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Spending $1 million of his employer’s money on legal fees to fight a $70,000 insider-trading penalty may have been easy for Robert D. Happ, but having to pay the million back to his former company because of a court ruling will be more painful. Happ’s expensive lesson is more than a cautionary tale. It is now a helpful precedent in the 1st U.S. Circuit Court of Appeals for companies that dole out indemnification protection for officers and directors but can’t get off the hook even if the executives’ conduct is shady. The ruling, which interprets Delaware law, creates a potentially important guide for companies to limit their exposure under indemnity provisions if they tie indemnification for legal costs to the guilt or innocence of the officer covered. The court held that companies that advance legal fees to officers and directors being sued may force executives to foot their own bill if it is ultimately determined that they did not act in good faith. Happ v. Corning Inc., No. 06-1324. Although Happ’s insider trading occurred in Massachusetts, the indemnification rights turn on state law in Delaware, where most corporations register, including Corning. “Historically, indemnification under Delaware law has been unbreakable,” said Boris Feldman, a securities litigation defense lawyer with Wilson Sonsini Goodrich & Rosati in Palo Alto, Calif. The law was drafted to protect the innocent executive who is thrown on the street after a hostile takeover by parties who ignore contractual obligations, Feldman said. “If you ever read an indemnification, even Houdini couldn’t get out of it,” he said. Then came the scandals of Enron Corp., WorldCom Inc., HealthSouth Corp. and a new era of executive wrongdoing. Now it appears that some judges are prepared to say that they will not make companies foot the bill, according to Feldman. Turning the tables “This is a very important decision,” Feldman said, who added that it could come up in the expected wave of stock-options backdating cases if companies decide that they don’t want to pay legal fees of those accused. Nancy M. Reimer, an attorney at Donovan Hatem in Boston specializing in complex corporate litigation, agreed. “I actually think it is significant. It turns the tables a bit,” she said. “Executives in Happ’s position always have indemnity agreements. They make decisions daily that entail risk. You don’t want to stifle that.” Executives need protection, “but not for their own untoward acts,” added Reimer. “In my view this decision is likely to change behavior,” said Jonathan Sablone, attorney for Corning Inc., the company wanting its money back from Happ. “It will certainly give corporations another tool” in the form of an undertaking with specific language, said Sablone of the Boston office of Nixon Peabody. Happ’s attorney, Gary C. Crossen of Boston’s Rubin and Rudman, did not return calls for comment. He is in the midst of his own legal troubles with the Massachusetts Board of Bar Overseers, which last month upheld a recommended three-year disbarment. Crossen and two other lawyers were accused of tricking a court clerk into providing information helpful in litigation over a grocery store chain by making the clerk believe he was being recruited for an attractive new job overseas. [NLJ, 7-25-05.] Happ served as a director for Galileo Corp., later renamed NetOptix Corp., prior to its purchase by Corning Inc. in 2000. The company agreed to indemnify him as a director for legal expenses of litigation, so long as he “acted in good faith and in a manner he reasonably believed to be in or not opposed to the best interests of the company,” according to the circuit decision. In April 1998, while head of the board’s audit committee, Happ learned that the company had problems and the chief executive sought Happ’s advice. On the same day that Happ scheduled a meeting with the CEO, he also sold 4,000 of his 5,000 shares of company stock for $47,000, according to the court. A short time later, the company revealed revenue problems, and the stock price dropped by 64%. Happ then bought 5,000 shares, according to the court. The U.S. Securities and Exchange Commission (SEC) filed a civil complaint alleging insider trading against Happ in October 2000. He sought advances for legal expenses, and Corning agreed to pay but only if Happ signed an undertaking stipulating that he would repay defense costs if it were “finally determined” that he “wrongfully used material non-public information of Galileo Corp . . . .for personal gain,” the opinion states. Corning eventually paid nearly $900,000 to cover Happ’s legal fees, and in 2003 a Massachusetts jury found him liable for insider trading. He was ordered to disgorge $35,000 and pay a penalty of $35,000 plus interest. At the same time, Happ sued Corning, contending that the company’s advances for fees were too little and too late. Corning countered that it wanted all of its money back. Happ, who now lives in Ocean Ridge, Fla., argued that he signed the undertaking while under financial duress. The question of how much pressure he was under should be a question for a jury, he argued unsuccessfully. “I had no choice,” Happ told the Boston Globe this month. “I was at a point where it was becoming financially severe for me to try to continue to fight the SEC because of its unlimited resources.” ‘A better fight’ The district court ordered Happ to pay back all the funds, and the 1st Circuit agreed in an Oct. 20 decision written by Chief Judge Michael Boudin. The decision was was joined by Judge Bruce M. Selya and visiting U.S. District Judge William Schwarzer of San Francisco. Corning’s insistence on the undertaking “was not unlawful or wrongful” under the duress doctrine, according to Boudin. What Happ should have done when faced with the demand for an undertaking was to sue for a court declaration that upheld his indemnification, Boudin said. Sablone agreed. A declaratory judgment action “is a better fight to have at the front end” before so much money is spent. Sablone said that the duress argument “plays nicely,” and “is what a lot of officers and directors might say. But the 1st Circuit answered loud and clear that if you think your rights are trampled, file a declaratory relief action,” he said. Not everyone thinks the ruling is a significant break from existing Delaware law on indemnifying officers, however. A Delaware court of chancery denied a request for indemnification in the Disney Corp. derivative litigation over the hiring and firing of Michael Ovitz, according to Robert K. Payson of Potter Anderson & Corroon in Wilmington, Del., and a corporate litigator who represented a director in the Disney case, In re Walt Disney Co. Derivative Litigation, 2907 A.2d 693 (New Castle Co., Del., Ch. 2005). “I thought this ruling was consistent,” he said. “I’m not surprised by the result.” He did agree that it gives corporations some more options. John Sturc, a former SEC associate director of enforcement now in Los Angeles-based Gibson, Dunn & Crutcher’s Washington office, said that insider trading allegations are different from other claims. “By definition they involve something an officer has done for their personal account. That is different than situations in which an officer does something in the ordinary course of work that may be erroneous or reckless,” he said. Ultimately, this may be a very fact-specific case because of the unique nature of the Happ case. “I have had clients in circumstances where the issue was insider trading and the company has not advanced fees, period,” he said. “They don’t view it as arising out of the officer’s duties.” The lesson of this case may be simpler, according to Sablone. If a company is going to require an undertaking when it advances fees, the key is to be very specific. The language should track the SEC allegations, he said. For Feldman, the case remains significant in the current corporate climate where companies such as HealthSouth have been ordered to keep paying legal fees for disgraced former executives. “I can’t tell you the number of boards that have asked me, ‘Isn’t there a way out of this?’” he said. “This decision will be explored by many boards of directors,” he said.

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