UPDATE: $100 MILLION VERDICT REVERSED
The July, 1991 issue of The ACE Report discussed a recent $100 million jury verdict in California against two senior officers of Apple Computer for violation of the federal securities laws. In September, 1991, the district court judge in that case set aside the jury verdict, concluding that no reasonable jury could have found the officers liable under the evidence presented at trial.
Surprisingly, the judge also ruled that the jury's verdict exonerating Apple is irreconcilable with the jury's determination that the two officers violated the securities laws. Because the parties conceded that all public statements at issue were made on behalf of Apple, the district judge ordered a new trial against only Apple to determine if the corporation itself violated the securities laws even though the two senior officers did not.
If upheld, this ruling will likely be used by D&O insurers to demonstrate in the allocation context that a corporation has liability exposure under the federal securities laws separate and independent from the directors and officers. The corporation is not simply a nominal defendant in such lawsuits, but as demonstrated in the Apple case, can be subject to substantial liability exposure even if the director and officer defendants are exonerated. In cases where both the corporation and D&Os are defendants, an appropriate percentage of the defense costs and any settlement amounts collectively incurred by both the corporation and the D&Os should be allocated to the corporation and thus not covered under the D&O insurance policy.
D&O SPOUSAL LIABILITY – IS YOUR SPOUSE BARE?
A few recently filed lawsuits alleging director and officer misconduct have named as defendants not only the allegedly culpable directors and officers, but also their spouses. These lawsuits allege that the wrongful acts of the defendant D&Os were for the benefit of the director's or officer's "marital community" and therefore seek recovery from the spouses to the extent the spouses' marital property was increased as a result of the alleged wrongful acts. The spouses are not alleged to have committed any wrongful acts themselves.
To date, the few cases in which such allegations have been made have been limited to community property states (i.e. states which by law treat all assets acquired by either spouse during the marriage as community property and therefore each spouse has a direct ownership interest in all such assets). Both regulators (including the RTC) and professional plaintiff lawyers have recently asserted this type of D&O spousal claim, their apparent motive being two fold. First, the plaintiffs seek to insure that their recovery will not be frustrated by community property laws or asset transfers to the D&O spouses. Secondly, and perhaps more significantly, the plaintiffs may intend to increase their psychological leverage over the D&O defendants by exerting pressure through litigation against the spouses of the defendant D&Os.
This spousal exposure may be troublesome from a risk management standpoint because spouses will likely not have any mandatory financial protection for such claims. Virtually all internal corporate indemnification provisions mandate indemnification only for directors, officers and perhaps employees, but not spouses. Virtually all state corporate indemnification statutes expressly authorize indemnification only for "directors, officers, employees or agents". However, most of those statutes further provide that the corporation may extend indemnification protection beyond that expressly authorized by the statute. Therefore, corporations under such statutes probably would be permitted to indemnify spouses for this type of passive, "marital community" claim if the corporation so desires.
For the same reason that internal corporate indemnification provisions mandate broad indemnification protection to directors and officers, corporations may wish to now examine whether such mandatory indemnification should also extend to spouses for such passive liability exposure. If the internal corporate indemnification provision is amended to include spouses, the amended language should apply only to liability of spouses based upon the alleged wrongful acts of an indemnified director or officer and should not extend to protect the spouse's own wrongful acts.
Similarly, traditional D&O insurance policies do not insure spouses and would not extend coverage for these claims. Therefore, a D&O insurer would be justified in denying coverage for that portion of the defense costs, settlement and judgment reasonably allocable to the claims against the spouse. To the extent any such allocable portion of loss is not covered by either insurance or indemnification, it would have to be paid directly by the spouse out of his/her personal assets.
Like the exposure of D&Os, a responsible risk management approach to this possible gap in financial protection includes both indemnification and insurance. D&O carriers will likely be reluctant to extend coverage to the spouse for this "marital community" exposure unless indemnification is also afforded. Otherwise, the coverage extension could be used by insureds as a method to circumvent the higher corporate reimbursement deductible (or in the case of CODA circumvent the corporate reimbursement exclusion). However, if mandatory indemnification is extended to the spouse, D&O carriers may be willing to extend the coverage to include this passive spousal exposure, assuming acceptable policy language can be agreed upon to assure that coverage does not extend to the wrongful acts of the spouse.
D&O FIDUCIARY DUTIES TO CREDITORS
The dramatic increase of financially distressed companies in recent years has resulted in an increased number of damaged creditors pursuing recovery not only from the distressed company, but also from the company's directors and officers who allegedly caused or at least failed to prevent the company's financial problems. This is causing a reexamination by creditors, D&Os and the courts of traditional fiduciary duty concepts.
Basic corporate law states that directors and officers owe fiduciary duties only to their corporation and its shareholders, but do not owe fiduciary duties to other corporate constituents such as creditors. Indeed, directors have been held liable for taking a course of action that benefited creditors or others at the expense of shareholders.
However, once a corporation becomes insolvent, the fiduciary duties of the insolvent company's D&Os arguably shift from the equity holders to the dept holders, who are then the true stake holders in the company's operations. Courts have ruled that under these circumstances, the D&Os of the insolvent company owe fiduciary duties to the creditors as well as the stockholders, or in some instances instead of the stockholders.
One basis for this post-insolvency duty to creditors arises from what is known as the "trust fund" doctrine which states that upon insolvency all of the assets of the corporation become a trust fund for the benefit of the corporation's creditors. Another basis is the recognition that when a company is financially distressed, either the company will eventually be liquidated and the proceeds of the liquidation will go to the creditors, or a workout will be engineered and the creditors will end up owning most of the equity.
A key question, of course, is when does "insolvency" occur for purposes of triggering this fiduciary duty to creditors. Clearly, a corporation is deemed to be insolvent when it files for protection under the Bankruptcy Code. However, a corporation can be insolvent long before a bankruptcy filing. For example, some courts have recognized a "balance sheet" test, which determines if liabilities exceed assets. Other courts have recognized an "equity" insolvency test, which determines if the corporation is unable to pay its debts as they mature. In the aftermath of the highly-leveraged acquisitions and recapitalizations during the late 1980's, many companies are now technically "insolvent" under at least the balance sheet test even though their operations are healthy and profitable. Do the D&Os of such companies owe fiduciary duties to corporate creditors? Under current case law, they may.
Not only is the existence of fiduciary duties to creditors troublesome, the nature of those duties is equally problematic. Because one justification for the existence of the duty is the "trust fund" doctrine, D&Os arguably must comply with the very high standard of conduct applicable to trustees. In that case, directors may not be permitted to invoke the business judgment rule as a defense to creditor claims, although several cases have allowed a trustee in bankruptcy to use that defense.
An example of when the existence of this duty to creditors may be important is the decision by directors to file for bankruptcy protection. Such a filing typically protects the interests of creditors but not the interests of shareholders. If directors owe fiduciary duties only to the corporation and its shareholders, they will likely postpone the bankruptcy filing until it is needed to preserve the existence and integrity of the corporate entity. However, if fiduciary duties are owed to creditors at some point prior to bankruptcy, directors may be obligated pursuant to this duty to seek bankruptcy protection well before they would otherwise. Failure to do so may create significant D&O liability exposure to the creditors.
The possibility that directors owe fiduciary duties to creditors also demonstrates the potential liability exposure of directors of subsidiary corporations. When the subsidiary incurs financial difficulties, its directors may be required pursuant to this duty to act in the best interests of the creditors and not just the parent company.
The law in this area is vague at best and the stakes are frequently enormous. Although further judicial clarification is expected in the next few years, it may come too late for many D&Os who today are managing technically insolvent corporations.
REGULATORY EXCLUSION IS ALIVE AND WELL
D&O insurance policies issued to financial institutions regularly include a so-called "regulatory" exclusion pursuant to which claims by or on behalf of regulatory agencies such as the FDIC are excluded from coverage. Beginning with a Utah federal district court decision in 1987, a series of courts ruled that this exclusion was unenforceable by the insurer against FSLIC and FDIC because it was against public policy. These courts reasoned that those regulatory agencies are given extremely broad powers and duties by statute and regulation for the purpose of maximizing the agencies' ability to collect "every dollar available", in their effort to recoup losses resulting from a failed financial institution. Those courts viewed enforcement of the regulatory exclusion as seriously hampering the carrying out of those duties by the regulatory agency since the exclusion eliminates the D&O insurance policy as a source of recovery.
In August, 1991, the highest state court in Maryland ruled that the regulatory exclusion in a D&O insurance policy did not violate public policy and was enforceable against the Maryland Deposit Insurance Fund, which is the state equivalent of FDIC. Although this decision was given a great amount of publicity, it is important to put the decision in the context of other judicial decisions on this issue across the country.
Ironically, the "turning point" for D&O insurers on this issue came in mid-1990 in a Sixth Circuit federal court of appeals decision not involving a D&O insurance policy. The court in that case rejected an argument by the FDIC that a bankers' bond automatic cancellation provision which was triggered upon a regulatory taking over the insured bank was against public policy. The FDIC's argument was essentially the same as its argument in attacking the D&O regulatory exclusion. The court strongly rejected that argument and ruled that "the dominant public policy exposed by this review is that the parties' freedom to contract must not be disturbed".
Since that Sixth Circuit opinion, courts in Oklahoma, California, Minnesota, Texas, Colorado and now Maryland have found that the regulatory exclusion in the D&O insurance policy is enforceable and not against public policy. No decisions since that Sixth Circuit case are known to have ruled otherwise. The rationale and justification by these different courts have varied and include one or more of the following:
- No Statute or regulation requires the purchase of D&O insurance or prohibits a regulatory exclusion. If the legislature has not recognized a public policy requiring the existence of D&O insurance coverage for regulatory claims, courts should not create such a public policy.
- A logical extension of the FDIC's argument is that all provisions of the D&O insurance policy which limit recovery by the regulatory agency would be unenforceable as against public policy. For example, the limit of liability portion of the policy would arguably also be unenforceable and the insurer would have unlimited liability exposure to the regulator. Such a result would be clearly inequitable and unjustified.
- The D&O insurer and the insureds have a constitutionally recognized freedom to contract as they choose. By ruling that the regulatory exclusion is unenforceable, a court would judicially rewrite a contract voluntarily entered into by two consenting parties.
- Because of the regulatory exclusion, no insurance coverage under the policy exists. Public policy cannot create something that does not otherwise exist.
- The amount recovered by depositors is unaffected by the amount of recovery by the FDIC under the D&O insurance policy. Thus, public policy considerations need not be invoked in order to protect the interests of the public depositors.
In light of this strong, consistent line of cases, including cases from a federal court of appeals and a state's highest court, D&O insurers can now take more comfort that the regulatory exclusion will be enforceable as intended by the parties to the contract. However, if no regulatory exclusion exists in the policy, some of these same recent cases hold that the "insured v. insured" exclusion is ambiguous as to whether it applies to regulatory claims and therefore is not applicable to such claims.