NEWSLETTER FINEX NORTH AMERICA TO INDEMNIFY OR NOT TO INDEMNIFY: THAT WAS THE QUESTION BEFORE THE DELAWARE COURT

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1 FINEX NORTH AMERICA NEWSLETTER May In this Newsletter we consider the expansive nature of indemnification under Delaware Law, potentially significant changes to the rules of ediscovery, and announce our new D&O Dictionary. TO INDEMNIFY OR NOT TO INDEMNIFY: THAT WAS THE QUESTION BEFORE THE DELAWARE COURT A critical touch point in structuring D&O insurance programs and advocating for D&O claims is whether or not the individual insureds are or can be indemnified by the organization. In traditional D&O insurance programs, where the directors and officers are covered for both indemnifiable and non-indemnifiable claims, this is relevant principally in determining whether or not the self-insured retention (often referred to as a deductible ) applies to the claim or has been satisfied. As retentions typically range from the hundreds of thousands of dollars to millions, or tens of millions of dollars for the individuals involved in a D&O claim, this is an absolutely essential point. For those who purchase A-Side only D&O insurance, this concern is central to whether the policies respond at all, as this specialized form of D&O insurance only covers the directors and officers for matters that are not indemnifiable by the company. 1 The issue of corporate indemnification was also the question recently decided by the revered Delaware Chancery Court with a fact pattern and an outcome that might initially be surprising. 2 The court in this instance considered whether the former chief executive officer (CEO) of a company was entitled to mandatory indemnification under Delaware law after several regulatory and criminal actions had been brought and the executive pled guilty to certain criminal charges resulting in regulatory penalties, while successfully defending only one of four underlying suits. If mandatory indemnification was not required, the court then considered whether permissive indemnification was called for. On permissive indemnification, as the Indemnification Agreement in place entitled the executive to indemnification to the fullest extent not prohibited by law, the key question was then whether the executive had acted in good faith and in a manner reasonably believed to be in or not opposed to the best interest of the TABLE OF CONTENTS To Indemnify or Not to Indemnify: That was the Question Before the Delaware Court Potential Dramatic Changes to ediscovery Introducing the Willis D&O Dictionary.. 5 Contacts corporation, and, with respect to any criminal action or proceeding, had no reasonable cause to believe [his] conduct was unlawful. The results, for the strict liability charges, may have initially generated the most surprise.

2 DE CODE The court began by noting that Delaware law mandates that a corporation indemnify an officer who has been made a party to a proceeding by reason of his service to the corporation and has achieved a success on the merits or otherwise in these matters. This then opens up the question of what it means to succeed on the merits or otherwise. On the other hand, the Delaware Code prohibits a corporation from indemnifying an officer who was not successful in the underlying proceeding and has acted in bad faith. Between these two extremes, the corporation and its executives have wide leeway to enter into an agreement determining the scope of (permissive) corporate indemnification. INDEMNIFICATION CONTINUUM MANDATORY PERMISSIvE PROHIBITED Successful on merits - Wide leeway- Not successful + (or otherwise) Acted in bad faith The indemnification agreement in place was as broad as permitted by law and provided that in any dispute over indemnification the company shall, to the fullest extent not prohibited by law, have the burden of proof to overcome [the] presumption that the individual had not acted in bad faith. This means that to avoid indemnifying the CEO, the company would have to show convincing evidence that he acted in bad faith in the underlying proceedings. Usually, a finding of bad faith in an underlying proceeding is deemed conclusive evidence that the individual is not entitled to indemnification. But where there s a settlement or merely a regulatory investigation (with no adjudication of guilt), there may not be an underlying judicial record to establish a finding of bad faith. NO FAITH (GOOD OR BAD) NEEDED FOR STRICT LIABILITY Critical to understanding the outcome in this case over indemnification is that none of the underlying proceedings involved a finding of bad faith. True, in the criminal case, the executive pled guilty but only to strict liability offenses. Because he had been charged with strict liability crimes, the guilty plea did not establish that he had acted in bad faith, as no intent was necessary to establish guilt. To avoid permissive indemnification, the company would then have to show that its CEO knew that his actions were damaging the company or that his conduct was unlawful. For many, the outcome on the criminal matters will be the most surprising in this eye-opening decision. Strict liability: Liability without fault. Strict liability crimes: Unlawful acts whose elements do not contain the need for criminal intent or mens rea. These crimes are usually acts that endanger the public welfare, such as illegal dumping of toxic wastes. See per se violations. Black s Law Dictionary 2 Willis North America 05/12

3 DECISIONS, DECISIONS 1) CRIMINAL PROCEEDING The U.S. Attorney s Office had charged the executive, as a responsible corporate officer, with two federal strict liability misdemeanors for which he pled guilty, was ordered to pay $1.9 million in penalties and spend 15 days in jail. OUTCOME: No mandatory indemnification. Although he pled guilty to the criminal charges against him in the criminal proceeding and was required to pay a significant fine and serve time in prison, the executive argued that he actually was successful on the merits or otherwise because, by pleading guilty, he avoided conviction on harsher charges. In the court s view, [t]his was not a successful outcome and there was no mandatory indemnification available to him in this matter. Possible permissive indemnification. The strict liability charges (to which the executive pled guilty) do not establish a lack of good faith. Based on the scant evidence before it, the court ordered a trial on the question as to whether the executive had acted in good faith in connection with the matters at issue. 2) THE EXECUTIvE BAR The Office of Inspector General of the U.S. Department of Health and Human Services (HHS) moved to exclude the executive from all federal health care programs for 20 years; to prevent the company from suffering a similar fate, the CEO agreed to sell his stake in the company and waive any rights he had to appeal his own exclusion. OUTCOME: No mandatory indemnification. The court concluded that while good corporate policy may support the indemnification of officers [on a permissive basis] who, in good faith, take one for the company to avoid bringing down the whole enterprise, such consideration had no place in assessing entitlement to mandatory indemnification under Delaware law. Possible permissive indemnification. The court ordered a trial on the question of whether the executive had acted in good faith in connection with the matters at issue. 3) THE CONSENT DECREE In connection with an investigation of the company s compliance with relevant regulations, both the company and the executive entered into a consent decree. The provisions of the consent decree were not applicable to the executive as long as (1) the Board s resolutions to terminate the officer remain in effect and (2) the executive has no role in the decision making, management, or operation of the [company] that could affect the company s compliance. OUTCOME: The executive is entitled to mandatory indemnification. He successfully argued that these proceedings were a victory for him as they did not find him personally guilty of misconduct and the consent decree, at least initially, did not apply to him. The court agreed and found that because the restrictions contained in the Consent Decree did not place any additional restrictions on the executive, he was entitled to mandatory indemnification because he avoided a personally negative result. 4) THE JAIL RECORDS PROCEEDING While the executive was jailed following his guilty plea deal in the criminal proceeding, his private conversations with visitors were recorded by prison officials per the jail s policy. After a local reporter requested the recordings, the executive asked a state court to enjoin their release on the ground that they were purely private matters. This court entered a permanent injunction in the executive s favor. OUTCOME: No indemnification, mandatory or permissive. In the court s view, this matter was initiated by the executive and therefore didn t fall within the terms of the Indemnification Agreement. This decision tells us that when reading an Indemnification Agreement, the particular outcome of a proceeding does not itself create a presumption that the indemnitee had a non-indemnifiable state of mind unless the underlying proceeding established that the indemnitee acted in bad faith. Without such a finding, additional discovery in some instances mimicking the very litigation avoided by the settlement may be required to permit a determination on whether the indemnitee acted in good faith. This should not be an open-ended proceeding, however, but one limited to [the executive s] conduct underlying the proceedings for which [he] seeks indemnification. In determining whether the officer was successful on the merits, the court, in this case, refused to look behind the result of criminal and regulatory proceedings. 3 Willis North America 05/12

4 POTENTIAL DRAMATIC CHANGES TO EDISCOvERY Electronic discovery (ediscovery) is now mandatory in federal court and in the majority of state courts, which makes it relevant to D&O, fiduciary liability and professional liability or E&O matters, and therefore, when dramatic changes in the Federal Rule of Civil Procedure are being proposed relating to ediscovery, of key interest to those of us who are concerned with such matters. The most immediate change will likely be to the obligations of parties to preserve documents and electronically stored information (ESI) and resulting penalties should they fail to do so. TO PRESERvE AND DELIvER: PRESERvATION AND SPOLIATION The Special Committee on Discovery and Case Management in Federal Litigation of the New York State Bar Association (the Committee ) was tasked with examining the perceived delays and expense of litigation in federal court and to make recommendations to reduce both. The Committee decided to focus on, and make recommendations regarding four stages of litigation. The first of these addresses the absence of rules about preservation and spoliation in the Federal Rules of Civil Procedure. 3 Until now, courts have established their own guidelines, but there is no established rule governing preservation. 4 To clarify what is expected and lead to uniformity in practice, these amendments to Federal Rules of Civil Procedure 26 and 37 have been proposed: n n Rule 26(h) would specify that the duty to preserve documents and ESI arises when a subpoena is received by a non-party, or when a person becomes aware of facts that would lead a reasonable person to expect to become a party to an action. This duty shall continue for all existing and subsequently created documents or ESI until (where an action has been commenced) the termination of the party or non-party s involvement, or (where no action is commenced) until a person becomes aware of facts that would lead a reasonable person to believe that he or she will not be a party to an action. Rule 37(g) would specify the possible penalties to be imposed, depending on the level of culpability of the spoliating party and the remedial requirements necessary to the case, based on the importance of the information lost to the party seeking its discovery, ranging from dismissal of the action to allowing further discovery, but requiring the court to impose the least severe remedy or sanction to redress the violation Back in November 2011, the Advisory Committee on the Federal Rules of Civil Procedure decided not to pursue any rule change dealing with preservation, but only those dealing with penalties for spoliation. Nevertheless, the ensuing discussion and Committee report makes clear that the lesson on best practices for preservation of evidence includes a litigation hold to those key players in an organization most likely to possess documents or ESI that will be important in a case. This litigation hold might best be periodically reviewed and renewed to avoid a negative outcome. SPOLIATION: A spoliator of evidence in a legal action is an individual who neglects to produce evidence that is in her possession or control. In such a situation, any inferences that might be drawn against the party are permitted, and the withholding of the evidence is attributed to the person s presumed knowledge that it would have served to operate against her. Source: 4 Willis North America 05/12

5 INTRODUCING THE WILLIS D&O DICTIONARY In discussions regarding Directors & Officers Liability (D&O) insurance, we invariably mingle the language of law, finance and insurance; all otherwise separate and distinct disciplines with their own unique concepts and terms of usage. This makes every conversation potentially full of pitfalls for unwary individuals knowledgeable in their own areas of expertise but not so much when addressing insurance matters. For this reason we have compiled a D&O Dictionary of terms that might be useful as they may be used in conversations relating to D&O insurance. Our goal was not to just describe what something plainly is, such as Application, but also to provide context as to why the term may be relevant. DIRECTORS & OFFICERS LIABILITY INSURANCE DICTIONARY At times, this project seemed to be endless as literally everyone asked to review the Dictionary suggested yet more terms that might best be added. We also had to become comfortable with the uncomfortable idea that there might be those who would erroneously believe that we are speaking directly to their particular insurance contract rather than to D&O policies in the abstract, or, that we are providing legal or financial or tax advice none of which is intended by dictionaries as a whole or this D&O Dictionary in particular. We hope that you find this latest Willis offering of interest and assistance. To obtain a copy of the North American version or the Anglicized version from FINEX Global, click here. You are invited to submit to us terms that you would like to see added in the next edition. To contact us about those suggestions, visit FINEX_NA@willis.com. DICTIONARY, n. A malevolent literary device for cramping the growth of a language and making it hard and inelastic. This dictionary, however, is a most useful work. - Ambrose Bierce CONTACTS For additional information, please contact your Willis Client Advocate or FINEX_NA@willis.com. For past issues of our publications on other topics of interest, please visit the Executive Risks website. FINEX Alerts and Newsletters provide a general overview and discussion on a wide range of topics. They are not intended, and should not be used, as a substitute for legal advice in any specific situation. 1 Note that the strongest policies today would also respond where the company could legally indemnify but has chosen not to do so (or disputes its legal obligation to do so); the dispute then continues between the insurance carrier and the company as the policy advances funds to the individual where the company fails to do so. 2 In Hermelin v. K-V Pharmaceutical Co., C.A. No VCG, 2012 WL (Del. Ch. Feb. 7, 2012). 3 Report of The Special Committee on Discovery and Case Management in Federal Litigation of the New York State Bar Association, April 2, Zubulake v. UBS Warburg, 217 F.R.D. 309 (S.D.N.Y. 2003); Zubulake v. UBS Warburg, 220 F.R.D. 212 (S.D.N.Y. 2003); Zubulake v. UBS Warburg, 2004 WL (S.D.N.Y. July 20, 2004). 5 Willis North America 05/12