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Caveat Directors and officers. In the name of cooperation, corporations are increasingly bowing to government pressure and forcing directors, officers, and employees to pay their own legal fees from government investigations. Executives are also being asked to pay settlements, fines, and penalties out of their own pockets, too. Historically, companies shouldered all costs associated with civil suits and government investigations, as well as judgments, settlements, and fines for directors and employees. But directors and officers are finding that the solid footing they were once standing on is no longer there. Even D&O insurance policies don’t always reduce their exposure, because sometimes the government prohibits these policies from being tapped. At the same time, a company’s refusal to indemnify a director or officer may directly contradict its corporate bylaws, as well as state laws. But faced with either placating a federal prosecutor or ignoring state corporate law, companies sometimes pick the former. These developments put businesses and individuals in a bind and can pit corporations against their most valuable executives. Thanks to a spate of corporate scandals in recent years, the U.S. Department of Justice has put corporate misconduct at the top of its agenda. In this new environment, the government expects corporations to cooperate with investigations and prosecutors. If the government believes companies have cooperated, they are spared prosecution and their civil penalties are cut. In exchange for cooperating, federal prosecutors have rewarded a number of U.S. corporations with deferred prosecution agreements rather than indictments. American International Group, Inc., Monsanto Company, Computer Associates International, Inc., Merrill Lynch & Co., Inc., and Bristol-Myers Squibb Company have all recently received deferred prosecution agreements. While the government is treating corporations more leniently, it is aggressively pursuing employees and directors in criminal and civil proceedings. And it’s not just prosecuting those at the top. Cases are also being brought against middle-ranking executives such as Jamie Olis, a former Dynegy Inc. employee who was sentenced to more than 25 years in jail last year. In this zealous prosecutorial climate, the government has often concluded that paying the legal bills of an employee accused of wrongdoing amounts to a lack of cooperation � particularly if the government believes that the employee is guilty and if his lawyer mounts a vigorous defense. In January 2003, then � deputy attorney general Larry Thompson issued a memo listing factors prosecutors should consider when deciding whether to indict a business organization. Among them was a corporation’s “promise of support to culpable employees” through the advancement of attorneys’ fees. The same memo also inveighed against “overly broad assertions of corporate representation of employees.” The Securities and Exchange Commission has taken a similar view. In June 2003 remarks to the New York Financial Writers Association, then � SEC chairman William Donaldson expressed concern about companies using permissive state laws to indemnify officers and directors against fines and penalties. “This just isn’t good public policy,” he said. Shortly thereafter, the SEC adopted a policy requiring individuals settling SEC enforcement actions to forgo any potential rights to indemnification, reimbursement by insurers, or favorable tax treatment. Companies that don’t abide by the SEC’s policy face significant penalties. In May 2004, the SEC announced a $25 million penalty against Lucent Technologies for its lack of cooperation in an investigation conducted by the commission. One of the factors cited was the company’s decision to increase the number of employees covered by indemnification. The SEC noted that neither state law nor Lucent’s corporate charter obliged the company to expand indemnification rights. Voluntarily doing so was considered a failure to cooperate. Similarly, SEC settlement agreements now frequently prohibit companies from seeking insurance coverage to pay fines, penalties, and disgorgement (returning ill-gotten gains). In a December 2004 settlement with broker Edward Jones & Co., the SEC stated that its decision to agree to a $75 million disgorgement and civil penalty was based, in part, because the brokerage company agreed that it would not seek reimbursement or indemnification under available insurance policies. Without such a pledge, presumably the settlement amount would have been even higher. At the same time that indemnification is under attack, executives and directors are facing increased responsibilities under Sarbanes-Oxley. A company’s CEO and CFO must certify the accuracy of public filings, under penalty of perjury, for example. But as their responsibilities increase, directors and officers’ protection for corporate actions is coming under increased scrutiny. These new duties raise difficult questions for companies, such as: What position should a company take toward a corporate executive under suspicion for alleged accounting errors? If a corporation obtains legal counsel for an employee and that counsel then mounts a vigorous defense for the executive, does it constitute a lack of cooperation by the company? Cooperating with the government might mean a failure to meet competing obligations under corporate bylaws, as well as state laws that require companies to indemnify their directors, officers, and employees. Many corporate bylaws say that if the government initiates an investigation or lawsuit against the company, it must advance legal costs and indemnify corporate representatives. These bylaws typically are enacted under state corporate law. The Delaware Code, for instance, permits indemnification “if the person acted in good faith and in a manner the person reasonably believed to be in or not opposed to the best interests of the corporations, and, with respect to any criminal action or proceeding, had no reasonable cause to believe the person’s conduct was unlawful.” Once the investigation or litigation has started, corporations often require individuals to sign an undertaking, or agreement, that makes advancement or indemnification conditional upon the individual having met the statutory or bylaw standard. Some companies have attempted to use these undertakings to deny indemnification or recoup fees in cases where the company concludes that the individual violated the law. But in several recent decisions, the Delaware Court of Chancery has thwarted these efforts and held companies to a strict standard. In 2003 in Bergonzi v. Rite Aid, the drugstore chain’s former CFO pleaded guilty to participating in a criminal conspiracy to defraud the company. Frank Bergonzi’s plea deal required him to testify in a related proceeding. Prior to sentencing for his admitted crime, Rite Aid’s board of directors decided that Bergonzi was not entitled to indemnification or advancement and sought to have previous advances repaid. Even though Bergonzi admitted committing a crime, the court held that a provision of Rite Aid’s corporate charter required the advancement of fees and continued indemnification until Bergonzi was sentenced. The Delaware court employed similar logic this past April in Tafeen v. Homestore, Inc. Former executive Peter Tafeen sued Homestore over a dispute concerning his right to advancement of legal fees. The court rejected Homestore’s attempt to avoid advancement, specifically pointing to the company’s policy on indemnification and advancement of legal fees. Despite the corporate scandals of the past five years, the motivations behind indemnification and advancement bylaws remain valid. By providing for indemnification, companies ensure they have the services of well-qualified employees, directors, and officers, willing to work in good faith and with due care. But companies must be careful that generous policies regarding indemnification and advancement of fees � written in a different legal and regulatory environment � do not obligate them to indemnify executives that the government wants cut off. Kirby D. Behre, a former assistant U.S. attorney for the District of Columbia, is a litigation partner in the Washington, D.C., office of Paul, Hastings, Janofsky & Walker. Jeremy Evans is a litigation associate there.

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