The United States Court of Appeals for the Eleventh Circuit, in In re HealthSouth Corp. Securities Litigation,1 recently affirmed the approval of a partial settlement of a major securities fraud class action, holding that the Private Securities Litigation Reform Act (the “PSLRA”) did not preclude the entry of a bar order that extinguished non-settling defendant Richard Scrushy’s contractual right to advancement of legal fees, and certain other contractual indemnification rights, against settling co-defendant HealthSouth Corporation. HealthSouth had agreed to settle with the plaintiffs for $445 million. Scrushy, HealthSouth’s former CEO and chairman, did not settle. Although the PSLRA expressly requires the entry of mutual bar orders extinguishing contribution claims between settling and nonsettling defendants, courts had not previously generally extended the PSLRA to bar contractual claims for indemnification and advancement of defense costs. The Court determined that such contractual claims between HealthSouth and Scrushy could be, and were, properly barred by the partial settlement stipulation approved by the district court, except if Scrushy actually prevailed at trial on the merits.

Background

Partial settlements are a common feature of private securities fraud actions since such actions typically involve multiple defendants of varying degrees of wealth and culpability. Defendants who enter into partial settlements with plaintiffs are naturally keen on obtaining assurances that their involvement in the litigation is over and that they will not face contribution or other similar claims from other defendants. Such assurances typically come in the form of a bar order that extinguishes the contribution rights of other defendants against the settling defendant. Absent a bar order partial settlements would often be impossible.

Settlement bar orders generally provide that non-settling defendants will receive a credit against any judgment that may be entered in favor of the plaintiffs after trial. One purpose of the judgment credit is to compensate non-settling defendants for the loss of their contribution rights against settling defendants, by assuring that no non-settling defendant pays more than its proportionate share of liability. Another purpose of the judgment credit is to prevent plaintiffs from reaping a windfall. Both plaintiffs and non-settling defendants also generally need to know, for tactical reasons, the amount of credit that non-settling defendants will receive, in the event that plaintiffs prevail at trial, on account of prior partial settlements.

The PSLRA, enacted in 1995, expressly provides that partial settlements must include bar orders that extinguish all “future claims for contribution” against settling defendants that arise out of the underlying securities action.2 Such orders are reciprocal, extinguishing settling defendants’ potential contribution claims against non-settling defendants as well.3 These orders ensure that settling defendants are effectively able to “buy peace” not just from plaintiffs, but also from their non-settling co-defendants. However, the PSLRA preserves the right of a non-settling defendant who ultimately prevails in the action to pursue contractual indemnity claims to recover successful defense costs against settling defendants.4

The PSRLA also provides for a “capped proportionate share” approach to calculating the judgment credit to be awarded to non-settling defendants. Under this approach, any judgment ultimately obtained against non-settling defendants is reduced by the greater of the amount of the settling defendants’ proportional share of liability (as determined at trial) or the dollar amount paid by settling defendants in prior partial settlements.5

The Eleventh Circuit’s Decision

HealthSouth announced in 2003 that it had materially misstated its income and assets in its previous public financial statements. Shortly thereafter, HealthSouth investors filed a series of class actions (later consolidated in the Northern District of Alabama) alleging fraud and violations of the securities laws against HealthSouth, its CEO Richard Scrushy and others. HealthSouth and its insurers agreed in 2006 to enter a partial settlement agreement with the plaintiffs, under which HealthSouth paid $215 million of the total $445 million settlement, with its insurers paying the balance. Scrushy, not a party to the partial settlement, objected to the district court’s entry of a bar order extinguishing his rights under a 1994 indemnity agreement he had with HealthSouth. The agreement, governed by Delaware law, provided that Scrushy would be indemnified for any judgment rendered against him in his capacity as CEO of HealthSouth, provided “he acted in good faith and reasonably believed he was acting in the best interest of the company.”6 The agreement also provided that HealthSouth would advance Scrushy legal fees as they became due and, as required by the PSLRA, preserved Scrushy’s right to indemnity if he actually prevailed in a suit.

Scrushy challenged the bar order, arguing that (1) the PSLRA’s mandatory bar of contribution claims was exclusive and precluded the barring of other claims, specifically his contractual indemnity and advancement of legal fees claims; (2) his contractual claims against HealthSouth were independent and not based on his liability to the plaintiffs and again therefore not properly the subject of a bar order; and (3) the partial settlement did not compensate him for the loss of his contractual indemnification rights.

The Eleventh Circuit upheld the bar order in its entirety. The Court held that the PSLRA did not explicitly preclude the barring of contractual indemnity claims, observing that “[t]he statute merely mandates a contribution bar, but is silent with respect to barring similar indemnification claims.”7

Reviewing the case law of other circuits, the Court concluded that “the background of case law against which the PSLRA was enacted clearly established that the barring of [contractual] indemnity claims is permissible.”8

The Court likewise rejected Scrushy’s contention that his indemnity and advancement of legal fees claims against HealthSouth could not be barred because they arose independently of his liability to plaintiffs. The Second Circuit, in a prior bar order case, Gerber v. MTC Elec. Tech. Co., Ltd.,9 had modified a bar order to limit the barred claims to those “where the injury is the non-settling defendants’ liability to the plaintiffs.”10 Scrushy argued that a bar order should not extend to claims beyond those representing a liability owed to the plaintiffs in the action. The Court, however, declined to hold that the advancement of legal fees claims is categorically independent and therefore cannot be barred: “We believe that the nature of Scrushy’s claim for advanced attorneys’ fees is so close to the nature of the claims which established case law holds are appropriately barred that our application of that case law here constitutes a minimal and reasonable extension thereof.”11 It concluded that even though the attorneys’ fees Scrushy sought would not be paid to plaintiffs, they would be “paid on account of liability to the underlying plaintiffs or the risk thereof.”12 The Court also found that the reciprocal nature of the bar order and the judgment credit awarded to him “constitutes very significant compensation to Scrushy, in light of the perception by the underlying plaintiffs and HealthSouth that Scrushy was a central figure in the [alleged] violations.”13

The Court acknowledged that barring claims for advancement of legal fees could make it difficult for non-culpable officers and directors to prove their innocence. Indeed, in most instances, without advancement an individual defendant may well lack the resources to mount a credible defense in a complex class action. The Court stated that “policy arguments supporting advancement of legal fees must be balanced against countervailing policies in favor of settlements and against indemnification in the securities litigation context.”14 In any event, according to the Court, Scrushy “made no showing in the district court that he was merely an innocent bystander with respect to the violations at issue here.”15 The Court argued that the absence of such a showing, coupled with the lack of any evidence that barring Scrushy’s claim for advancement of legal fees would prejudice his defense, supported the Court’s conclusion that the district court’s approval of the partial settlement, including the bar order, did not constitute an abuse of discretion.16

Conclusion

It remains to be seen whether other courts will follow the Eleventh Circuit’s conclusions as to the appropriateness of settlement bar orders that extinguish contractual claims for indemnification and/or advancement of defense costs. In this case, the Court may well have perceived Scrushy as the primary active perpetrator of the alleged fraud (notwithstanding his acquittal in a related criminal proceeding). How this issue plays out for non-settling defendants in securities actions, particularly for directors and officers with contractual indemnity and advancement rights, will likely continue to be litigated.