August 31, 2012

TRAINING FOR TOMORROW: Corporate Counsel Checklist for a D&O Protection Program

James D. Wing

The ABA Business Law Section's Director and Officer Liability Committee has this year sponsored two programs titled "Protecting the Corporate Director," one live and another through a national webinar. The programs have received excellent reviews. They were intended to introduce the following Corporate Counsel Checklist. The Checklist is intended to give corporate counsel--who are not and cannot be experts in the intricacies of this area of the law--a basis to supervise and manage the creation or renewal of an executive protection program by making sure that the firm's professional advisers and risk manager have expressly considered each of the items on the list. The list was created in response to requests by corporate counsel tasked with managing such a program for a guide to ensure that the rights and exposures of both corporations and executives are properly balanced.

The Committee's programs partially explored the history of and justification for the Checklist's provisions directed at Fifth Amendment and document access rights of indemnified directors and officers, reviewed recent case law bearing on a number of other checklist issues, and then discussed in considerable detail the nature, purpose, and extent of Side-A only "difference-in-conditions" cover, an increasingly important component of responsible executive protection programs. The latter discussion was enhanced by involving a strong representative from the D&O insurance broker industry who added a perspective and experience rarely heard at ABA gatherings.

What emerged from these programs is a realization that the overwhelming mass of corporate by-laws and D&O insurance policies presently in use fail to take account of the fact that the most dangerous and potentially catastrophic exposure faced by executives is that of being without the legal right to enforce advancement of defense costs they may incur incident to an internal or governmental investigation. Existing policies and by-laws were written in the pre-Arthur Andersen context where executives may have been added as personal defendants in claims and lawsuits primarily directed against their corporations, and where both parties could generally share joint counsel.

Since Andersen, however, executives, not their corporations, find themselves in the front line of potential criminal liability with interests adverse to the corporation and other executives. This is because, under America's system of plea-bargaining, other executives and the corporation itself seek to "cooperate" with enforcement authorities, leaving those who may be only marginally aware of wrongdoing, or falsely accused by others, without assistance or protection at great personal cost. The ethical implications of this for house counsel and others who preside over the creation or renewal of executive protection programs where the executives are mostly without separate representation, remains largely unexplored and will likely be the subject of further attention by the Committee. They appear to be significant.

Final take-aways from the programs were:

  1. The Committee endorses the "three-legged stool" approach of Delaware commentary, i.e., every executive protection program should rest on a combination of (a) maximum use of statutory exculpation opportunities where possible, (b) indemnity by-laws (usually) that not only express the concept of mandatory advancement and indemnity rights "to the fullest extent permitted by law," but do their best to make those rights real; and (c) effective D&O insurance that truly protects them against undue erosion of limits and catastrophic loss by accessing the best cover available in a rapidly-changing market.
  2. Historically, D&O insurance and corporate indemnity programs focused on protection from claims from third parties such as shareholders, employees, competitors, and regulators who generally directed their attention at both corporations and their executives equally. But since Arthur Andersen, that is no longer true, given that corporations can obtain deferred prosecution agreements by cooperating with enforcement authorities, thereby placing executives in the front line of corporate criminal exposure, sometimes under laws that substantially water down the government's need to show mens rea. One of this Committee's functions is to educate corporate practitioners to this new reality and suggest balanced solutions consistent with the above "three-legged stool" approach to executive protection.
  3. Under modern practice, this means that in-house or outside counsel whose client is exclusively the corporation is in the position of supervising the creation of what amounts to an unregulated benefit program for directors and officers. While protection "to the fullest extent permitted by law" is expressed as the goal, the interests of the corporation in being able to manage costs and to be able to deal with true bad actor scenarios conflict with executives' expectations that the corporation will stand behind them, at least in grey area circumstances. Balancing these competing interests is not easy.
  4. The Delaware cases already make clear that a corporation's desire not to advance or indemnify for such things as insider trading, claims of diversion of corporate opportunity, embezzlement, etc., should be expressly negotiated into a by-law or indemnity agreement at the outset. Similarly, the corporation's right to terminate a director or officer for "taking Five" in a corporate internal investigation and to refuse advancement if the executive declines to expressly assert his or her innocence (yes, innocence) should be disclosed at the time a protection program is instituted or renewed. These discussions should encourage the parties to discuss possible limits to the corporation's total monetary advancement and indemnity liability as part of an overall conversation of aggregate insurance limits and the possible acquisition of "Side-A only" cover for some key executives. Only a negotiated resolution of these issues in an atmosphere of disclosure can hope to satisfy counsel's ethical duties, protect the board from criticism by shareholders that it has unknowingly made overly-expansive promises of advancement and indemnity to perceived miscreant executives, and guarantee that the right executives receive advancement to the correct extent.

The Committee intends to monitor developments on these fronts in both the insurance markets and through results of litigated cases. It intends to revise its checklist annually to reflect new developments. In this manner, the Committee's work hopes to provide best practice support to corporate counsel in developing responsible, comprehensive, and balanced executive protection programs.

Corporate Counsel Checklist for Supervising Creation/Renewal of D&O Protection Program

To obtain and retain effective directors and officers (executives), corporations employ risk managers, outside counsel, and insurance brokers to protect them from personal financial and criminal liability. Their task is to create a comprehensive program to protect them from claims that they have been guilty of wrongful acts or omissions while serving the corporation. The protection consists of four elements: (1) legal immunity from claims for damages resulting from directors' failure to exercise due care; (2) advancement to selected executives of defense costs and expenses until any claim is resolved and then relieving them from any duty to repay the amounts advanced; (3) indemnifying them for any additional amount they may agree to pay in settlement of such a claim or that they may be compelled to pay by judgment; and (4) a credible program of D&O insurance coverage.

The first element, statutory exculpation, is simply a matter of verifying whether the correct language appears in the corporation's certificate or articles of incorporation.

The second, third, and fourth elements--rights to advancement of defense costs, relief from the duty to repay the advances, and indemnity against settlements and judgments--is found usually in corporate by-laws. By-laws frequently state that some number of executives will be advanced defense costs and indemnified "to the fullest extent permitted by law." While this phrase is facially expansive, it is in fact a limitation, because no corporate statute permits indemnity for all conceivable claims against executives. Further, developing case law and prosecutorial techniques create significant hurdles to realizing the goal implicit in that phrase: making sure that the entity's by-laws actually provide the maximum rights to advancement and indemnity that the law permits.

Directors' and Officers' (D&O) liability insurance is the fourth element of a protection program and is intimately related to the issues of advancement and indemnity. Indeed, the corporation's obligation to indemnify its executives "to the fullest extent permitted by law" is these days written into most D&O insurance policies as a de facto covenant of the corporation procuring the coverage for them.

What follows is a checklist intended to guide an attorney serving as counsel to a corporation tasked with overseeing specialists in risk management and insurance who recommend an executive protection program:

I. Director Exculpation under Certificate/Articles of Incorporation

Under most states' corporation laws, directors may be exculpated in advance from civil liability for damages for breach of the fiduciary duty of due care. This is a corporate articles/certificate of incorporation matter that requires no further checklist. Volunteers for not-for-profit corporations may be entitled to exculpation or immunity from suit under federal and state laws. Taking the legal steps necessary to allow directors to avail themselves of these exculpatory provisions contained in governing law is an important component of any comprehensive director protection program.

II. Advancement and Indemnity

Executives may be given a right to advancement of reasonable defense costs for all claims against them arising from their service, and a mandatory right to be relieved from repaying these advances. They may also be indemnified for any ultimate settlement or judgment against them under corporate by-laws or formal indemnification agreements. In all cases, however, these rights exist only if and to the extent that advancement and indemnity is permitted by governing law.

Checklist issues are:

A. Are the advancement and indemnity rights contractually mandatory, or are they only to be conferred by separate action of the board on a discretionary basis after a claim arises?

B. If granted in by-laws, is the board prohibited from amending the by-laws to eliminate protection for circumstances that accrue during the executive's tenure but before a claim is made?

C. Does the right to advancement accrue at a sufficiently early stage to protect the executive without causing premature "lawyering up" that is detrimental to corporate collegiality and informal communication?

D. Does the right to advancement cover derivative demand, special litigation committee, and corporate internal investigations?

E. If the corporation has foreign subsidiaries on whose boards executives are expected to serve or if they are expected to otherwise supervise foreign operations, is the corporation obligated to post bonds or otherwise pay to secure the release of the executive's person from physical arrest and the executive's personal assets from sequestration orders issued by a foreign court or governmental agency?

F. If the executive is in any way implicated in a matter that creates potential personal criminal exposure, does the executive:

i. have access to (but not possession, custody, or control over) all relevant corporate documents useful to the executive's defense?

ii. have the express right to assert Fifth Amendment privileges (and his or her lawyer the right to assert work product privileges) without jeopardizing the executive's advancement and indemnity rights or limiting the amount of defense costs for which the executive is entitled to advancement? Does the by-law specify a mechanism for resolving privilege disputes?

iii. have the right to receive advancement of defense costs until at least the first "final adjudication" (i.e., after appeal) of facts that forbid the corporation from indemnifying the executive under the relevant corporate law, provided these facts are found in a criminal case against the executive or in a U.S. civil case in which the executive has participated without asserting Fifth Amendment rights? Is the corporation prohibited from instituting or continuing any civil case against the executive that requires the executive to assert Fifth Amendment rights before final adjudication of any actual or threatened claim that gives rise to the right to advancement?

iv. have the right to subrogate to the corporation's Side B coverage should the corporation refuse to advance defense costs and the D&O pay such a cost directly?

v. have the right to judicially compel advancement at the corporation's expense without making any assertions of fact, good faith, or innocence? If the governing corporate law requires such an assertion as a condition to advancement, is the executive protected by insurance? (See next section in respect of DIC cover.)

G. If the executives' advancement and indemnity rights cover claims that are broad in scope, does the board understand that the broad definition may include a duty to advance reasonable defense costs in an unlimited amount in respect of claims for insider trading, embezzlement of the corporation's assets, or allegedly criminal conduct against third parties, leaving the corporation in a delicate public relations situation should such a claim occur and uninsured defense costs rise to a substantial level? If the corporation elects not to advance or indemnify for claims in which an executive is accused of obtaining an improper personal benefit, is that intention adequately expressed in the bylaws and is it consistent with similar exclusionary language contained in the corporation's D&O insurance policies?

III. D&O Insurance

A corporation typically obtains what is called "Side A and B" or "Side ABC" insurance to backstop its advancement and indemnity obligations and to provide its executives direct coverage for certain defined claims. It may then expand protection to particular executives for certain matters for which the corporation may not legally indemnify, financially cannot indemnify, or for which the corporation refuses to indemnify. This type of cover is excess over both the corporation's duty to advance and indemnify under the corporation's by-laws and the Side A and B cover. This type of insurance is called "Side A-Only Difference-in-Conditions" (DIC) cover. To the extent any refusal by the corporation or the Side A and B insurer to advance or indemnify the executive is unlawful, the DIC carrier is subrogated to the executive's rights against them.

Checklist issues are:

A. Are all individuals that the board wishes to insure in fact covered? Are those it does not wish to cover excluded from the policy definition of insured?

B. Has the board made a reasoned and appropriate decision on policy limits, particularly given that under its Side B coverage, it seeks to cover its complete advancement and indemnity exposure to all covered executives beyond its agreed retention? Are all parties cognizant of the phenomenon of competition among insureds for access to policy limits and the accepted means for reducing such competition?

C. Does the policy cover defense costs within overall limits or through sublimits for matters such as derivative investigations (both those that arise immediately after demand and those that arise after the creation of a special litigation committee) and corporate internal investigations, even though there is no definition of any charge or claim nor assertion that the executive may be personally implicated in misconduct, which facts may not otherwise constitute a defined "claim" subject to policy coverage?

D. Where advancement coverage incepts under "C" above before a defined "claim" under the corporation's ABC policy arises, does the policy contain a provision that gives the insured the option of not treating an event less than a defined "claim" as a reportable claim or mandatorily-reportable circumstance?

E. Does the policy cover employment practice claims, crisis management costs, and claims against employed lawyers? If the latter have separate professional liability cover, is it clear which cover is primary?

F. Is the policy definition of "wrongful act" sufficiently expansive so that "all risk" coverage is obtained, assuming such is the desire?

G. Does advancement coverage expressly continue until there has been a final adjudication of facts in the underlying proceeding for which advancement is given that permits the application of the "willful or intentional act" policy exception, and is the insurer prohibited from bringing any suit to accelerate that process?

H. Is the insurer prohibited from recovering its advances should the conduct fall within the "willful or intentional act" exclusion?

I. Is the definition of "loss" sufficiently expansive? Does it exclude the types of claims for which the board may not wish to grant advancement and indemnification rights such as insider trading, embezzlement, and money laundering?

J. Does the policy contain an exclusion for claims against executives that seek to recover amounts that the corporation should have paid in addition to amounts it did pay in a merger, share exchange, or sale transaction? If so, are executives entitled to advancement and indemnity if personally sued in such a case without being required to allocate their defense costs between other covered claims and the claims seeking an increase in consideration? Generally, are executives permitted to be advanced and indemnified against all legal costs in any matter that also includes uncovered claims or parties so long as the facts or issues relevant to the covered and uncovered claims overlap?

K. Are the exclusions for illegal conduct, "other insurance," and timing of claims (including the provisions relating to giving of notice of claim or circumstance), reasonable and readily understandable? Are the "notice of circumstance" provisions objective, subjective, or both; mandatory or permissive?

L. Is there an "insured-versus-insured" exclusion and, if so, is it phrased narrowly to exclude only truly collusive claims?

M. Does the insured entity have in place reporting mechanisms to ensure that the risk manager is kept fully informed of any potential claim or circumstance requiring notice to the insurer? Does the insurer bear the burden of establishing prejudice from late notice and is its remedy for late notice limited to the actual damage it sustains as a result?

N. Does the policy permit an executive subject to potential or actual criminal charges to assert Fifth Amendment rights, and his or her counsel assert work product privileges, without violating the policy's cooperation clause or limiting the executive's recovery of defense costs due to a claim by the insurer that the executive's counsel has provided insufficient descriptions of services rendered in billings or otherwise? Is there a severability clause that protects "cooperating" executives should "non-cooperating" executives be held to violate a cooperation clause

O. Is the policy's definition of "application" reasonably narrow and understandable? Are the covenants and representations made by the corporation and any insureds in either the application or the policy reasonable and understandable?

P. Is there an application severability provision that insulates innocent executives from a claim of application fraud due to the guilty knowledge of less than all of their number?

Q. Are there appropriate limits on the insurer's right to rescind a policy, such as an incontestability clause? Is the insurer's right to cancel the policy appropriately limited?

R. Is there a settlement "hammer" clause and has it been appropriately drafted to avoid unfair and unintended results?

S. Does the policy sufficiently define the parameters of the consent-to-settlement clause and the clause permitting the insurer to associate counsel to eliminate micro-management of the defense?

T. Is there an "order of payments" provision sufficient to reasonably mitigate the effects of a corporate insolvency?

U. Are the claim reporting time limits reasonable? Does a broad definition of "claim" result in an undesirable expansion of the insureds' duties to give notice of claims or circumstance?

V. Have the implications of "DIC" or "dedicated limits" coverage for directors as a group, or outside directors only, been appropriately vetted and explored to provide advancement and indemnity coverage (1) for claims that the corporation's by-laws and the underlying ABC policy does not cover, (2) where the corporation refuses or is unable to advance defense costs and indemnify, and (3) to mitigate the risk of program failure due to competition among competing insureds for policy limits?

W. Does the policy insure executives for costs of obtaining release from incarceration and release of sequestered personal assets if they act as directors or agents of a foreign subsidiary or act for the parent corporation in a foreign country?

X. Does the carrier selected have a reasonable financial rating and a good reputation for claims handling and payment?

Y. Do the insureds have the right to recover their attorneys' fees under applicable law should they be required to litigate coverage with the insurer?

Z. Are there to be one or more excess policies above the negotiated first-tier policy that do not "follow the form" of the first-tier policy, and, if so, have questions "B" through "Y" above been asked in respect of each of the excess policies? Has there been separate consideration of the effects of arbitration and choice of law clauses in these policies as potentially derogating from the executives' contemplated protection, particularly if they mandate arbitration in jurisdictions unfamiliar with U.S. plea bargaining? Do these policies have appropriate provisions relating to when each layer of excess coverage attaches so as to avoid gaps in protection, including provisions requiring that upper tiers "drop down" should insureds reach a settlement with the lower-tier carrier below its policy limits?

AA. Have the appropriate locally issued D&O policies been obtained in respect of foreign subsidiaries and operations?

James D. Wing

Co-Chairman, D&O Insurance Subcommittee

James D. Wing, co-chairman, D&O Insurance Subcommittee of the Director and Officer Liability Committee of the Business Law Section. Mr. Wing acknowledges the extensive contributions to the checklist of his partner, Thomas H. Bentz, Jr. Mr. Wing's email address is