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American Bar Association

ABA Section of Business Law


Volume 13, Number 1 - September/October 2003

Will the company cover an ex-officer's legal costs?
The new world of Sarbanes-Oxley
    By Sean T. Carnathan

You represent a publicly traded corporation that is embroiled in a lawsuit with one of its former officers. The officer demands that the corporation pay her legal expenses during the course of the proceedings, and the corporation asks you whether it must comply. What do you say?

Does your answer change if the person is a current officer and the corporation wants to advance the legal expenses? What if you represent the officer? What is the likelihood of your client's success in seeking payment of legal expenses prior to resolution of the action?

Before July 30, 2002, lawyers could generally answer such questions with a high degree of confidence by reference to the company's corporate bylaws and the law of the state of incorporation, or in some cases a separate employment or indemnification agreement. In most instances, the bylaws and statutes would have dictated that the corporation advance the expenses. See, for example, 8 Del. C. § 145.

Enter the Sarbanes-Oxley Act of 2002. It has complicated matters considerably by broadly prohibiting extensions of personal credit to officers and directors at publicly traded companies. Sarbanes-Oxley Act of 2002, § 402 (amending 15 U.S.C. § 78m) (Section 402). This provision may come into play because state law often requires repayment of advanced funds if the officer is later determined not to be entitled to indemnification.

Last fall, 25 prominent law firms circulated a joint letter, outlining their interpretation of the issues raised by Section 402. Sarbanes-Oxley Act Interpretive Issues Under § 402 – Prohibition of Certain Insider Loans, Oct. 15, 2002 (October 2002 Memo). These law firms concluded that advancing legal expenses remained permissible despite Section 402. Because neither the SEC nor any court has provided any guidance on this issue, however, uncertainty reigns. Here is how to analyze the matter.

Corporate governance issues, such as whether a corporation can or must indemnify its directors and officers, are generally controlled by the law of the state of incorporation. Because the lion's share of public companies are incorporated in Delaware, that is usually where these issues play out. Under Delaware law, a corporation is authorized to indemnify its officers, directors and employees for expenses incurred as a result of a legal action, suit or proceeding (action) against them as a result of their service to the corporation. 8 Del. C. § 145(a). This authority includes actions the corporation files itself, whether directly or derivatively. 8 Del. C. § 145(b).

Indeed, Delaware law requires that its corporations indemnify present or former officers and directors who are "successful on the merits or otherwise in defense" of any such legal action. 8 Del. C. § 145(c). On the flip side, however, a corporation is prohibited from indemnifying its officers and directors if they acted in bad faith or in a manner that they did not reasonably believe was in — or at least not opposed to — the best interests of the corporation. 8 Del. C. § 145(a); see also Waltuch v. Conticommodity Servs. Inc., 88 F.3d 87, 95 (2d Cir. 1996) (statute does not permit indemnification of officer who did not act in good faith). In criminal proceedings, the standard is whether the person "had reasonable cause to believe that the person's conduct was unlawful." 8 Del. C. § 145(a).

Most states will have similar statutory schemes. In Massachusetts, for example, the applicable statute also provides for indemnification of officers and directors so long as they are not "adjudicated in any proceeding not to have acted in good faith in the reasonable belief that [their] action was in the best interest of the corporation." M.G.L. ch. 156B, § 67. Massachusetts also provides for advancement to an officer or director who undertakes to repay the funds. Id.

Sarbanes-Oxley does not affect indemnification as a general matter, because the corporation is not obligated to indemnify an officer or director until the matter has been resolved. The potential problem arises when the officer or director demands that the company advance funds to pay the legal expenses incurred in defending against the action. Delaware law authorizes corporations to advance expenses, so long as the officers or directors undertake to repay the funds if they are ultimately determined not to be entitled to indemnification. 8 Del. C. § 145(e).

Corporations are not required to provide for advancement under Delaware law, but most of them do. The corporation's undertaking to indemnify its officers and directors and advance them legal expenses is generally found in the corporate bylaws. In some instances, the corporation may also enter into a separate contractual arrangement with a particular officer or director. If there is a contingent repayment obligation, the arrangement arguably becomes an extension of credit, which Sarbanes-Oxley Section 402 may prohibit.

Sarbanes-Oxley Section 402, entitled "Enhanced Conflict of Interest Provisions," states that publicly traded companies are not allowed "directly or indirectly . . . to extend or maintain credit, to arrange for the extension of credit, or to renew any extension of credit, in the form of a personal loan to or for any director or executive officer (or equivalent thereof) of the issuer." This provision is intended to prevent the sort of loans to corporate insiders that were found in a number or recent corporate scandals, where officers received personal loans to purchase securities or other property that did not benefit the corporation or its shareholders.

As of this writing, no reported decision addresses Section 402's effect on the advancement of legal expenses. Neither has the SEC provided any guidance on this point. Indeed, in a speech delivered to the American Bar Association on Jan. 22, 2003, SEC Division of Corporate Finance Director Alan Beller stated that the SEC would not provide any guidance with regard to Section 402 for at least the next year. Corporations and their counsel are, therefore, currently left to interpret the effect of Section 402 on any advancement undertaking for themselves.

Not surprisingly, the private bar has largely come down in favor of continuing to advance legal fees. In the joint letter circulated last fall, 25 prominent law firms (the firms) concluded that advancing legal expenses remained permissible despite Section 402. October 2002 Memo, supra. They gave several reasons.

The firms reasoned that the policy behind advancement — to encourage qualified people to serve as officers and directors of public companies — is "[w]ell- developed and longstanding." Nothing in the text or legislative history of the act suggests that Congress intended to eliminate this protection for corporate officers and directors. Discouraging qualified people from serving in these positions would be poor public policy.

On a more technical note, the firms suggested that advancement is not a true "loan," because the repayment obligation is contingent on a finding of some wrongdoing by the officer or director. Practical realities surrounding most advancements may buttress this reasoning. Advancement is not generally collateralized, and is extended without evaluation of the officer's or director's ability to repay the funds. On the other hand, unsecured and nonrecourse loans are available in other contexts, and are still loans for legal, accounting and tax purposes.

Finally, the firms offered the rationale that advancement is not "personal," because the litigation expenses are "incurred in connection with services to the issuer that constitute a business purpose regardless of whether ultimately these amounts need to be repaid." Although the same could be said with regard to any loan to any officer or director because the arguable business purpose is to encourage that person to serve the corporation, this reasoning is widely viewed as the strongest of the lot.

Indeed, it recently received some tangential support from the Delaware Chancery Court, when the court held that a county's reimbursement of legal fees for certain county employees does not violate the Delaware Constitution, because reimbursement serves a public purpose. Mell v. New Castle County, Civil Action No. 20003-NC, slip op. at 10-13 (Del. Ch. April 11, 2003).

In Mell v. New Castle County, certain New Castle County employees worked on political campaigns while at work. The FBI began an investigation into the matter on behalf of the U.S. attorney's office, and the employees under investigation retained counsel at the county's expense. A group of New Castle County taxpayers filed an action seeking to enjoin payment of the employees' attorney's fees.

The taxpayers argued, inter alia, that Article VIII, § 8 of the Delaware Constitution prohibited payment of the employees' fees because it provides that "[n]o county, city, town or other municipality shall lend its credit or appropriate money to, or assume the debt of, or become a shareholder or joint owner in or with any private corporation or any person or company whatever."

Under existing Delaware case law, this provision had long been interpreted to permit payment of public funds to a private individual, so long as the funds were used for a "public purpose." Mell v. New Castle County, Docket No. 20003-NC, slip op. at 10 (Del. Ch. April 11, 2003). The court found a public purpose for paying the fees, because

indemnification ordinances promote the public interest by encouraging recruitment and retention of high-risk officers, protecting the government from liability for their officers' criminal actions, helping to maintain morale, and providing necessary protection to those whose line of work exposes them to the financial burdens of defending baseless civil and criminal charges.

Id. at 12.

This is the same rationale generally offered for corporate indemnification of its officers and directors. Accordingly, it may support the contention that advancement remains permissible under Section 402. Indeed, in this light, Section 402 may simply emphasize the existing requirement under Delaware law that advancement is available only for proceedings resulting from the officer's actions on behalf of the corporation. See Hibbert v. Hollywood Park Inc., 457 A. 2d 339, 344 (Del. 1983).

Nevertheless, from a practical standpoint, the matter will be open to dispute until the SEC or the courts clarify the availability of advancement after Sarbanes-Oxley. The opinion of the private bar is obviously not binding authority anywhere, and will not necessarily persuade a court or the SEC.

In fact, shortly before the firms circulated their opinion letter, Sens. Susan M. Collins and Carl Levin, of the Permanent Subcommittee on Investigations that investigated the Enron scandal, wrote to then-SEC-Chairman Harvey L. Pitt. They urged him not to "narrow the scope of the [Section 402] prohibition or otherwise weaken it through regulation, guidance or other means." Letter from Collins & Levin to Pitt, Sept. 25, 2002. Collins and Levin cited widespread insider abuse and a lack of effective board or management oversight. They advocated a "bright- line" approach to enforcement of Section 402. Although this letter does not directly address the advancement issue, it suggests the potential for a hard-line approach to interpretation of Section 402.

In the event that the SEC takes a hard line on Section 402, the penalties for violation are potentially severe. Because Section 402 amended Section 13 of the Exchange Act of 1934 (15 U.S.C. § 78m), a "willful" violation of Section 402 potentially subjects individuals to criminal penalties including a fine of up to $5 million and up to 20 years in prison. The company itself could be subject to a criminal penalty of up to $25 million dollars. See Sarbanes- Oxley § 1106 (amending Section 32(a) of the 1934 Act (15 U.S.C. § 78ff(a)).

Such stiff penalties for advancing legal expenses to an officer or director involved in a lawsuit seem extremely unlikely. But corporations can also be subject to SEC administrative penalties, including censure, cease-and- desist orders, revocation of registration or fines of up to $500,000. See 15 U.S.C. §§ 78u-2, 78u(d)(5). A corporation might also suffer a shareholder derivative action for improperly advancing expenses.

Because the law is unsettled and the penalty for violation may be stiff, corporations are justified in taking different positions. In advising your client, you should note this state of uncertainty, outline the options and discuss the potential consequences of the possible positions.

For example, if the corporation's relationship with the officer or director making a demand for advancement has soured, the corporation has a justifiable, good faith position that the act prohibits advancement, particularly in light of the potentially severe penalties for a violation. The author knows of at least one case in which a corporation has asserted Sarbanes-Oxley Section 402 to refuse to advance legal expenses to one of its former officers embroiled in a lawsuit.

You should advise your client in making this calculus that, in a recent decision, the Delaware Supreme Court awarded an officer "fees for fees," that is, permitted the officer to recover not only the fees he sought, but the fees he expended in obtaining them. Stifel Financial Corp. v. Cochran, Docket No. 548 (Del. June 13, 2002). Your client should be aware of the potential to be ordered to pay the fees the officer or director incurs in obtaining an order to force advancement.

On the other hand, the corporation may face a potentially more difficult decision where the relationship between the corporation and its officers and directors remains strong. The corporation may want to advance fees, but legitimately fear that to do so would violate Sarbanes-Oxley.

In that case, the corporation could choose to rely on the October 2002 Memo as support for a decision to advance fees, or could seek another opinion from counsel. The corporation might also request a "No-Action Letter" from the SEC, but given the SEC's recent statement of its intention not to provide guidance in this area, a helpful response seems unlikely. There's no getting around it: The corporation will likely need to make a determination for itself with knowledge of the risks involved.

If representing the officer or director, you will almost certainly advise making the demand. But your prospect of receiving voluntary payment will likely depend on the strength of your client's relationship with the corporation. Until there is clear guidance, you will need to be braced to pursue advancement in court. On the bright side, if you prevail, you should be able to send the corporation the bill for that work as well.



Foreign or privately held

Publicly traded companies will include foreign private issuers who have securities registered with the SEC following Section 12 of the Securities Act of 1933 or who are required to file reports with the SEC following Section 15(d) of the 1933 Act.

Privately held companies are not subject to Section 402's provisions, although some lawyers are advising that privately held companies should try to comply with Sarbanes- Oxley if they perceive any possibility that they will go public or want to be acquired by a public company.

— Sean T. Carnathan


Carnathan is a principal at Rubin Hay & Gould, P.C., in Framingham, Mass. His e-mail is scarnathan@rhglaw.com.

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