Newsletter of the ABA Section of Business Law Committee on
  Director and Officer Liability Report

Message from the Chair

Featured Articles
  Important Cases Regarding Director and Officer Liability: 2012
  Defending Directors and Officers Against Breach of Fiduciary Duty Claims in Bankruptcy

Editorial Board:

Corinne Amato
    Newsletter Co-Editor
    Associate at Morris James LLP

Frances Goins
    Newsletter Co-Editor
    Partner at Ulmer & Berne LLP

Michaela Sozio
    Newsletter Co-Editor
    Partner at Tressler LLP

Special thanks to Anton Tupa, University of Pennsylvania Law School 3L, for his substantial contribution to this edition of the Director and Officer Liability Report.

  Message from the Chair

Welcome to the inaugural edition of the Directors and Officers Liability Report. We aim to become the site of choice for inside and outside counsel and practitioners aiming to stay current with the latest case law and statutory developments affecting director and officer liability. In a world of rapid change, understanding the risks to officers and directors and the rules and practices regarding insurance, indemnification and advancement is vital for those who are called upon to advise officers and directors or the corporations, stockholders and other constituencies they serve. If you are receiving this in due course as a member of our section, we hope this report contributes to your satisfaction as a section member. And if you wish to help by contributing to the newsletter, we welcome your participation. Feel free to email me at or one of the co-editors, Corinne Amato at, Frances Goins at or Michaela Sozio at Special thanks to Corinne, Frances and Michaela for getting this project off the ground. I hope to see you at our next meeting on April 5, 2013 during the ABA Business Law Section spring meeting in Washington D.C. where we will meet from 10:00 to 11:30 a.m. in The Independence Room, Lobby Level, of the Washington Hilton Hotel in Washington, D.C.

Lewis H. Lazarus
Morris James LLP
Chair, Directors and Officers Liability Committee
ABA Business Law Section

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  Featured Articles
Important Cases Regarding Director And Officer Liability: 2012

FDIC v. Perry

Litigation resulting from the financial crisis of 2008 regarding director and officer liability continued in the latter part of 2011 and 2012, with several important decisions coming out in the area. In Federal Deposit Insurance Corporation v. Perry, the Ninth Circuit Court of Appeals declined a petition for interlocutory appeal to review a California district court decision denying defendant Matthew Perry's Motion to Dismiss plaintiff Federal Deposit Insurance Corporation, as Receiver for Indymac Bank, F.S.B.'s Complaint on the basis that the Complaint failed to allege facts sufficient to overcome the presumption of the business judgment rule. See FDIC v. Perry, 2012 WL 589569 (C.D. Cal. Feb. 21, 2012), leave to appeal denied, 12-80033 (9th Cir. May 11, 2012). For a copy of the district court's decision denying the defendant's Motion to Dismiss, please click here. In the Complaint, the plaintiff alleged that Indymac's CEO breached his duties to Indymac and negligently permitted the production of a pool of more than $10 billion in risky residential loans intended for sale into the secondary market, and, since the secondary market was too volatile, Indymac was forced by the fourth quarter of 2007 to transfer the loans into its own portfolio. Allegedly, these loans generated losses of $600 million. In July of 2008, Indymac closed, with the FDIC appointed as receiver.

Perry argued in the Motion to Dismiss that the plaintiff had not pleaded facts sufficient to overcome the business judgment rule. Perry was both an officer and director at the time of the challenged conduct. California Corporations Code § 309, which codifies California's common law business judgment rule, explicitly makes reference to directors and directors' duties and liabilities but does not make reference to officers. The district court found that the plaintiff had sufficiently alleged that Perry's actions were undertaken primarily in his capacity as an officer. The district court focused on two lines of argument. First, the court suggested that the scant case law on point tended to support the holding that the common law business judgment rule does not apply to corporate officers. Second, the court found that the California Legislature spoke clearly on the issue when it omitted any mention of officers in its legislation. Moreover, the legislative committee's comments revealed that it was the drafters' intent to exclude officers from the protection of the business judgment rule.

The Perry opinion interprets only California law. However, the opinion may be persuasive authority in the interpretation of other states' common law and corporate statutes that do not explicitly provide for the application of the business judgment rule to officers, given that so little precedent exists in this area.

SEC v. Mudd, et al.; SEC v. Styron, et al.

In a pair of Complaints filed in December of 2011, the United States Securities and Exchange Commission alleged that certain senior executive officers of Freddie Mac and Fannie Mae approved misleading statements which asserted that the companies had minimal holdings in high-risk mortgage loans--primarily sub-prime loans. For a copy of the Complaints please click here and here. As a result of these misleading statements, the SEC alleged, investors materially underestimated Freddie Mac's and Fannie Mae's exposure to the risk of such loans. The SEC alleged that the officers violated Rule 10b-5 under the Securities Exchange Act of 1934 (the "Exchange Act") and Section 17(a) of the Securities Act of 1933, in addition to Section 302 of the Sarbanes-Oxley Act of 2002. With regard to the Freddie Mac officers, the SEC alleged that the officers were aware of Freddie Mac's increasing subprime exposure and were responsible for Freddie Mac's disclosures to investors, and that each officer made, or aided and abetted Freddie Mac or each other in making, false and misleading credit risk disclosures regarding sub-prime loans in a "single family" guarantee portfolio. With regard to the Fannie Mae officers, the SEC alleged that each of the officers made or substantially assisted others in making materially false and misleading statements regarding Fannie Mae's exposure to sub-prime and so-called "Alt-A" (reduced documentation) loans.

Louisiana Municipal Police Employee's Retirement System v. Pyott

Important developments in the law of demand futility in derivative actions also emerged in 2012. The Delaware Court of Chancery, in Louisiana Municipal Police Employee's Retirement System v. Pyott, held that a previous dismissal with prejudice of a companion California federal court derivative action brought by stockholder plaintiffs on behalf of the corporation based on the same allegations of the same alleged wrongs did not collaterally estop the Delaware plaintiffs of the same corporation or finally determine the demand futility issue under Rule 23.1. 46 A.3d 313 (Del. Ch. 2012). Instead, the California federal court's dismissal was merely persuasive on the issue, not preclusive. Pyott is significant because it upsets decades of established precedent across the country on collateral estoppel. For a copy of the Pyott opinion please click here.

Pyott arises from Allergan Inc.'s settlement with the United States Department of Justice pursuant to which Allergan pleaded guilty to criminal misdemeanor misbranding and paid $600 million relating to its off-label promotion of Botox. Very soon after the settlement, several law firms filed derivative actions in California federal court and the Delaware Court of Chancery. The California court ultimately dismissed a consolidated complaint pursuant to Rule 23.1 with prejudice for failure to demonstrate demand futility, reasoning that because a stockholder plaintiff in a derivative action sues in the name of the corporation, all other stockholder plaintiffs whose suits arise under the same facts are in privity with the plaintiff.

The defendants then moved to dismiss the complaint in the Court of Chancery on grounds, among others, of collateral estoppel. Denying the motion, the Court of Chancery held that the issue of privity is governed by the internal affairs doctrine and, accordingly, would be governed by Delaware law. The Court of Chancery stated that Delaware Supreme Court precedent requires that until a Rule 23.1 motion has been denied, a derivative plaintiff does not have authority to sue in the name of the corporation; thus, privity does not exist at the early stages of such lawsuits. The Court of Chancery proceeded to analyze the defendant's motion to dismiss on grounds of Rule 23.1 and Rule 12(b)(6). The Court of Chancery disagreed with the California federal court on the Rule 23.1 issue and denied the motion.

If Pyott survives as the law of Delaware, successive derivative actions could become the norm. Corporate defendants had relied on the grant of a motion to dismiss a derivative case for failure to sufficiently plead demand futility to collaterally estop other similar suits. However, such early-won victories could have significantly less impact in the future.

Monday v. Meyer

The U.S. District Court for the Northern District of Ohio in Monday v. Meyer issued an opinion granting a motion to dismiss, which, while not ground-breaking, provides a thorough defense-friendly analysis of demand futility in a derivative case--an area in which there is an increasing amount of director liability litigation. The complaint in the case alleged that the directors of KeyCorp violated Section 10(b) of the Exchange Act and Rule 10b-5, breached their fiduciary duties, committed corporate waste, and were unjustly enriched by way of their approval of certain tax strategies. Defendants moved to dismiss the complaint on grounds, among others, that plaintiffs had failed to make any pre-suit demand. The court reasoned that "[d]emand is excused only when Plaintiffs adequately plead actionable claims against a majority of the board at the time the suit was filed, thus showing that a majority of the board faces a substantial likelihood of liability." The court's analysis of the complaint's allegations against specific directors and officers at the time the complaint was filed is instructive: "It is insufficient to allege that, because Defendants were members of certain committees, and because of the defined roles of those committees, Defendants automatically knew or should have known about the falsity of financial statements. . . . In order to allege futility based on a director's committee membership, the complaint would have to show some specific report or piece of information that the committee was given which would have tipped them off to misconduct. Click here to read more.

Hermelin v. K-V Pharmaceutical Co.

The Delaware Court of Chancery, in Hermelin v. K-V Pharmaceutical Co., issued a noteworthy decision in summary judgment involving Delaware law and contract indemnity provisions. 54 A.3d 1093 (Del. Ch. 2012). For a copy of the opinion, please click here. The opinion provides a rare analysis of indemnity provisions under Delaware case law. Marc Hermelin, former CEO and member of the board of directors of the defendant K-V Pharmaceutical Company (K-V), filed suit against his former employer seeking indemnification or advancement for several criminal, civil, and regulatory matters that arose due to K-V's manufacturing and distributing oversized morphine tablets. Hermelin pleaded guilty to criminal misdemeanor charges under the "Responsible Corporate Officer" doctrine. Separately, the U.S. Food and Drug Administration and K-V entered into a consent decree to refrain from manufacturing, holding or distributing any drug until the defendants undertook certain quality control measures, and the U.S. Department of Health and Human Services barred Hermelin from all federal healthcare programs for twenty years. Hermelin and K-V were parties to an indemnification agreement which, crucially, made mandatory the otherwise permissive provisions for indemnification under the General Corporation Law of the State of Delaware ("DGCL") (K-V's bylaws also made those provisions mandatory).

The court looked to four different proceedings for which Hermelin sought a declaration that he was entitled to indemnification - the criminal matter, the HHS exclusion matter, the FDA consent decree matter and the Audit Committee matters. The court held that Hermelin was not entitled to mandatory indemnification under Section 145(c) of the DGCL for the criminal matter and the HHS exclusion matter, since his guilty plea meant he was not "successful on the merits or otherwise." However, the court held that he was entitled to mandatory indemnification for the FDA consent decree matter. The court then performed an analysis of the matters for which indemnification is permitted under Section 145(a) of the DGCL, which generally applies to indemnification of directors, officers, employees and agents in third-party proceedings and criminal actions. That provision was made mandatory by the indemnification agreement and the bylaws. The court held that with regard to the criminal matter, the HHS exclusion matter and the Audit Committee matter, Hermelin might be entitled to the otherwise permissive indemnification due to the expansive scope of his indemnification agreement, as long as he met the standard of conduct in Section 145(a) (i.e., he "acted in good faith and in a manner [he] reasonably believed to be in or not opposed to [KV's] best interest." Whether he met this standard of conduct would depend on the results of a further evidentiary hearing. In short, the court held that there could be room between an indemnitee's failure to be "successful on the merits or otherwise" and Section 145(a)'s standard of conduct. In raising the question of good faith, this opinion highlights an area for which there is little case law and provides practitioners with additional guidance when drafting indemnifications and advancement provisions.

America's Mining Corporation v. Theriault

In 2012, in America's Mining Corporation v. Theriault (a decision affirming the Court of Chancery's decision in the Southern Peru Copper litigation), the Delaware Supreme Court affirmed what is believed to be the largest award--$2 billion for breach of fiduciary duty in addition to approximately $304 million in attorney fees--in a shareholder derivative case in Delaware history. 51 A.3d 1213 (Del. 2012). For a copy of the opinion, please click here. The Court of Chancery had held that the defendant-appellants breached their fiduciary duty of loyalty to a subsidiary and its minority stockholders by causing the subsidiary to acquire the controller's 99.15% interest in a Mexican mining company.

The Delaware Supreme Court, in a 110-page opinion, held that the Court of Chancery was correct in concluding after a full trial that, in analyzing fiduciary duty, the "inquiry must focus on how the special committee actually negotiated the deal--was it 'well-functioning'" rather than merely focusing on the mandate of the committee and how it was composed. The Delaware Supreme Court determined that, applying this standard, "evidence of unfairness was . . . overwhelming."

The attorney fee award represented approximately 15% of the judgment for breach of fiduciary duty, plus post-judgment interest until the attorney fee and expense award is satisfied. Plaintiff had sought 22.5% of the recovery, plus interest. The Court of Chancery had explored whether the fee award "fairly implements" numerous factors, including "1) the results achieved; 2) the time and effort of counsel; 3) the relative complexities of the litigation; 4) any contingency factor; and 5) the standing and ability of counsel involved." In addition, the court looked to whether the fee award "creates a healthy incentive" for plaintiff's lawyers to seek substantial achievement for plaintiffs in derivative actions and the classes that they represent in class actions, among other factors. In this analysis, the Court of Chancery, in determining whether the fee award was appropriate, looked beyond a mere examination of counsel's time and effort. The Delaware Supreme Court, after a careful analysis, held that the fee award was a proper exercise of the Court of Chancery's broad discretion in applying the multi-factored test.

Defending Directors and Officers Against Breach of Fiduciary Duty Claims in Bankruptcy
Jeffrey Baddeley

When a company files for bankruptcy protection, the search for scapegoats is nearly inevitable. If the company has failed, someone must have breached a duty. And if the company fails, someone will get less than they want. As "bankruptcy protection" becomes synonymous with "orderly liquidation," creditors will start to investigate claims against officers and directors. When the auction comes up short, directors and officers become targets.

One increasingly prevalent pattern in Chapter 11 cases is:

  1. The lenders and the company management agree to a series of forbearance agreements;
  2. The lenders strengthen their collateral positions;
  3. The debtor's collateral will not repay the debt;
  4. The debtor and the lenders agree that the debtor will file for bankruptcy to sell the debtor's assets as a going concern;
  5. The assets are sold; and
  6. Avoidance claims held by the debtor are left for the creditors' committee to pursue.

Read more....

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