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

Message from the Chair

Featured Articles
  New and Noteworthy Decisions Relating to D&O Coverage
  The JOBS Act - Implications for Director and Officer Liability

Editorial Board:

Corinne Amato
    Newsletter Co-Editor
    Associate at Morris James LLP

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

Michaela Sozio
    Newsletter Co-Editor
    Partner at Tressler LLP

  Message from the Chair

Our Committee has had an active year. This is our second newsletter summarizing developments in the law, highlighting tips and trends for practitioners and keeping members up to date on Committee activities. At our spring meeting, we had a robust discussion of how the increasing criminalization of certain activities poses risks for directors and officers and raises potential conflicts between the interests of a company and the interests of D's and O's. During our Committee meeting on August 10 from 10-11:00 a.m. in the Empire Room of the Fairmont Hotel, Jim Wing, chair of our insurance sub-committee, will lead a discussion to explain to inside counsel and outside practitioners the context in which this issue arises, how recent cases have addressed the issue and the current state of D&O insurance as it relates to this issue. We will also receive Committee reports from Bill Johnston concerning the advancement and indemnification sub-committee, from Frances Goins concerning the developments sub-committee, from Matt Boos and John Grossbauer concerning the anticipated publication date of our model indemnification agreement and from Dan Formeller concerning the implications of the new JOBS Act for director and officer liability, and a brief update on the Committee's efforts to combat human trafficking, which our own Bill Johnston co-chairs.

I look forward to seeing you in San Francisco. If you are unable to attend in person the dial-in information is as follows:

Toll-free dial-in number (U.S. and Canada):
(866) 646-6488

International dial-in number:
(707) 287-9583

Conference code:

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

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  Featured Articles
New and Noteworthy Decisions Relating to D&O Coverage
By Frances Floriano Goins, Ulmer & Berne LLP

Pyott v. Louisiana Municipal Police Employees' Retirement System

As discussed at the Director & Officer Liability Committee Meeting in Washington, D.C., on April 4, 2013, the Delaware Supreme Court handed down its opinion in the appeal from the earlier Court of Chancery decision in Pyott v. Louisiana Municipal Police Employees' Retirement System, reversing the Court of Chancery decision of last June. Click here for a complete copy of the Supreme Court's opinion.

The Delaware Supreme Court found that the Court of Chancery erred in failing to give preclusive effect to a final California federal court judgment dismissing with prejudice a derivative action on behalf of a Delaware company on demand futility grounds. Applying principles of judicial comity and the Full Faith and Credit Clause, the Supreme Court held: "[A] state court is required to give a federal judgment the same force and effect as it would be given under the preclusion rules of the state in which the federal court is sitting [in this case, California]. Accordingly, federal common law imposes on the state of Delaware a full-faith-and-credit requirement to give the California Federal judgment the same force and effect as it would be entitled to in the California federal or state courts under California's preclusion rules."

Applying this premise, the Supreme Court found that the Court of Chancery had mistakenly "conflated collateral estoppel with demand futility." Although Delaware demand futility law governed that issue for a Delaware company wherever it was sued, the Supreme Court found that "[o]nce a court of competent jurisdiction has issued a final judgment . . . a successive case is governed by the principles of collateral estoppel, under the full faith and credit doctrine, and not by demand futility law, under the internal affairs doctrine." The Supreme Court also rejected what it called an "irrebutable presumption" imposed by the Court of Chancery that a derivative plaintiff who failed to conduct a Section 220 books and records review prior to filing suit was an inadequate representative of the company. However, in the circumstances of this case where the Supreme Court held that California law governed the preclusive effect of the judgment, it declined to review the Court of Chancery's analysis of the issue of the California plaintiff's privity status with the company.

In another approach to the issue of multi-forum litigation and Delaware's ability to exercise judicial control over its companies, Chevron Corp. and FedEx Corp. argued in the Delaware Court of Chancery, in two separate but related lawsuits, against stockholder-plaintiffs' challenges to the validity of the companies' "forum selection" bylaws. These bylaws generally provided that derivative claims, fiduciary duty claims and other claims under the Delaware General Corporation Law or subject to the internal affairs doctrine must be litigated in the Court of Chancery. (At least 9 companies that had enacted such bylaws revoked them in the face of similar litigation.) On June 25, 2013, the Delaware Court of Chancery upheld these "forum selection" bylaws. For a complete copy of the opinion, please click here.

Mt. Hawley Insurance Company v. Lopez

This California appellate court decision provides an instructive analysis of some of the public policy arguments supporting advancement of defense costs when a director or officer is facing criminal prosecution. Click here for a complete copy of the opinion. The decision arose as a result of an insurer's denial of coverage for defense costs based on a California statute, California Insurance Code 533.5(b), which states: "No policy of insurance shall provide, or be construed to provide, any duty to defend" in certain situations. The insured claimed the statute applied only to civil and criminal claims seeking recovery of a fine, penalty or restitution under certain specific California statutes addressed to unfair competition and unfair advertising, brought by one of four specific state agencies. The insured was charged by federal prosecutors with criminal violations of federal statutes. The insurer argued, and the trial court held, that Section 533.5(b) barred insurers from covering defense costs in any criminal action.

The Mt. Hawley decision reversed the trial court, and held that Section 533.5(b) was limited in scope to proceedings brought by one of the named state agencies under the specifically identified state statutes, and did not bar the advancement of defense costs in a criminal proceeding brought by a federal prosecutor. The appellate court relied on the legislative history of Section 533.5(b) and on other California statutes, which authorize insurance that "provides a defense to individual defendants in various kinds of proceedings, including criminal proceedings." For a corporation, advancement of defense costs is allowed assuming the person to be advanced "acted in good faith and in a manner the person reasonably believed to be in the best interests of the corporation" and, in a criminal case, where the person "had no reasonable cause to believe the conduct of the person was unlawful." See, e.g., Cal. Corp. Code 317(b) & (c). The appellate court also supported the concept that "[a]llowing insurers to provide for defense costs in criminal cases against corporate agents enhances the ability of for-profit and non-profit organizations to attract directors [and officers] who otherwise might hesitate or decline to serve because of fear of lawsuits and criminal prosecutions," and held that advancement was "consistent with the principle that insureds charged with crimes begin with a presumption of innocence." For this purpose, the court differentiated between indemnification and defense, and noted that "there is no public policy in California against insurers contracting to provide a defense to insureds facing criminal charges, as opposed to indemnification for those convicted of criminal charges."

The opinion does not, however, address the issue that this Committee has been discussing: whether advancement may be required when the person seeking advancement from either the corporation or an insurer asserts the Fifth Amendment privilege (or the work product privilege) in response to inquiries by the corporation or the insurer. But the opinion does reiterate that Section 533.5 does not preclude an insurer providing a defense of a federal criminal proceeding, especially where, notably, the Mt. Hawley policy at issue defined "Claim" to include certain types of criminal proceedings, including an indictment.

Salinas v. Texas

The U.S. Supreme Court reached a decision in the matter of Salinas v. Texas, which arose out of the criminal prosecution of a defendant, who, when voluntarily responding to a police officer's questions about a murder, became suddenly silent when asked whether ballistics testing would match his shotgun to shell casings found at the scene of the crime. For a copy of the opinion, please click here. The defendant was charged, and in a closing statement at trial, the prosecutor commented on the defendant's sudden silence as an indication of guilt. The defendant claimed that this use of his silence violated the Fifth Amendment, while the government relied on his failure to "invoke" his Fifth Amendment rights. The Court found that defendant's challenge to his conviction on Fifth Amendment grounds failed because he did not expressly invoke the privilege.

While the context of Salinas does not lend itself to garden-variety director and officer liability matters, the opinion's arguable expansion of prosecutorial rights and its limitation of the Fifth Amendment privilege in situations where the subject of questioning is not in custody may have far-reaching implications for directors and officers responding to internal corporate investigations.

In the words of one commentator, "Although no one wants to formally admit it, in the typical internal investigation the company lawyers are basically highly-paid deputy prosecutors with the badge hidden under their suits." See The issue has arisen in recent years in cases where the Department of Justice has charged corporate executives with obstruction of justice based on lies told during corporate internal investigations being conducted by outside law firms. The DOJ relies on the reasoning that the investigating lawyers frequently pass on the false information received from company employees in reports to federal agencies such as the U.S. Attorney's Office. See, e.g., U.S. v. Singleton, 2006 WL 1984467 (S.D. Tex. July 14, 2006).

The Salinas opinion notes that a witness's failure to invoke the Fifth Amendment privilege is excused in certain circumstances including: "where governmental coercion makes its forfeiture of the privilege involuntary," and "where threats to withdraw a governmental benefit such as public employment sometimes make exercise of the privilege so costly that it need not be affirmatively asserted." These exceptions mirror the situation faced by a corporate executive or employee who refuses to be interviewed. Such an individual does so only at risk of losing his job since, as a practical matter, any individual who refuses to cooperate with a company's internal investigation will likely be terminated. Cf., Garrity v. New Jersey, 385 U.S. 493, 497 (1967) (no explicit assertion of the Fifth Amendment required during an investigation where such assertion would, by law, have cost police officers their jobs).

The implications for directors and officers are twofold. First, officers and directors who are formally interviewed in an internal investigation should be cautious about participating in interviews, particularly after they receive an Upjohn Warning, without the advice of counsel. Whether the corporation or an insurance company will pay such counsel may be problematic, particularly in jurisdictions where directors must waive their Fifth Amendment rights and assert innocence of breach of fiduciary duty as a condition to obtaining advancement. Salinas moves the problem up earlier in time, before there is a formal investigation and before any Upjohn Warning, a circumstance made even more challenging because today virtually no advancement bylaw or insurance policy on the market covers the Salinas facts. At a minimum directors and their counsel should consider the implications of Salinas in determining whether to participate in internal investigations. Second, from the perspective of an attorney conducting the investigation, Salinas may signal a need to consider more specific warnings to interviewees concerning their rights and risks.

J.P. Morgan Securities, Inc. v. Vigilant Insurance Company

In a recent decision reinstating a complaint on a motion to dismiss, the highest court of New York State recently held that insurers could not deny coverage for "restitution" damages where the policy was silent on that issue. In J.P. Morgan Securities, Inc. v. Vigilant Insurance Co., No. 113, NYLJ 1202603747925 (Ct. of App. June 11, 2013), (a copy of the decision may be found at, the New York Court of Appeals refused to accept the insurers' argument that the New York "public policy rationale . . . to prevent the unjust enrichment of the insured by allowing it to, in effect, retain the ill-gotten gains by transferring the loss to its carrier" applied where most of the Bear Stearns' $160 million agreed settlement payment was calculated on the basis of profits allegedly received by Bear Stearns' hedge fund customers rather than Bear Stearns itself. The Court held the payment did not implicate that policy, despite being described in the settlement agreement as "disgorgement."

In defense of an SEC enforcement action and related private litigation, Bear Stearns had argued that it acted solely as a clearing firm in the challenged transactions, that it did not knowingly violate the law, and that it did not share in the profits or benefits of the allegedly improper trading by its customers. Nevertheless, to avoid being charged on a strict liability basis with violations of federal securities laws based on late trading and market timing allegations, Bear Stearns negotiated a settlement with the Securities and Exchange Commission ("SEC") and the private plaintiffs that included a $90 million penalty and a $160 million "disgorgement" payment. Bear Stearns did not seek coverage for the penalty payment from the insurers.

The insurers cited two public policy reasons to justify denying coverage. First, they argued that "Bear Stearns enabled its customers to make millions through its trading tactics;" and second, they argued "that there is a separately applicable public policy category that prohibits insurance coverage for intentionally-caused harm." The Court applied a strict motion to dismiss standard of review, insisting that the insurers "must establish that the documentary evidence 'conclusively refutes' [Bear Stearns'] allegations." Noting that "insurance contracts, like other agreements, will ordinarily be enforced as written," the Court found there was no evidence to support the insurers' first argument. Further, as to the second argument, the Court held that the language of the contract and the SEC cease and desist order did not support the insurer's position. There was neither a specific policy exclusion nor a recognized public policy excluding payment for loss incurred by the insured which had not been established to be the return of the insured's own ill-gotten gains, regardless of whether such payment was labeled as "disgorgement" in the SEC order.

Despite some discussion of whether or not a payment like Bear Stearns' qualified as a "loss" under the policies, the Court noted that the insurers did not "earnestly dispute" this issue, and as a result did not reach it. Thus, it remains in play for future litigation. And, since this decision was reached on a preliminary motion to dismiss, it does not foreclose the possibility that development of a factual record could yield a different result down the line.

The JOBS Act - Implications for Director and Officer Liability
By Daniel R. Formeller, Tressler LLP

On April 5, 2012 the Jumpstart Our Business Startups Act (JOBS Act) (Public Law 112-106) became effective. There is much debate about whether companies wishing to take advantage of the provisions of this Act are taking on increased risk and whether current available forms of D&O insurance will cover potential resulting claims.

The Act includes three fundamental changes to laws and regulations affecting how emerging companies can raise capital. These changes will become effective when final SEC implementing regulations are authorized.

  • Emerging Growth Companies (EGC) - companies with annual revenues of less than $1 billion in their most recent fiscal year - will have significant flexibility in determining the appetite of potential investors for their initial public offerings before they disclose their finances and other management information to the general public.
  • Certain limitations concerning how and to whom private companies can market their private Rule 144A securities offerings will be either relaxed or removed completely.
  • "Crowdfunding" will be authorized so that raising up to $1 million in capital over a 12-month period from numerous small investors will be not only permitted but encouraged.

Under the Act, EGCs can file a registration statement with the SEC on a completely confidential basis to determine any regulatory or financial issues up to 21 days prior to making the registration documents available to the general public for scrutiny. EGCs can also gauge institutional investor interest in their company prior to a planned IPO through published research by investment banks. Finally, there is a reduction in disclosure requirements for up to five years as long as the company remains an EGC. Most significantly, there is no requirement for an auditor attestation report on internal controls. In addition, the EGC is exempt from certain executive compensation disclosures.

The stated purpose of the Act is to make it easier and less expensive for private companies to go public and raise capital. What are the implications for director and officer liability and protection of directors and officers through D&O insurance?

  • Will there be insurance coverage that will respond to claims arising from the new, limited SEC disclosure and broadened publicity allowed by the Act?
  • Does the 21-day public disclosure period give EGCs sufficient time to negotiate and procure public D&O coverage to adequately protect directors and officers transitioning from a private company environment?
  • Will the underwriting standards for D&O insurance change materially in response to limited access to the filed S-1? Will additional warranty statements be required or necessary?
  • How will the pricing of public company D&O policies respond to the narrowed public disclosure requirements for EGCs?

The Act also significantly changes two sections of Rule 144A of the Securities Act of 1933.

  • Private companies can now engage in general solicitation and general advertising in the offer and sale of their securities in the private market. Do the new SEC Rules on this issue mean that EGCs will be able to employ investor seminars, dedicated websites and/or social networks to attract the "crowd"?
  • The threshold for private company registration with the SEC for the sale of securities has changed from 500 shareholders or $1 million to 2000 shareholders or $10 million as long as there are no more than 499 non-accredited investor shareholders. The listing company must use "reasonable steps" to determine qualified investor status.

There are a number of issues related to these changes that impact D&O insurance. Private companies using these new private offering mechanisms will need to analyze the specific language of any desired policy to determine if Rule 144 activities are covered or if there are limitations that exclude such activities.

Title III of the JOBS Act amends the Securities Exchange Act of 1934 for Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure (CROWDFUNDING). These provisions will, when fully implemented, allow a private company to use a web portal that has been registered with the SEC to raise up to $1 million in any 12-month period. Although this may appear to open a new major capital market to entrepreneurs, Section 302(c) of the Act imposes express liability on issuers and their officers and directors for material misrepresentations and omissions made in connection with any crowdfunding offering.

The following inquiries about this funding mechanism as related to the standard D&O insurance policy provisions seem germane:

  • Is the "Loss" definition in the policy broad enough to cover liability under Section 302(c)?
  • Is the policy's exclusion language regarding public offerings (and road shows) a concern when Crowdfunding is used?

There are a few parts of the Act that are self-effectuating, but a majority of the Act's provisions will require substantial SEC rulemaking before they become effective. The first set of final regulations dealing with lifting the ban on general solicitations and advertising by private funds in the sale of securities and certain "bad boy" provisions denying the benefit of the new exclusions to persons found to have committed securities fraud were issued by the SEC on July 10, 2013, and will become effective in mid-September 2013, 60 days after publication in the Federal Register.

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