally dishonest acts or omissions • Fraudulent acts or omissions • Criminal acts or omissions • Willful violations of any statute, rule or law

• Illegal profit • Illegal remuneration Of course, it is not uncommon for plaintiffs to

allege that a director or officer was engaged in such “bad conduct.” Therefore, it is critical that the corporate policyholder purchase a D&O policy containing the following features with respect to these types of exclusions:

• “Final adjudication” language: Before coverage can be barred based on these “bad conduct” exclusions, there must be a determination by a “final adjudication” that the director and/or officer committed such “bad conduct.”

• “No imputation” language: No conduct of any individual insured will be imputed to any other insured with respect to these exclusions.

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RECENT DEVELOPMENTS: “Bad Conduct” Exclusions

a. “Final adjudication” language

As part of the new climate of D&O insurance, insurers are not offering “final adjudication” language in their “bad conduct” exclusions to the same extent that they once did. Consequently, a company may need to negotiate with an insurer in order to include “final adjudication” language in its policy.

It is important to note, however, that courts continue to enforce “final adjudication” language. See Associated Elec. & Gas Ins. Servs. v. Rigas, 2004 WL 540451 (E.D. Pa. 2004). The issue before the court in Rigas was whether insurers were required to advance defense costs for five of Adelphia’s former officers and directors pursuant to a D&O policy. The policy contained a fraud exclusion with “final adjudication” language. The insurers wished to rescind coverage, but also argued that no coverage would exist anyway due to the fraud exclusion and the “prior knowledge exclusion.” With respect to the “final adjudication” language, the court noted that binding precedent had established that the fraud exclusion would not apply until a final adjudication of fraud occurred. Thus, the fraud exclusion was inapplicable to the Adelphia directors and officers, none of whom had yet been convicted of a crime or lost a civil case (although all were awaiting civil and/or criminal trials). b. “Illegal profit” exclusions

The Fifth Circuit has held that an illegal profit exclusion in a D&O policy precluded coverage of claims against a corporation and its directors and officers arising from fraudulent conduct by a director and officer. TIG Specialty Ins. Co. v. PinkMonkey.com



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Inc., 375 F.3d 365 (5th Cir. 2004). The D&O policy at issue in PinkMonkey contained an illegal profit exclusion excluding coverage for any claim against any insured “based upon, arising from, or in consequence of an Insured having gained in fact any personal profit, remuneration, or advantage to which such Insured was not legally entitled.” The Fifth Circuit ruled that the CEO had gained a personal advantage or profit from his securities fraud—namely, the opportunity to own a successful business—because the trial jury had found that the CEO had “benefited from [his] false representation or promise.” The illegal profit exclusion therefore precluded coverage for the claims against the CEO. By extension, the claims against other directors and officers, as well as the securities dealer, were excluded because these claims likewise “arose from” the CEO’s illegal profit.

In addition, because the claims against PinkMonkey and the claims against the CEO constituted a single claim under the policy’s “Limits of Liability” section, the court held that the illegal profit exclusion also precluded coverage for the claims against the corporation. In response to arguments that its decision would effectively eviscerate the policy’s Securities Claims Endorsement, the court noted that the illegal profit exclusion only applied against an “Insured”; it did not necessarily apply to claims against the company (even though the court considered the claims against the “Insured” to be claims against the company in this case).

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2. The “Insured v. Insured” Exclusion Many D&O policies contain an exclusion

commonly known as the “insured v. insured” exclusion. This exclusion bars coverage for a claim brought either by an insured officer or director or the insured corporation against any other insured party. One example of this clause provides the following:

It is understood and agreed that the [insurer] shall not be liable to make any payment for Loss in connection with any claim made against the Directors and Officers by any other director or officer of the [corporation] or by the [corporation], except for a shareholder’s derivative action when such action is brought by a shareholder who is neither a director nor officer of the [corporation] nor beneficial holder of shares for a director or officer of the [corporation].

The “insured v. insured” exclusion was originally developed by D&O insurers in response to perceived “friendly” suits brought by various financial institutions against their own directors and officers

seeking to recoup operating losses resulting from the alleged business mistakes of corporate officials. D&O insurers felt that such suits were never intended to be covered by D&O insurance and constituted an attempt to transform what was essentially a third party liability party into a first party business policy. Given this background, it is not surprising that it is widely recognized that the purpose of the exclusion is to prevent collusion among insureds. See, e.g., Ostrager and Newman, Handbook on Insurance Coverage Disputes, § 20.02(g) (10th ed. 2000); Kalis, Reiter and Segerdahl, Policyholder’s Guide to the Law of Insurance Coverage Disputes, § 11.05[d] (2001); Russ and Segalla, Couch on Insurance 3d, § 131:33 (1997).

One factual scenario not involving the risk of collusion in which the “insured v. insured” exclusion has been urged by D&O insurers as a bar to coverage occurs in the context of corporate bankruptcy proceedings. Following a bankruptcy filing, claims are frequently asserted against corporate directors and officers by a bankruptcy trustee or other person or entity acting on behalf of the bankruptcy estate and/or creditors of the bankrupt corporation. Seizing on the “insured v. insured” exclusion, D&O insurers have argued that no coverage is afforded under their D&O policies for such claims on the grounds that the bankruptcy claimant “stands in the shoes” of the corporation for purposes of the exclusion.

Obviously, directors and officers will want the protection of D&O insurance if a bankruptcy trustee asserts claims against them. Under that scenario, they are left unprotected with no corporate indemnification. In order to avoid this problem, the policyholder should:

• Insist that the “insured v. insured” exclusion be deleted from the policy

• If the insurer refuses to delete the exclusion, insist that it be modified as set forth below so as to carve out actions arising out of a bankruptcy filing

The insurer shall not be liable to make any payment for Loss in connection with any claim made against an insured by, on behalf of, or at the direction of the Company, except and to the extent such claim is brought by the bankruptcy trustee or examiner of the Company or an assignee of such trustee or examiner, or any receiver, conservator, rehabilitator, or liquidator or comparable authority of the Company.

• Insist on the inclusion of a “priority of payments” provision in the policy requiring that the limits of the policy be applied first to claims made against corporate directors and officers and then to the company. Several



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versions of the “priority of payments” endorsements are attached to this paper.

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RECENT DEVELOPMENTS: “Insured v. Insured” Exclusion

In a decision by a New Jersey appellate court, the

insured v. insured exclusion did not preclude coverage for an officer sued by his former corporation for negligence in the performance of his duties. Hebela v. Healthcare Ins. Co., 851 A.2d 75 (N.J. Super. Ct. App. 2004). Although the exclusion excluded claims brought by a director or officer against another director or officer, the policy did not exclude claims brought by the corporation against a director or officer. The court further ruled that coverage for the claim did not violate public policy. Rather, the court was obligated to enforce the insurance contract as written.

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G. The Insured’s Key Responsibilities: Notification and Cooperation

The key responsibilities of the insured under a D&O policy include notification to the insurer and cooperation. 1. Reporting the Claim

Under a D&O policy, it is critical to report the “claim” to the insurer. A failure to timely report a claim to a claims-made D&O insurer may result in a loss of coverage irrespective of any prejudice to the insurer resulting from the late notice. See, e.g., Precis, Inc. v. Fed. Ins. Co., 2005 WL 1630319, at *6 (N.D. Tex. July 12, 2005); Hirsch v. Texas Lawyers Ins. Exch., 808 S.W.2d 561, 565 (Tex. App.⎯El Paso 1991, writ denied). Policies differ with respect to when the claim should be reported. Some of the variations include the following:

• Claims must be reported within the policy period (this is often referred to as a “claims-made and reported” policy and is the least preferred type of reporting clause)

• Claims must be reported “as soon as practicable”

• Claims must be reported “as soon as practicable” but in all events within XX days (usually 30 to 60)

• Claims must be reported “as soon as practicable” and in all events within the policy period plus 30 days (this one along with just “as soon as practicable” are the preferred clauses)

Since reporting the “claim” to the insurer is an important obligation of the insured, the insured must be careful to understand how the term “claim” is defined

under the policy. The term “claim” may include more than just a lawsuit. It may also include a demand for money, an informal investigation, a notice of charges, or a subpoena by a regulatory body.

The Fifth Circuit’s opinion in Nat’l Union Fire Ins. Co. v. Willis, 296 F.3d 336 (5th Cir. 2002), shows the importance of timely reporting of a claim. In that case, Willis was an officer of EqualNet. In September 1998, Willis and EqualNet were sued by a collection of plaintiffs for fraud relating to stock transactions. Id. at 338. The allegations by the underlying plaintiffs were amended in March 2000 to include negligent misrepresentation claims. Id. During this time, Willis was insured by National Union under claims-made policies issued to EqualNet. These three polices had policy periods of March 8, 1998 to March 8, 1999; March 8, 1999 to March 8, 2000; and March 8, 2000 to March 8, 2001. Id. These policies required both the claim be made and notice be given to National Union during the same policy period. Willis notified National Union of the claims on May 11, 2000. Id.

The Willis suit was centered around National Union’s denial of coverage due to untimely notice of the claim. The trial court and the Fifth Circuit both rejected Willis’ argument that notice was timely because it was not until March 2000 that a covered claim was made—namely the amendment to allege negligent misrepresentation. Id. at 337. Relying on the policy definition of “claim,” the Fifth Circuit concluded that because the claim “commenced” at the filing of the lawsuit, the “claim” was made when the lawsuit was filed, not at the point that it was amended to include a covered allegation. Id. at 341-42. Thus, even though Willis was correct that in September 1998 National Union had no duty to defend Willis, Willis had to notify National Union to protect himself from the possibility that the lawsuit would be amended to invoke coverage.

Insureds can learn two valuable lessons from Willis. First, while insurance policies are normally liberally construed in favor of the insured, courts are strictly applying the notice provisions of claims-made policies. Thus, an insured needs to pay close attention to the notice period allowed under the policy. Second, if Willis is an accurate statement of Texas law, the insured must notify its carrier as soon as a lawsuit has been served that has the potential to develop into a covered claim. This will require an insured to notify its carrier even though all parties recognize that the current pleadings do not allege a covered “wrongful act.” An insured needs to preserve its rights in light of potential amended pleadings which would invoke coverage.

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RECENT DEVELOPMENTS: Reporting the Claim

In Federal Insurance Co. v. CompUSA, Inc., the

Fifth Circuit held that actual notice to an insurer does not eliminate an insured’s obligation to comply with the notice provisions in its D&O policy. 319 F.3d 746 (2003) (5th Cir. 2003) (applying Texas law). The insured corporation’s D&O policy required that notice of a claim be given “as soon as practicable.” When a suit arose against the CEO, the corporation decided to handle it without notifying the insurer. A year after the case ended, however, the corporation decided to pursue coverage, maintaining that the insurer had acquired actual knowledge of the dispute within a reasonable time. The Fifth Circuit, adopting the trial court’s decision, held that, even if the insurer had actual notice, the insured was still obligated to comply with its policy’s notice requirements. Furthermore, the court found that a clause in the policy, providing that the insured business would give notice on behalf of all the insureds, did not preclude an officer from notifying the insurer directly. Even if the contract did preclude such direct notice, the officer could have directed the business to give timely notice.

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H. The Policy Application: An Integral Part of the Policy

Unlike many liability policies, a D&O policy requires the named insured to submit an application for insurance. Not only does the application require detailed information about the company to be insured, but this required information becomes a part of the D&O policy. Some of the information requested in the application includes the following:

• Name and address of the insured entity • State and date of incorporation • Nature of business • Limits and retention requested • Identity of publicly-traded stocks • The number of voting shares outstanding

versus total issued • Shares owned by directors and officers • A list of any 5% or more of voting

shareholders • Other stocks convertible to voting stock • A listing of directors and other entities to be

insured • A listing of officers to be insured • A listing of all subsidiaries to be insured

(along with the percentage of ownership, type of business, foreign or domestic, and date acquired or created)

• Any upcoming plans for mergers, acquisitions or consolidations

• Future registration of securities • Knowledge of any pending claims against

any of the potential insureds • Whether any potential insured knows or has

any information of any act, error or omission which might give rise to a claim under the proposed policy

• Previous D&O insurance • Any refusal by another carrier to provide

insurance • Attached annual reports and latest 10k • Usually must be signed by the Chairman or

President of the company

VI. Understanding Emerging Issues Under the D&O Policy The Enron case and others following it have

raised several important issues involving D&O insurance. First, in the post-Enron world, the frequency of corporate bankruptcies raises the question of whether the coverage afforded under the D&O policy should primarily benefit the directors and officers when both they and the company are covered by the policy. Second, the proliferation of corporate restatement of earnings and irregularities in corporate financial reporting has raised the question of whether the D&O insurer can rescind coverage based on misrepresentations, i.e., allegedly “false” information, provided by a company in its D&O application. Third, the enactment of the Sarbanes-Oxley Act in response to America’s corporate crisis has created numerous novel issues with respect to D&O coverage. Finally, as insurers and insureds battle over coverage for large securities litigation damages, insurers are questioning whether such damages constitute “loss” under D&O policies. As addressed below, these issues are vitally important because each may affect hundreds of millions of dollars in critical coverage. A. Bankruptcy’s Effect on D&O Coverage

D&O insurance is frequently viewed as professional liability insurance for directors and officers. Corporations traditionally seek D&O coverage in order to encourage individuals to serve as corporate officials, the thought being that such insurance protects the personal assets of corporate officers and directors from claims made against them arising out of their service on behalf of the corporation.

Today, however, corporate risk managers are likely to view the D&O insurance policy as much more than just another professional liability policy. This is because most D&O insurance policies now also offer coverage to the corporation (commonly referred to as



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“entity coverage”) for employment-related claims and “Securities Claims,” a defined term in D&O policies generally equated with claims brought under the Securities Act of 1933, the Securities Exchange Act of 1934 and parallel state securities statutes.

With the expansion of the insurance coverage available under the D&O policy to include entity coverage for these types of claims, D&O insurance plays an even larger role in the risk management programs of publicly-traded corporations, frequently serving as the first line of defense against such claims.

The expanded entity coverage for employment and securities claims afforded by modern D&O policies also highlights the fact that most D&O policies now serve two different masters, the corporation on the one hand and its directors and officers on the other. In many situations, such as a Securities Claim asserted against both the corporation and its directors and officers, the interests of both masters are aligned against the claimant(s). More problematic, however, is what happens when the interests of the corporation and its directors and officers diverge.

Diverging interests can result when claims against a corporation and its directors and officers leave insufficient insurance limits available to satisfy the claims against both the corporation and its directors and officers. Litigation brought by a corporation against its directors and/or officers, although rare, is another event which can lead to diverging interests. D&O policies generally do not respond to such suits because of an exclusion barring from coverage disputes brought by the corporation against its directors and officers (i.e., the “insured v. insured” exclusion). Such an exclusion seems harmless enough on its face given that (1) a corporation’s directors will naturally be reluctant to authorize a suit by the corporation against themselves, and (2) the corporation may be obligated to indemnify its directors and officers in any event. See, e.g., N. Chimicles and M. Meermans, The Insured v. Insured Exclusion in D&O Insurance Policies, C938 A.L.I. - A.B.A. 749, 753 (1994) (further noting that the mere presence of the exclusion decreases the likelihood of a corporate board authorizing such a suit since the net result would be to place the personal assets of the directors and officers at risk).

What many corporations and their directors and officers may not realize, however, is that, notwithstanding its innocuous appearance, this same exclusion may bar coverage for claims made against corporate directors and officers when financial difficulties result in a corporate bankruptcy filing and claims are brought against directors and officers not by the corporation, but by a bankruptcy trustee or other party asserting claims in the bankruptcy proceeding. Ironically, it is at just such a time when officers and

directors are likely to most need the protection of D&O insurance as any indemnification obligation of the corporation following such an event is likely to be worthless.

In light of the above, it is imperative that the directors and officers fully understand bankruptcy’s effect on the D&O coverage, especially in those situations where the company as well as its directors and officers are insureds under a D&O policy. As discussed earlier, the original intent of D&O coverage was to protect the assets of the directors and officers of the company. Now that entity coverage is more prevalent, a new challenge has arisen over the availability of coverage for the directors and officers in the face of the company’s bankruptcy.

The problem arises because, upon the filing of bankruptcy, the policy proceeds may belong in whole or in part to the bankruptcy estate. If so, the directors and officers may find it difficult to gain the protection of the D&O policy in both defending claims and paying settlements. With no protection from a D&O policy, the personal assets of a director and/or officer are greatly at risk.

No director or officer of a company should be ignorant concerning the methods by which D&O coverage can remain available to protect his personal assets. Fortunately, there are several ways of avoiding the real danger of a director or officer being stripped of available coverage under a D&O policy. These include the following: 1. Purchase a Policy With No “Entity” Coverage

Since the real purpose of D&O insurance is to protect the personal assets of the company’s directors and officers, it may make sense to avoid jeopardizing that protection by simply not purchasing “entity” coverage. If the policy provides no direct coverage for the company’s wrongful acts, then it will be difficult for the bankruptcy estate of the company (should it file for bankruptcy protection) to successfully argue that the policy proceeds are assets of the estate. If the policy proceeds are not assets of the bankruptcy estate, then the directors and officers should have no difficulty demanding that the D&O insurer advance defense costs or settle claims on their behalf.

Most securities and employment-related claims, however, involve the corporate entity. With this in mind, companies will want the coveted insurance to protect not only the personal assets of the directors and officers, but also the company assets. In short, this may not be a likely solution to the problem in most cases. 2. Insist on a “Priority of Payments” Provision in the Policy

As discussed above, a “priority of payments” provision requires that the claims against the directors


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and officers be paid first before claims against the company are paid. This priority of coverage feature in the policy will equip the directors and officers with a compelling argument that the policy proceeds of the D&O policy are not assets of the bankruptcy estate. In this way, the directors and officers can continue to seek coverage for defense costs and indemnity in the pending litigation even when the company is in bankruptcy. Various forms of a “priority of payments” endorsement are attached for review. 3. Insist on a “Bankruptcy” Clause in the D&O Policy

One way to diffuse the effect of the company’s bankruptcy, is to insist that the policy provide that the insurer’s obligations are not relieved should the company file bankruptcy. Here is one example of such a clause:

In the event of bankruptcy or insolvency of the Company, subject to all the terms of this policy, the insurer shall pay on behalf of the directors and officers under Insuring Agreement I(A)(1) [coverage to the directors and officers where no indemnity is provided by the company] for Ultimate Net Loss they shall become legally obligated to pay which would have been indemnified by the Company and reimbursable by the insurer under Insuring Agreement I(A)(2) but for such bankruptcy or insolvency.

This type of clause leaves no doubt that the insurance company is required to continue providing coverage to the directors and officers even where the company is unable to indemnify the directors and officers despite its commitment to do so. 4. Make Sure the Policy Contains a Modified “Insured v. Insured” Exclusion

As discussed above, the “insured versus insured” exclusion, as its name suggests, is an exclusion that bars from the coverage afforded by D&O policies any claim brought either by an insured officer or director or the insured corporation against any other insured party. In the absence of such an exclusion, there is no bar to coverage under a D&O policy for claims brought by one insured against another insured. See, e.g., A. Windt, Insurance Claims and Disputes § 11:18B (3rd ed.) 2000. When the exclusion is present, however, it has been repeatedly enforced under Texas law so as to bar coverage for suits involving insured parties on both sides of the docket. See, e.g., Fidelity & Deposit Co. of Maryland v. Conner, 973 F.2d 1236, 1245 (5th Cir. 1992); Voluntary Hospitals of America, Inc. v. National Union Fire Ins. Co. of Pittsburgh, PA, 859 F. Supp. 260, 262 (N.D. Tex. 1993), aff’d without

opinion, 24 F.3d 239 (5th Cir. 1994); National Union Fire Ins. Co. of Pittsburgh, PA v. Resolution Trust Corp., 1992 WL 611463 at **2–3 (S.D. Tex. 1992).

The “insured v. insured” exclusion was originally developed by D&O insurers in response to perceived “friendly” suits brought by various financial institutions against their own directors and officers seeking to recoup operating losses resulting from the alleged business mistakes of corporate officials. D&O insurers felt that such suits were never intended to be covered by D&O insurance and constituted an attempt to transform what was essentially a third party liability policy into a first party business loss policy. Given this background, it is not surprising that it is widely recognized that the purpose of the exclusion is to prevent collusion among insureds. See, e.g., Ostrager and Newman, Handbook on Insurance Coverage Disputes § 20.02(g) (10th ed. 2000); Kalis, Reiter and Segerdahl, Policyholder’s Guide to the Law of Insurance Coverage, § 11.05[d] (2001); Russ and Segalla, Couch on Insurance 3d, § 131:33 (1997).

An exclusion aimed at preventing collusion certainly seems reasonable. A problem arises, however, when D&O insurers attempt to apply the exclusion to situations not involving collusion between insureds. See, e.g., Sphinx Int’l, Inc. v. Nat’l Union Fire Ins. Co. of Pittsburgh, Pa., 412 F.3d 1224, 1229–30 (11th Cir. 2005) (applying insured v. insured exclusion notwithstanding non-collusive nature of suit for which coverage was sought). Such a scenario is particularly troubling given that the literal wording of the exclusion may control over its underlying anti-collusive purpose even in situations in which no concern of collusion exists. See, e.g., Level 3 Comms. v. Fed. Ins. Co., 168 F.3d 956, 958-59 (7th Cir. 1999) (rejecting an argument that the purpose of the exclusion should be considered so as to avoid a finding that coverage was barred by the actual wording of the exclusion); American Medical Int’l, Inc. v. National Union Fire Ins. Co. of Pittsburgh, 244 F.3d 715, 723 (9th Cir. 2001) (refusing to read into the exclusion an anti-collusive intent given the broader purpose indicated by the wording of the policy). Cf. Township of Center v. First Mercury Syndicate, Inc., 117 F.3d 115, 119 (3d Cir. 1997) (“Where, however, it is clear that the underlying action is not collusive, the exclusion has not precluded coverage.”). One factual scenario not involving the risk of collusion in which the “insured versus insured” exclusion is being urged with increasing frequency by D&O insurers as a bar to coverage occurs in the context of corporate bankruptcy proceedings.

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entity acting on behalf of the bankruptcy estate and/or creditors of the bankrupt corporation. Seizing on the “insured versus insured” exclusion, D&O insurers have argued, with some, but far from complete, success that no coverage is afforded under their D&O policies for such claims on the grounds that the bankruptcy claimant “stands in the shoes” of the corporation for purposes of the exclusion. B. Misrepresentation in the Application

With more and more frequency, insurers are seeking to rescind policies on the basis that the insured made misrepresentations in the policy application. A company’s statement about its financial strength is often cited by an insurer as a misleading statement that supports forfeiture of the coverage. Since this is becoming a prevalent practice by D&O insurers, the corporate policyholder must become familiar with its rights.

Importantly, jurisdictions vary on what an insurer must demonstrate in order to bar coverage or rescind the policy based on an alleged misrepresentation in the application. Fortunately, Texas law strongly favors the policyholder. 1. In Order to Prevail on a Misrepresentation Defense in Texas, an Insurer Must Prove That the Insured Intended to Deceive

One of the major differences in the law governing misrepresentations in the insurance application across jurisdictions is whether the misrepresentation has to be intentional to bar coverage. OSTRAGER, BARRY R. AND THOMAS R. NEWMAN, 1 HANDBOOK ON INSURANCE COVERAGE DISPUTES 101-102 (11th ed., Aspen Law & Business 2002). In most jurisdictions, an innocent misrepresentation can be the basis for a denial of coverage under a D&O policy, as long as it is material.2 Texas is among the minority of jurisdictions that requires that a misrepresentation be made with an intent to deceive for coverage to be denied. Union Bankers Ins. Co. v. Shelton, 889 S.W.2d 278, 283 (Tex. 1994); Continental Cas. Co. v. Allen, 710 F.Supp. 1088, 1092 (N.D. Tex. 1989).

In order to prevail on a common law misrepresentation defense under Texas law, an insurer must prove that the insured intended to deceive the insurer when it applied for insurance. Shelton, 889 S.W.2d at 283; Allen v. American Nat. Ins. Co., 380 S.W.2d 604, 607-08 (Tex. 1974). The intent element of a common law fraud defense requires the insurer to 2 See, e.g., Nat’l Union Fire Ins. Co. v. Sahlen, 999 F.2d 1532, 1536 (11th Cir. 1993); First Nat’l Bank Holding Co. v. Fid. & Deposit Co. of Md., 885 F.Supp. 1533, 1535 (N.D. Fla. 1995); UFG Int’l Inc. v. Agricultural Express & Surplus Ins. Co., 207 B.R. 793, 798 (S.D.N.Y. 1997).

demonstrate the making of a known false statement intended to induce it to issue the policy. Absent actual knowledge that the response to the application was false, there can be no intent to deceive. Enserch v. Shand Morahan & Co., Inc., 952 F.2d 1485, 1496-1497 (5th Cir. 1992). Thus, even a material misrepresentation in an insurance application will not preclude recovery if the alleged misrepresentation was made negligently, carelessly or by mistake. Allen, 380 S.W.2d at 607-08; Enserch, 952 F.2d at 1496-97.

In contrast, in other jurisdictions such as New York, a carrier can prevail on a misrepresentation in the application for insurance defense merely by showing that a misrepresentation was made without also being required to show that the insured made the misrepresentation with the intent of deceiving the insurer. Mutual Benefit Life Ins. Co. v. JMR Elect. Corp., 848 F.2d 30, 32 (2nd Cir. 1988); Nationwide Mut. Fire Ins. Co. v. Pascarella, 993 F.Supp. 134, 136 (N.D.N.Y. 1998). 2. Will an Innocent Director be Entitled to Coverage When Another Director Makes a Material Misrepresentation in the Application?

Under New York law, a misrepresentation in the application by one director or officer may bar coverage for all directors and officers. See, e.g., INA Underwriters Ins. Co. v. D.H. Forde & Co., P.C., 630 F.Supp. 76, 77 (N.D.N.Y. 1985) (where president of an accounting firm which purchased professional liability insurance made material misrepresentations in the policy application, the policy was void ab initio even as to the individuals who had not signed the application). Cf. Wedtech Corp. v. Federal Ins. Co., 740 F.Supp.214, 218-219 (S.D.N.Y. 1990) (holding that, were a D&O policy contains a severability provision providing, in substance, that the insurance is to be construed as a separate contract with each insured, the policy would afford coverage for an innocent director not participating in the fraud). The question of whether coverage will be barred for an innocent insured based upon a misrepresentation made by another insured in an insurance application has not been addressed under Texas law. However, Texas’ long-standing public policy against allowing an insured to benefit from his fraudulent conduct has been held not to preclude an innocent co-insured from recovering policy benefits. See, e.g., Texas Farmers Ins. Co. v. Murphy, 996 S.W.2d 873, 881 (Tex. 1999) (involving question of whether an innocent spouse could recover insurance proceeds when the co-insured spouse intentionally destroyed insured community property).

Although Texas law makes it difficult for an insurer to avoid coverage based on an alleged misrepresentation in the policy application, the insured should carefully consider the following:











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• The policy application should be carefully reviewed before submission to the insurer. The policyholder must remember that the application becomes a part of the policy. It should not be treated as an afterthought or as a perfunctory responsibility.

• In particular, pay close attention to those items in the application dealing with (a) financial information of the entities to be covered and (b) knowledge of potential claims. Oftentimes, policy applications are poorly worded and do not clearly specify what information the insurer seeks concerning “potential claims.” The policyholder should carefully review the language in the application⎯as phrased⎯and provide accurate information to the question asked by the insurer.

• If possible, make sure that the innocent directors and officers are shielded from any alleged “misrepresentations” made by those responsible for filling out and submitting the application. Most policies will indicate that the omission of one director or officer will not be imputed to any other insured. If possible, make sure that the policy contains this feature, known as a “severability clause,” and applies equally to any omissions with respect to the submitted application.

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RECENT DEVELOPMENTS: Misrepresentations in the Application

Several recent cases have discussed

misrepresentations in D&O applications and severability clauses pertaining to such misrepresentations. a. Cutter & Buck Inc. v. Genesis Ins. Co., 2005 WL 1799397 (9th Cir. Aug. 1, 2005).

The Ninth Circuit Court of Appeals affirmed a decision by the district court granting summary judgment to an insurer on its claim for rescission on the basis of material misrepresentations made by the insured Company’s CFO in applying for two different policies. According to the lower court, the subject policies’ severability provisions contained an exception for “for material information known to the person or persons who signed the application.” Thus, as affirmed by the Court of Appeals, “misrepresentations in the application materials know to the officer signing the application were imputed to the other directors and officers.” See also Fed. Ins. Co. v. Homestore, Inc., 2005 WL 1926483 (9th Cir. Aug. 12, 2005) (severability provision unambiguously permits

rescission as to all directors and officers based on material misrepresentation known to a signer.). b. In re HealthSouth Corp. Ins. Litig., 308 F. Supp. 2d 1253 (N.D. Ala. 2004).

HealthSouth stemmed from a multitude of securities fraud actions brought against HealthSouth and its directors and officers. The issue before the court was whether insurers could rescind HealthSouth’s D&O policy based on misrepresentations in the policy application in light of a severability clause stating, “no statement in the application or knowledge possessed by any Insured Person shall be imputed to any other Insured Person for the purpose of determining if coverage is available.” The court held that, for the individual directors and officers, the severability clause necessitated individual treatment. That is, a “guilty” director’s knowledge of wrongdoing could not be imputed to innocent directors. Thus, the insurers could not rescind the policy for all the directors; instead, they would have to show on a person-by-person basis that each individual knew of the misrepresentation. In addition, for purposes of the corporate indemnity reimbursement coverage, the severability clause also precluded the insurers from denying coverage to the entity, HealthSouth, for the indemnification it provided to “innocent” directors. In other words, knowledge of the misrepresentation would not be imputed to directors or HealthSouth for purposes of this coverage.

However, for purposes of the policy’s entity coverage for securities claims, the policy language changed the severability clause, rendering it less effective where misrepresentations occurred in the application. As a result, even though the court still required the insurers to prove that HealthSouth, as a severable insured, had knowledge of the misrepresentation, the knowledge possessed by the entity’s individual directors and officers could be imputed for purposes of the entity coverage.

A later ruling by the court established that the rescission of the policy was not an “all or nothing” proposition, meaning that insurers could partially rescind the policy with respect to those insureds whom the insurers could prove had individual knowledge of wrongdoing. In re HealthSouth Ins. Litig., No. CV-03-BE-1139-S, order issued (N.D. Ala. July 15, 2004). c. Federal Ins. Co. v. Tyco International Ltd., 2004 WL 583829 (N.Y. Sup. Ct. 2004).

In Tyco, the court held that a D&O insurer could not unilaterally rescind its insured’s D&O policy. Instead, the insurer had a duty to pay defense costs until the insurer’s claim for rescission was adjudicated. The insurer had argued that, due to misrepresentations in the insurance application, the insured’s policy was




21

void from the beginning, thus relieving the insurer of its obligation to pay defense costs. However, the court decided that the insurer could only rescind coverage after first litigating its claim for rescission. At that time, assuming the insurer succeeded, the insured might be required to repay its defense costs to the insurer.

_______________

C. The Impact of the Sarbanes-Oxley Act on D&O Insurance.

In response to the accounting scandals at Enron, Worldcom and other publicly-traded companies, Congress enacted the Public Company Accounting Reform and Investor Protection Act of 2002 (the “Sarbanes-Oxley Act”). The Sarbanes-Oxley Act was designed to protect against further financial statement improprieties by setting forth new standards of corporate responsibility, enhancing disclosure requirements and providing for heightened criminal penalties. Margulis, The Sarbanes-Oxley Act and D&O Insurance – Who Bears the Cost of Corporate Responsibility?, 12 Andrews Del. Corp. Litig. Rep. 18 (2003) (hereinafter “Margulis”). Certain significant provisions of the Sarbanes-Oxley Act and their potential effect on the coverage afforded by a D&O insurance policy are addressed below. 1. Sarbanes-Oxley Act Requirements.

The Sarbanes-Oxley Act imposes duties on corporate directors and officers and provides significant civil and criminal penalties for violations of the Act. a. Certification Requirements.

There are two different certification provisions in the Sarbanes-Oxley Act. Section 302 of the Act requires that a company’s Chief Executive Officer and its Chief Financial Officer each sign a written, personal certification accompanying each quarterly and annual report filed by an issuer with the Securities and Exchange Commission pursuant to the Securities Exchange Act of 1934. The Section 302 requires a certification that: (1) each officer has “reviewed” the report, (2) based on their knowledge, the report does not contain an untrue fact or omit to state a material fact, (3) the report fairly presents the company’s financial condition, (4) each officer is responsible for establishing and maintaining internal controls and procedures designed to insure that material information is made known to the officer, and (5) the officer has disclosed to the company’s independent auditors and the company’s audit committee all significant deficiencies and material weaknesses in the internal controls and any fraud involving the company’s internal controls. Sarbanes-Oxley Act § 302(a). The second certification provision is contained in

Section 906 of the Act. That section requires a certification that the company’s reports comply with Sections 13(a) or 15(d) of the Securities Exchange Act of 1934 and that the information contained in the periodic report fairly presents, in all material respects, the financial condition and results of the operations of the company. Id. at § 906(a). b. Increased Audit Committee Duties.

Sarbanes-Oxley requires the audit committee, rather than company senior management, to be responsible for the outside auditor relationship, including the hiring, compensating, overseeing and firing of the auditor. The Sarbanes-Oxley Act thus increases the responsibilities imposed upon directors and officers who serve as members of a publicly-traded company’s audit committee. Under the Act, the audit committee is (1) directly responsible for the appointment, compensation and oversight of the company’s independent auditors, (2) charged with the responsibility for resolving any disagreements between management and the auditor concerning financial reporting matters, (3) required to be “independent,” i.e., the committee members cannot serve in a consulting, advisory or other capacity for which a fee is paid by the company and (4) must establish procedures for the receipt of whistleblower complaints received by the company regarding accounting or auditing matters. Sarbanes-Oxley Act § 301. c. Corporate Governance Issues.

The Sarbanes-Oxley Act also addresses certain other perceived abuses in corporate governance and officer compensation, issues which received substantial publicity in the wake of the Enron and Worldcom scandals. For example, the Act provides that if an issuer restates its financials “due to the material non-compliance of the issuer, as a result of misconduct, with any financial reporting requirement under the securities laws,” the CEO and CFO must repay any “bonus or equity-based compensation,” as well as profits from the sale of the issuer’s stock, received or realized in the year following the public issuance or filing of the original financial statements. Sarbanes-Oxley Act, § 304(a). The Act also prohibits, except under certain limited circumstances enumerated in the Act, loans or extensions of credit to directors or executive officers. Sarbanes-Oxley Act, § 402(a). The Act likewise prohibits directors and officers from buying, selling, acquiring or transferring any equity security of the issuer during any blackout period if the director or officer acquired such security in connection with his service or employment as a director or


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officer.3 Sarbanes-Oxley Act, § 306(a). The Act further creates a right of action in the issuer, or a security holder of the issuer if the issuer fails to take action to recover such profits, regardless of the intent of the seller. Id. d. Criminal Penalties.

Under the Act, it is a crime to certify the statement accompanying a periodic report while “knowing” that the report does not comport with the requirements of the Act. Sarbanes-Oxley Act § 906. The Act further defines as criminal conduct the following:

i. Securities Fraud – any person who knowingly executes or attempts to execute a scheme or artifice to defraud any person or obtain money or property in connection with the sale or purchase of securities of an issuer is subject to imprisonment of up to twenty-five years. Sarbanes-Oxley Act § 807; ii. Destruction of Corporate Audit Records – the Act requires accountants to maintain audit review work papers for five years; anyone who knowingly and willfully violates this section or rules promulgated thereunder is subject to fine and imprisonment of up to ten years. Sarbanes-Oxley Act § 802(a); iii. Destruction of Records and Investigations of Bankruptcy – it is now a crime, punishable by imprisonment of up to twenty years, to knowingly alter, destroy, mutilate, conceal, cover-up, falsify or make a false entry in any record or document with the intent to impede, obstruct or influence a federal government investigation or a bankruptcy case, “or in relation to or contemplation of any such matter or case.” Sarbanes-Oxley Act § 802(a); iv. Tampering with Records – it is a crime punishable by fine or imprisonment of up to twenty years to “corruptly” alter, destroy, mutilate or conceal records or attempt to do so, with the intent to impair their integrity or availability in an official proceeding, or to obstruct, influence or impede any official proceeding. Sarbanes-Oxley Act § 1102; and v. Retaliation against Informants – it is a crime punishable by fine and imprisonment of up to ten years to knowingly, with the intent to retaliate, take any action harmful to any person providing to

3 The term “blackout period” is defined with reference to individual account plans under the Employee Retirement Income Security Act, and generally includes any period in which the ability of at least half the plan participants to buy or sell the securities is suspended by the plan fiduciary.

a law enforcement officer any truthful information relating to the commission or possible commission of any federal offense. Sarbanes-Oxley Act § 1107.

Margulis, 12 Andrews Del. Corp. Litig. Rep. 18. 2. Increased Liability Exposure.

A recent article, Bailey, Washburn and Faust, Now It’s Personal: The Real Impact of Sarbanes-Oxley on Directors and Officers, 6 No. 4 Wallstreetlawyer.com (September, 2002), while emphasizing that the Sarbanes-Oxley Act does not criminalize behavior previously considered lawful, identifies the following areas of increased risk, either in the form of additional potential claims or increased penalties, to directors and officers as a result of the passage of the Sarbanes-Oxley Act: a. Breach of Fiduciary Duty Claims.

Sarbanes-Oxley sets forth new “required” activities for directors and officers. Failure to perform those activities may be viewed as evidence of a de facto breach of the duty of care. For example, failure to make required disclosures in a filing under the Securities Exchange Act of 1934 could be viewed as a breach of fiduciary duty that harms the company’s shareholders. Further, some practices (such as loans to officers and directors) are prohibited precisely to reduce conflicts of interest. Should an officer or director ignore one of these prohibitions, it could be considered a de facto breach of the duty of loyalty. b. Securities Fraud Claims.

Directors and officers now face increased penalties for civil and criminal securities fraud violations. . . . Individuals found guilty of securities fraud now face fines and as much as 25 years in prison (up from the previous penalty of up to 10 years in prison). In addition to increased penalties, Sarbanes-Oxley effectively increases the likelihood that claims will be brought against directors and officers. For example, with the new real-time disclosure obligations,4 no matter how vigilant directors and officers are in disclosing material events, shareholders (having the benefit of hindsight) can claim that other information was material and worthy of immediate disclosure. c. Unfitness Claims.

The SEC now has greater authority to enjoin individuals from serving as officers or directors of a public company. The SEC may impose such a ban upon a finding that the individual was “unfit” for such service – a lower threshold than the previous 4 Section 409 of the Sarbanes-Oxley Act requires a plain-English disclosure on a “rapid current basis” of material changes in a company’s financial condition.


23

“substantially unfit” standard. Until this new standard is clarified (through regulation or practice), the failure to meet any of the numerous new oversight requirements will likely be used as evidence of unfitness. d. Compensation Forfeiture.

CEOs and CFOs who must restate their company’s financial reports risk forfeiture of up to twelve months of their bonus or equity compensation if the restatement resulted from an act of misconduct or material noncompliance with any provision of the federal securities law. e. Certification Violations.

While officers have always been required to sign Exchange Act reports, now CEOs and CFOs must personally certify financial statements that are field with the SEC. This new certification requirement puts executives at personal risk if the financial statements are materially inaccurate, with potential penalties including fines as high as $5 million and imprisonment as long as 20 years. Certification not only adds a level of personal accountability to the audit process, but also makes it harder for a CEO or CFO to claim ignorance when the company’s financial statements are proven to be faulty. 3. Potential Implications of the Sarbanes-Oxley Act on D&O Insurance Coverage. a. Will A Claim for Violation of the Sarbanes-Oxley Act Satisfy the Policy Definition of “Loss.”

D&O insurance policies typically insure against “Loss” as a result of a “Claim” arising from “Wrongful Acts.” D&O policies typically cover “Loss” for damages, judgments, settlements and defense costs, but the term “Loss” may be defined in some D&O policies so as not to include “civil or criminal crimes or penalties.” A CEO or CFO alleged to have violated the certification requirements of the Sarbanes-Oxley Act is potentially subject to claims for civil and/or criminal penalties that may not be covered as a “Loss” within the meaning of the policy. Smith, The Sarbanes-Oxley Act: How Will It Affect D&O Insurance Coverage?, 91 Ill. B.J. 128 (2003) (hereinafter “Smith”). In order to provide corporate directors and officers with a greater level of protection, steps should be taken to procure a D&O policy with a broad “Loss” definition. b. Coverage for Criminal Proceedings. While the insuring agreement in many D&O policies defines a “Claim” so as to include criminal and/or regulatory proceedings, other D&O proceedings contain narrower definitions affording coverage only to demands for monetary relief in a civil proceeding. Given the criminal penalties available under the Sarbanes-Oxley Act, the purchase of a D&O policy with an expanded “Claim” definition will be necessary in order to provide protection to directors and officers

in the face of a regulatory or criminal proceeding. Margulis, 12 Andrews Del. Corp. Lit. Rep. 18. c. The Fraud/Dishonesty Exclusion.

D&O policies typically contain a fraud/dishonest acts exclusion. A typical such provision excludes coverage for claims arising out of deliberately fraudulent or deliberately dishonest acts or omissions or any willful violation of any statute or regulation. Certain versions of the fraud/dishonest acts exclusion provide that coverage is precluded under the exclusion only in the event that a judgment or other final adjudication establishes such deliberately fraudulent act or omission. A conviction for any of the crimes specified in the Sarbanes-Oxley Act would likely vitiate coverage under a D&O policy for loss arising out of such proceedings. Thus, it is important for directors and officers to make sure that the fraud exclusion in the policy will only apply if a trial on the merits has resulted in an actual finding of fraud so that the D&O insurer cannot refuse to advance defense costs based upon mere allegations of fraud in the complaint. In addition, a severability exclusion should be included in the policy in order to protect an innocent insured from losing coverage based upon the conduct of another insured. Smith, 91 Ill. B.J. 128. d. The Personal Profit Exclusion.

Another common exclusion in D&O policies excludes coverage in connection with a claim arising out of or based upon director or officer having gained any personal profit, remuneration or advantage to which he or she was not legally entitled. This exclusion could come into play in situations where a claim is made against a director or officer for trading stock during a blackout period or for repayment of bonus or equity-based compensation or profits on the sale of stock in the event of a restatement of financial statements. Margulis, 12 Andrews Del. Corp. Litig. Rep. 18. Similarly, the exclusion could come into play in connection with a claim by the company against a director or officer seeking to recover profits made by the director or officer on a security transaction in the company’s securities taking place during a blackout period. e. Insured v. Insured Exclusion.

The Sarbanes-Oxley Act also raises the possibility of claims being asserted by one insured against another. For example, claims against the audit committee members for failure to properly oversee the preparation of the company’s financial statements could lead to a claim for contribution or indemnity by the audit committee directors against the company’s CEO or CFO for allegedly failing to discharge their duties in preparation of the financial statements. In order to protect against the possibility of a loss of coverage in this situation, an insured v. insured


24

exclusion which does not apply to cross claims asserted by another insured should be procured. Smith, 9 Ill. B.J. at 142. Another situation in which the insured v. insured exclusion might come into play would be in connection with a claim by the company against a director or officer seeking to recover profits made by the director or officer on a purchase or sale of the company’s securities during a blackout period. f. Rescission of Policies.

In connection with an application for D&O insurance, D&O insurers frequently request copies of, and state that they will be relying upon, annual and quarterly reports. Under Sarbanes-Oxley, the certifications contained in such reports will also be submitted to the insurers. In the event that financial statements later turn out to be inaccurate, D&O insurers potentially could seek rescission of the policy based upon misrepresentations contained in the certifications. Margulis, 12 Andrews Del. Corp. Litig. Rep. 18.

_______________

RECENT DEVELOPMENTS: What constitutes “Loss” for Purposes of

Coverage for Securities Claims?

As securities litigation has proliferated, insurers have found new ways of curtailing their obligation to indemnify their insureds for the resulting judgments and settlements. One argument insurers are increasingly employing involves the definition of “loss” in D&O policies. Relying on two cases ruling that securities damages are fundamentally restitutionary in character, insurers are claiming that entity coverage for securities transactions—which insureds ostensibly purchase to protect themselves from all securities claims—does not cover certain securities-related settlements and damages because those damages do not constitute “loss” under the policy. See Level 3 Communications, Inc. v. Fed. Ins. Co., 272 F.3d 908 (7th Cir. 2001); Conseco, Inc. v. Nat’l Union Fire Ins. Co. of Pittsburgh, PA, 2002 WL 31961447 (Ind. Ct. App. 2002); see also Unified Western Grocers, Inc. v. Twin City Fire Ins. Co., 371 F. Supp. 2d 1234 (D. Haw. 2005); Pan Pacific Retail Props., Inc. v. Gulf Ins. Co., 2004 WL 2958479 (S.D. Cal. July 14, 2004).

According to Level 3 and Conseco, when a securities fraud claim involves a direct purchase or sale between the defendant and the plaintiff, any resultant damages for that claim merely represent the “disgorgement of an ill-gotten gain.” In other words, any insured who pays a settlement or a judgment for this kind of securities fraud is merely returning money that it effectively “stole” from the plaintiff. Because

the insured never should have acquired the money in the first place, by giving the money back to the plaintiff, the insured is not actually suffering a “loss,” as that word is commonly understood. Thus, a settlement or judgment for this kind of securities claim does not trigger the insured’s D&O policy because no “loss” has occurred, as required by the policy’s insuring agreement.

The reasoning in these cases, as well as their application of insurance and securities law, is debatable and subject to criticism. As time passes, courts might limit their holdings or distinguish them altogether. See St. Paul Mercury Ins. Co. v. Foster, 268 F. Supp. 2d 1035 (C.D. Ill. 2003) (distinguishing Level 3). Currently, however, very few cases have discussed either Level 3 or Conseco. Consequently, it remains to be seen how courts in Texas and elsewhere will treat these cases in the future.

What is quite evident is that insurers are using the threat of Level 3 and Conseco as leverage in negotiations with insureds who are confronting securities claims. Insureds should therefore be aware that, according to their insurers, D&O policies offering may only afford coverage for a narrow range of securities claims, such as fraud-on-the-market claims. Companies in the market to purchase or renew D&O liability insurance may wish to negotiate additional affirmations from their insurers to the effect that their entity coverage will provide indemnity for all forms of securities litigation, including, but not limited to, lawsuits under section 11 of the Securities Act of 1933 and lawsuits under Rule 10b-5 of the Securities and Exchange Act of 1934.





© Haynes and Boone, LLP 2006

Indemnification, Exculpation and D&O Insurance Protection

Evaluation Chart

4th Annual Advanced Business Law Course

TexasBarCLE Advanced Course

October 26, 2006

Tom D. Harris Haynes and Boone, LLP



Ernest Martin, Jr. Haynes and Boone, LLP



DERIVATIVE CLAIM

Alleged Breach of

Duty of Care

Business Judgment Rule

• Presumption • Requires a reasonable process

Exculpation Provision* Exceptions: • Duty of Loyalty • Intentional Misconduct • Knowing Violation of

Law • Improper Dividend • Absence of Good Faith

Derivative Claim

Alleged Breach of Duty of Loyalty

• Entire Fairness (subjective review)

• Possible deference to procedural analysis

• Dismissal • Settlement • Judgment

INDEMNIFICATION

Derivative Claim Indemnification

Company Advancement of Expenses

Company Payment of Judgment if

Unsuccessful on the Merits

Directors Reimburse Company if


Individually Enforceable/ Irrevocable

Procedural Protections

Corporation Law Maybe No Yes Maybe/No Few Charter/Bylaws Probably No Yes Yes/Yes Few Contractual Probably No Yes Yes/Yes More

Standard: The director must have “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 . . .”*

Two-Prong Test: In a derivative case, the director (a) must not be “adjudged to be liable to the corporation” (“adjudged” may include a settlement that resulted in any payment by the directors to the corporation) and (b) must meet the standard for indemnification*

Determination: Indemnification is subject to an affirmative determination, by one of the following, that the indemnification standard has been met:*

• a majority of the disinterested directors (even if less than a quorum)

• independent legal counsel in a written opinion

• a majority of the stockholders

TYPICAL D&O INSURANCE POLICY PROVISIONS

Three Types of Coverage:

A B C

Coverage for individual insured where the Company is Not Required or Permitted to indemnify the individuals (for example, a derivative claim where the directors were unsuccessful on the merits)

Coverage for individual insured where the Company is Required or Permitted to indemnify the individuals (for example, a derivative claim where the directors are successful on the merits)

Coverage for the Company for Company liability for “Securities Claims”

Retention: (Deductible)

None Yes unless the Company is insolvent Yes

Insured: Any past, present or future director or officer or member of the Board

Any past, present or future director or officer or member of the Board

The Company

Claim: Written demand for monetary or non-monetary relief against an insured person and against the Company for securities violations; court proceeding or arbitration against an insured person or against the Company for securities violations

Payment of Expenses: Insurer must advance defense costs on a “current basis” when requested in writing by the insured – potentially subject to the insured signing an undertaking to repay

Exclusions: Fraud, illegal profit, prior and pending litigation, “insured vs. insured” Rescission: An insurer may seek to rescind a policy if the insurer believes there was fraud in the policy application

*Based on the Delaware General Corporation Law. Other States’ laws may vary.


DIRECT CLAIM BY A PRIVATE PARTY

Direct Claim by a Shareholder

(Individual or Class Action)

Alleged Federal Securities Law

Violation

1934 Act Claim • Requires scienter

Alleged State Law Fraud Claim • Common law • Statutory

1933 Act Claim • Misstatements in

registration statement • No proof of scienter

or reliance required

Proof requirements vary by claim

• Dismissal • Settlement • Judgment

INDEMNIFICATION

Direct Claim by a Private Party Indemnification








Corporation Law Maybe Yes, if indemnity standard is met

No, if indemnity standard is met

Maybe/No Few

Charter/Bylaws Probably Yes, if indemnity standard is met


Yes/Yes Few

Contractual Probably Yes, if indemnity standard is met


Yes/Yes More


best interests of the corporation . . .”*

No Two-Prong Test: Unlike in a derivative claim, the question for indemnification is only whether the director met the standard for indemnification, not whether the director was found to be liable in the private party’s action*





Public Policy: Some courts have prohibited indemnification for violations of Federal securities laws

TYPICAL D&O INSURANCE PROVISIONS


A B C

Coverage for individual insured where the Company is Not Required or Permitted to indemnify the individuals (for example, the individual is found to have not met the standard for indemnification)

Coverage for individual insured where the Company is Required or Permitted to indemnify the individuals (for example, a securities claim where the directors are successful on the merits)






The Company

Claim: Written demand for monetary or non-monetary relief against an insured person and against the Company for securities violations; court proceeding or arbitration against an insured person or against the Company for securities violations


Exclusions: Fraud, illegal profit, prior and pending litigation, “insured vs. insured” Rescission: An insurer may seek to rescind a policy if the insurer believes there was fraud in the policy application

*Based on the Delaware General Corporation Law. Other States’ laws may vary.


CLAIM BY A GOVERNMENTAL ENTITY INDEMNIFICATION

Investigation (SEC or DOJ)

SEC Administrative Claim

• Negligence • Recklessness

SEC Civil Claim

• Negligence • Recklessness

DOJ Criminal Action

• Requires willfulness

• Cease and Desist Order • O&D Bar • Disgorgement

• O&D Bar • Disgorgement • Monetary Penalties • Injunction

• Fines • Imprisonment

Claim by a Governmental Entity

Direct Claim by a Governmental Entity Indemnification








Corporation Law Maybe Yes, if indemnity standard is met


Maybe/No Few

Charter/Bylaws Probably Yes, if indemnity standard is met


Yes/Yes Few

Contractual Probably Yes, if indemnity standard is met


Yes/Yes More


best interests of the corporation . . . .” In a criminal action, the director must meet the foregoing and must have “had no reasonable cause to believe [his] conduct was unlawful.”*

No Two-Prong Test: Unlike in a derivative claim, the question for indemnification is only whether the director met the standard for indemnification, not whether the director was found to be liable in the governmental entity’s action*





Public Policy: Some courts have prohibited indemnification for violations of Federal securities laws TYPICAL D&O INSURANCE POLICY PROVISIONS


A B C

Coverage for individual insured where the Company is Not Required or Permitted to indemnify the individuals

Coverage for individual insured where the Company is Required or Permitted to indemnify the individuals (for example, an SEC investigation where the directors are successful on the merits)






The Company

Claim: Criminal proceeding against an insured person commenced by return of indictment or against the Company for securities violations commenced by return of indictment; formal civil, criminal, administrative regulatory proceeding or formal investigation of an insured person depending on formality or identification of the person targeted; formal civil, criminal, administrative regulatory proceeding or formal investigation of the Company but, with respect to administrative or regulatory proceedings, only while and to the extent such proceeding is maintained against an insured person


Exclusions: Fraud, illegal profit, prior and pending litigation, “insured vs. insured” Donaldson Doctrine Governmental entities may require in a settlement that each settling party agree to not collect insurance or receive

indemnification Rescission: An insurer may seek to rescind a policy if the insurer believes there was fraud in the policy application

© Haynes and Boone, LLP 2006 *Based on the Delaware General Corporation Law. Other States’ laws may vary.