Wednesday, November 29, 2006

First Circuit Ruling on Indemnifying Exec's Defense Costs May Skew Incentives

Posted by Alan Childress

A recent First Circuit ruling allows a corporation to recoup the massive legal fees it had paid (over an indemnity agreement under Delaware law) to finance an executive to defend himself against insider trading, fraud, or similar charges--if ultimately he is found to have acted in bad faith.  See the story here.  Ultimately the exec (a director) owes his old company a million dollars for an offense in which he was civilly fined $70k.

At first blush, no one defends an exec 'rewarded' for acting in bad faith by paying his or her fat cat lawyers.  It does not seems fair that he or she gets the company defense.  But run-of-the-mill insurance contracts with a duty to defend built-in are really just indemnification agreements too.  Is anyone suggesting that each of us pay Allstate back after we lose the auto accident case for which it paid our defense?  Well, you say, this one acted in bad faith, but we don't when we run into a light pole.  Yes, but all sorts of insurance policies which cover bad faith--where allowed to--provide for defense costs.  I have not heard of paying back the insurer after losing such cases, if the policy is valid and covers the loss and defense.  It does not appear that the First Circuit is ruling that it is invalid as a public policy matter to contract for such defense.  The case then ultimately turns on this particular indemnity clause and the "out" it gave the corporation when the exec lost his civil case.  (in that sense it may just be fairly narrow and consistent with rulings in Delaware courts over Disney on which Jeff has posted.) But I fear it will not be read in that limited way.

This kind of ruling, while focusing on an unsympathetic party, ultimately creates rules for the rest of us.  It is one more notch in the expanding belt of disincentives to get smart people (who can do basic risk analysis) to be directors.  It also skews the risk analysis an innocent accused must do when presented with charges, a settlement offer, and the prospect of a bonus fine of one million dollars (past the smaller substantive exposure) if one rolls the dice and loses.  Wouldn't the smart innocent person just settle every time and swallow the pretense of guilt but no finding of bad faith rather than risk ruination with a formal guilty finding?  Or if the settlement or plea is proof of bad faith, so that settling equals a massive debt to the employer, wouldn't everyone innocent or not have to roll the dice, precluding rational settlement?  The implications are not just about sympathy for the bad corporate apple.

Economics, General Counsel | Permalink

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