Monday, April 23, 2007

Outside Director Exposure: A Recent Settlement Raises Alarms

Photo Sharing and Video Hosting at Photobucket Since the well-publicized settlements in the Enron and WorldCom cases, where individual directors were required to contribute toward settlement out of their own assets without recourse to indemnity or insurance, outside director exposure has been a hot topic (refer here for my prior discussion of those settlements). In addition, the SEC’s recent statements about pursuing outside directors as “gatekeepers” with a responsibility to prevent corporate misconduct, reinforced by its recent enforcement action against the outside directors of Spiegel (refer here), have further raised concerns.

The recent scholarly research of Bernard Black of the University of Texas, Brian Cheffens of Cambridge University, and Michael Klausner of Stanford Law School, in an article entitled “Outside Director Liability” (here) provides some reassurance that outside directors’ individual out-of-pocket contributions toward settlements have been, at least historically, an unusual and rare occurrence. The professors found only 13 cases in 25 years in which outside directors had to make out-of-pocket settlement payments. The authors conclude that the risk of outside directors being called upon to contribute has been “very low,” and have largely been a reflection of the insolvency of the corporate entity or the unavailability of D & O insurance. The authors conclude that this remote possibility could be even further reduced “with appropriate [D & O] policy limits and current state of the art protections.”

While the professors’ analysis is comforting, a recent settlement underscores the need for outside directors, as well as their advisors and insurance professionals, to continue to keep a sharp focus on outside director exposure. An April 23, 2007 Wall Street Journal article entitled “Settlement in Just for Feet Case May Fan Board Fears” (here, subscription required) describes a recently completed settlement in which five former outside directors of Just for Feet paid a total of $41.5 million to settle a bankruptcy trustee’s state court breach of fiduciary duty claim against the individual outside directors.

The Journal briefly relates that Just for Feet "collapsed amid an accounting fraud" in 1999. Three former Just for Feet officers pled guilty to crimes, and the company filed for bankruptcy protection in 2000. Just for Feet also settled a securities class action lawsuit, as a result of which, according to the Journal, only $100,000 remained available from the company’s insurance. A brief description of the $24.5 million corporate defendants' class action settlement may be found here. A copy of the consolidated class action complaint can be found here. The Notice of Settlement regarding the Just for Feet class action settlement may be found here. At least one of the individual defendants named in the trustee claim was also named as a defendant in the class action lawsuit.


The Just for Feet bankruptcy trustee filed Alabama state court allegations against the outside directors and the company's outside auditor in 2001. The lawsuit charged the individuals with, among other things, conflicts of interest, misrepresentations, breach of fiduciary duty and bad faith. According to the Journal, in September 2006, four former outside Just for Feet directors agreed to pay $40 million to settle the trustee’s claims against them. Last month, the last remaining outside director paid $1.5 million to settle the trustee’s claims. The former directors neither admitted nor denied liability.

It does not appear that the five individuals were, like the outside directors were in the Enron and WorldCom settlements, prohibited from seeking outside indemnity or insurance. Indeed, the Journal article notes that “[i]t is unclear whether any of the former outside directors’ employers, former employers or any other person on institution helped cover their portion of the settlement.”

The question whether the outside directors’ settlement may have been funded by a third party source, rather than out of the individuals' own assets, is an interesting and important detail (and not just to the individuals themselves). In that regard, it is important to note that one of the individual outside directors is a principal of a venture capital fund; two of the individuals are principals of private equity firms; one is a principal of an investment bank; and one is the president of a commercial bank. (The individuals' names and their respective affiliations are detailed in the Journal article.) These individuals at least potentially could have sought indemnity from the respective firms, particularly if their service on the Just for Feet board was at the direction or request of their firms. In addition, each of these individuals might have had the opportunity to attempt to recover Outside Director Liability (ODL) protection under their respective firms’ D & O insurance. The fact that several of the individuals are principals of venture capital or private equity firms is particularly noteworthy in this regard. The insurance coverage available for individuals’ outside directors service on the boards of venture capital and private equity firms’ portfolio companies’ boards is one of the most important reasons for venture capital and private equity firms to buy insurance providing this protection. Indeed, the Just for Feet settlement provides a powerful example of the reasons why private equity and venture capital firms should acquire this type of insurance.

The fact that the company’s D & O insurance program was virtually exhausted by the class action settlement apparently without obtaining a release of claims against the outside directors presents another question. It is not clear from the sequence of events and the publicly available information whether or not the trustee had initiated the claims against the outside directors at the time the securities class action was settled. But it would typically be a constraint against the exhaustion or near exhaustion of policy limits if the settlement would not secure universal claims releases. The outside Just for Feet directors would obviously have had a strong interest in avoiding exhaustion without their release. That such an outcome occurred in the Just for Feet case suggests that outside directors of other companies would be well served by having more control over the disposition of D & O policy proceeds, so that they are not faced with continuing individual exposure without further insurance protection. One possibility might be to structure the now standard order-of-payments D & O policy provision to that disposition of the policy proceeds is controlled by a vote of the outside directors.

There are now a variety of commercially available insurance structures that might also help in similar situations in the future, although the perverse combination of insolvency and insurance exhaustion is a particularly fraught situation. Certainly, the availability of a Side A Excess layer or stand-alone Side A program designed solely for the protection and benefit of individuals (as opposed to the corporate entity) potentially could have provided protection. For a summary regarding Side A insurance, refer here. Many companies have already taken steps to secure this type of protection; according to the recently recently released 2006 Towers Perrin Survey of Insurance Purchasing and Claims Trends (here), 38% of public companies in the survey reported purchasing a Side A only D & O product. But protecting even these separate limits from depletion by settlement for the benefit of insider individual defendants would seem to require some formal partition of coverage between the individual inside defendants and the outside individuals, especially given the company’s insolvency. The Just for Feet settlement may provide the best example yet of the need for a separate Side A program dedicated solely to the outside directors’ protection -- or better yet, for a separate Individual Director Liability (IDL) policy solely for the benefit of one individual or a group of outside directors. The existence of separate limits that cannot be depleted in resolution of others’ claims is the best protection against the possibility that individuals might be left to face their own liability exposure without insurance protection.

But perhaps the most significant aspect of this individual outside director settlement is its sheer size. As the Journal states, the $41.5 million Just for Feet outside director settlement may represent “the largest out-of-pocket payment by outside directors following corporate fraud allegations.” While many companies now purchase Side A protection or other variants to protect individual officers and directors, the limits available under many of these structures would typically not be sufficient to entirely fund a settlement of the magnitude of the Just for Feet outside director settlement. According to the 2006 Towers Perrin Survey, the average Side A Only limit for survey participants that also have a full A/B/C program is $15 million, and only $8 million for those with only a Side A only limit. According to the data in the survey, only the very largest companies carry Side A only limits that would have been sufficient to fund a settlement of the size of the entire Just for Feet outside director settlement.

This is just one of several recent developments that threaten traditional notions of D & O limits adequacy. The rising size of average and median class action settlements (refer here), the rising level of defense cost expense, and the emerging threat of separate class action opt-opt lawsuits (refer here), have all complicated the usual calculus of D & O limits adequacy. These factors and the continuing threat of outside director liability exposures (and the need for the D & O program to be structured to address this threat) underscore the need for the involvement of a skilled insurance professional in the D & O purchasing process.

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