Why You Need to Reconsider Indemnification and Insurance Arrangements
Even though Section 145 of the Delaware General Corporation
Law prohibits companies from indemnifying an officer or director unless the
person acted in "good faith," Section 145(g) – on the face of it anyways –
permits companies to purchase D&O insurance, notwithstanding bad faith. However,
in some cases, the D&O coverage might not be sufficient to cover a director’s
entire exposure.
It also should be noted that the SEC recently adopted a
policy requiring settling parties to forgo any rights they may have to
indemnification or reimbursement by insurers. Phil
Koehler of Stradling, Yocca, Carlson & Rauth LLP notes that once upon a
time, boards looked upon indemnification agreements – the ones that protect the
CEO and other executive officers against shareholder litigation and provided for
the advancement of their defense costs - as essential tools in the company's
struggle to recruit and retain the best and the brightest management talent.
Alas, yet another
cherished bit of corporate governance folklore is laid waste by the law of
unintended consequences. Last year the SEC concluded a contentious accounting
fraud investigation of Xerox Corporation. In the end, six former executives
coughed up $22 million in penalties and disgorgement payments to the SEC in
settlement of claims that they had personally benefited by receiving special
bonuses and proceeds from stock sales at a time when they were perpetrating
accounting fraud.
With Xerox's
announcement of the settlements came the mystifying revelation that Xerox would
indemnify these six rascals. Xerox argued that the terms of the indemnification
agreements were "bullet proof" and, therefore, it was compelled to reimburse
these officers.
Of course, the SEC
saw this for what it was: a cynical end run around personal responsibility
facilitated by a board too focused on the company's contractual obligations to
disgraced former executives and too blasé about its fiduciary duties to
shareholders. SEC Chairman, William Donaldson commented:
"[T]he fight
against corporate fraud requires resolve in the boardroom and at all levels of
government. I'm concerned about companies that, under permissive state laws,
indemnify their officers and directors against disgorgement and penalties
ordered in law enforcement actions, including those brought by the Commission.
In my mind, this isn't good public policy. This is an area we may need to
consider ways to bring about reform."
To avoid a repetition of this, the SEC enforcement staff adopted a policy in which all
settlement offers in SEC enforcement actions against officers and directors must
be contingent on a representation and warranty that no part of any penalties
paid to the SEC are being indemnified by the company or reimbursed by insurance.
The SEC is considering whether the policy should apply to disgorgement remedies
as well.
Thus, the "bullet
proof" indemnification agreement tumbles from grace as a tool in recruiting and
retaining executive officers. Indemnification agreements that strain the
maximum allowable limit under the state law of incorporation are no longer just
a "gimme" in negotiating the CEOs employment agreement.
The Rite Aid case
is another prime example of a wayward CEO with a bullet proof indemnification
agreement that caused the corporation to pay his fines and penalties and, in
effect, nullify the punishment for his transgressions against the shareholders.
These are not isolated cases.
As a result, Compensation Committees should consider scenarios like the Xerox settlements and
ensure that they negotiate exclusions and limitations on indemnifiable losses in
executive indemnification agreements – including renegotiating existing
indemnification agreements – so that shareholders are not left in the position
of helplessly watching corporate assets being paid for wayward executives’ fines
and penalties – and thus nullify the punishment meted out by the SEC for their
transgressions against the company. It would not be surprising to also see
courts take the same position in their damage judgments and in approving
settlements.
