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In the wake of the scandals involving Enron, WorldCom and other companies, circumstances combined to energize law enforcement agencies' investigation and prosecution of corporate fraud and mismanagement. New legislation, additional funds for law enforcement, and broad popular and political support for prosecution of management misconduct have all created a climate conducive to aggressive prosecutorial strategies.
One such strategy is to hobble officers' and directors' ability to defend enforcement actions by attacking corporate indemnification of defense expenses. Many defendants may assume that directors and officers liability insurance will fill the gap that prosecutors' tactics create. Given the structure of most D&O insurance policies and programs, those assumptions may be wrong.
Prosecutors generally have used three tactics to hamper indemnification.
The Sarbanes-Oxley Act gave the Securities and Exchange Commission a new tool to prevent individual defendants from looting their companies while an investigation is under way. Section 1103 of the Act allows the SEC to seek a court order freezing "extraordinary payments" by a company to its directors, officers and others. The order lasts up to 90 days, but can be extended indefinitely if the individual is charged with a violation of the federal securities laws. While the order is in effect, the company must make the payments into an escrow account.
Section 1103 makes good sense from a public policy standpoint. If someone has his or her hand in the corporate cookie jar, the SEC ought to have the means to, at least temporarily, slam the lid.
The SEC has given Section 1103 a broad reading, however, and has successfully argued that the cookies in the jar include indemnification payments. In its proceedings against WorldCom, the SEC obtained an order under Section 1103 to prevent the company from advancing defense costs on behalf of officers under investigation. This left the individuals without indemnity and personally exposed for the cost of responding to the SEC's efforts.
The SEC is the only entity that can seek orders under Section 1103. The Department of Justice has, nevertheless, attacked indemnification and achieved similar results by seeking injunctive relief. The DOJ has argued that a company that has been victimized should not have to pay the legal expenses of those who allegedly committed the crime. An injunction was issued on that basis in proceedings involving former officers of Westar Energy. As a result this move, the individuals were required to defend themselves while the injunction was in effect.
Prosecutors' coercion of accounting firm KPMG L.L.P. undoubtedly is the most notorious attack on indemnification to take place in recent years. Prosecutors threatened to indict KPMG if it advanced defense costs of the partners and employees being investigated for possible criminal wrongdoing. A January 2003 memorandum by Deputy Attorney General Larry Thompson, now popularly known as the Thompson Memorandum, encouraged this tactic. That memo described factors prosecutors should consider when deciding whether to indict a corporation. Mr. Thompson identified cooperation with prosecutors as a key factor, and stated that a company could show cooperation by not paying the defense expenses of "culpable employees."
KPMG, not wanting to suffer the fate of Arthur Andersen, acquiesced to the prosecutors' demands, and severely limited the amount of defense costs it would advance on behalf of individuals targeted by the U.S. attorney. The individuals then had to fund their own defense, and pursue indemnity claims against KPMG.
D&O insurance may not insulate individuals from prosecutorial attacks on indemnification. Traditional D&O policies cover loss that is not indemnified by the company, known as Side A coverage, and typically do so without any deductible or retention. However, most policies provide that Side A coverage will be subject to the same retention applicable to indemnifiable loss, known as Side B coverage, if the company does not indemnify the individuals for any reason other than financial insolvency. Because prosecutorial attacks on indemnification--not insolvency--are the cause of companies' failure to indemnify, individuals caught in a prosecutor's cross hairs may be required to pay a Side B retention before D&O coverage is triggered. For public companies, such retentions often exceed $1 million. The increasingly popular Side A-only policies may not shield directors and officers from this exposure, either. Not all Side A forms are broad enough to be triggered under these circumstances.
It is tempting to be heartened by a recent decision in the KPMG case. In June, the judge overseeing that litigation issued a strongly worded order finding that coercive tactics outlined in the Thompson Memorandum are unconstitutional. Whether this and other legal developments will clip the wings of other prosecutors considering attacks on the indemnification of individuals remains to be seen. Because new issues such as options backdating continue to capture the attention of law enforcement and the investing public, the current zeal to investigate and prosecute wrongdoing seems certain to continue.
Companies, therefore, must structure their D&O insurance programs to avoid subjecting their management to personal financial losses if they become the targets of prosecutors.