Wednesday, June 28, 2006

KPMG's Aftermath -- Revenge of the Insurance Companies?

U.S. District Judge Lewis Kaplan's opinion permitting former KPMG partners and employees to seek advancement of attorney's fees from the firm sets an interesting precedent regarding the scope of the government's ability to interfere in contractual relations between employers (and principals) and their employees (and agents).  An interesting question is whether the decision might have the inverse effect in future cases because employers and principals will be less generous in providing benefits to their employees and agents, thus advancing the purpose of the Thompson Memo even though it was found to violate Due Process.

Judge Kaplan did not rule on KPMG's contractual obligation to advance the attorney's fees, although he came pretty close to finding that there is an implied-in-fact contract based on the firm's course of performance in other cases, most recently the SEC's investigation of the firm and its partners in the Xerox audit in which it paid almost $20 million in defense costs.  When business organizations see that a course of performance may bind them contractually, one way around that is to make the policies on the issue clear by putting them in writing.  KPMG did not have a written indemnification agreement, but it (and others) most likely will adopt them in the future.

The opinion also seems to imply that advancement of attorney's fees is a right all employees have, but under corporate law statutes that is certainly not the case.  The only mandatory indemnification is when the officer, director, or employee is "successful on the merits or otherwise in defense of any action" under Delaware GCL Sec. 145(c), and Model Business Corporation Act Sec. 8.52 is the same.  The other indemnification provisions in corporate law permit, but do not require, the payment of attorney's fees in advance of a decision.  Corporations and other business organizations (such as LLCs and LLPs) are free to bind themselves contractually to provide these benefits, as KPMG's course of performance may have done, but they are not required to provide such protection.

After KPMG, will corporations rethink their position on advancement of attorney's fees?  Here's where the insurance companies that provide the directors & officers (D&O) insurance may come into play.  Stories about defense costs in recent cases must send shivers down the spines of the D&O insurers because they may be on the hook for millions of dollars in defense costs with little hope of recovering any of it if the individual is found guilty.  The first three pages of the Judge's opinion list counsel for the defendants, and the firms are among the leading white collar crime practitioners in the country, and they don't come cheap.  The defense of Jeffrey Skilling in the Enron trial shows that the defense lawyer's hourly-billing meter may appear to be spring-loaded, what with dozens of lawyers and support staff committed to the case (see earlier post A License to Print Money).  Other prosecutions triggering multi-million dollar defense costs include Dennis Kozlowski (Tyco), Bernie Ebbers (WorldCom), and Richard Scrushy (HealthSouth).  What makes Scrushy's case different is that he was found not guilty, so he should have a good claim under Delaware law for mandatory indemnification of his $20+ million in defense costs. 

I suspect that D&O insurers may impose their own little Thompson Memo -- if they have not done so already -- on companies by requiring them to put into employment agreements that defense costs will be cut-off after an indictment, or the obligation will be limited to a specified percentage of the fees or subject to a cap.  Absent such a provision, the insurers may not be willing to take on the risk, or will charge a much higher premium for policies without significant limitations on their obligation to pay attorney's fees in advance.  Companies may be pressured by shareholders in a similar direction to limit their liability in cases that may triggers millions of dollars in costs to the corporation to defend an officer who could end up being sent to jail. 

The government's position in the Thompson Memo that views the payment of attorney's fees as indicative of a company's lack of cooperation was hardly defensible, and Judge Kaplan's opinion shows how the courts will react to any perceived interference with the right to counsel -- unless you're a drug dealer and there is an asset forfeiture case, but that's a different story.  Whether any future case even comes to this point is an open question, and I think companies will view the KPMG decision as a signal to avoid the problem altogether by limiting the payment of attorney's fees in a way that keeps them from having to pay after an indictment of an individual officer or employee.  That may well fulfill the goal of the Thompson Memo, if the government actually wants companies to cut-off the attorney's fees for indicted employees. (ph)

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» Judge: Thompson memo imperils right to counsel from PointOfLaw Forum
In the KPMG case, federal judge Lewis Kaplan has blown a great big hole in the Justice Department's policy (as outlined in the now-notorious Thompson memorandum) of arm-twisting corporations under investigation into withholding legal support from their... [Read More]

Tracked on Jun 28, 2006 8:50:40 PM

» Judge: Thompson memo imperils right to counsel from PointOfLaw Forum
In the KPMG case, federal judge Lewis Kaplan has blown a great big hole in the Justice Department's policy (as outlined in the now-notorious Thompson memorandum, Sec. VI) of arm-twisting corporations under investigation into withholding legal support f... [Read More]

Tracked on Jun 29, 2006 5:54:18 AM


"The government's position in the Thompson Memo that views the payment of attorney's fees as indicative of a company's lack of cooperation was hardly defensible"

That is just a crazy statement.

Posted by: lawdevil | Jun 28, 2006 6:56:20 AM

A few observations regarding your comments on D&O policies in light of the KPMG decision. First, your standard public company D&O policy provides individual coverage in addition to entity coverage. The individual coverage kicks in if the company doesn't indemnify its executive. Of course, this coverage -- called Side A -- is subject to all the policy terms and conditions, but if the payment of fees by the corporation would otherwise be covered under the Side B (entity cover), then it would almost certainly be covered under Side A. If the corporation could validly refuse to advance after a certain point, the subject officer or director would likely be entitled to have his or her fees covered under Side A of the policy. Moreover, since Side A cover generally does not include a retention or deductible, requiring corporations to be more restrictive with their indemnification policies would likely hurt D&O insurers as it would increase the likelihood of Side A losses. Second, most D&O policies also have "presumptive indemnification" clauses that essentially state that, for purposes of the policy, it will be presumed that the corporation will indemnify its directors and officers up to the fullest extent allowed by law. As a result, efforts by companies to impose restrictive terms on their indemnification obligations almost certainly would create a problem with their D&O carrier (again, mostly due to the retention issue). Finally, the other thing companies need to be cognizant of in considering these issues, is that if they cut off an executive, that executive is almost certainly going to seek coverage on his or her own under the company's D&O program. If they are successful, this person will have access to the policy proceeds, and most policies also have a priority of payment provision that gives Side A claims priority over Side B or Side C (Entity securities claims cover) claims. The result is the person most likely to run-up huge defense costs gets first crack at the D&O policy, and the company has severely limited its ability to control the situation. An alternative approach is to work out a deal with targeted executives regarding payment of their defense costs (easier said than done, but probably worth a shot before cutting central players in the drama loose). That way the company can control how the policy proceeds are used. There also are other practical reasons companies would want to keep everyone "in the fold" in dealing with government investigations. Frankly, I think the KPMG decision might encourage companies to broaden their indemnficiation practices since -- assuming the 2d Circuit upholds it -- paying the fees no longer can be used against them. Although your comment on how shareholders may view indemnification, could temper this.

Posted by: NY 40 | Jul 25, 2006 8:07:00 PM

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