What happens when a company agrees to indemnify its officers against claims of wrongdoing by the government and others but fails to make it perfectly clear what the word “officer” means? The United States Court of Appeals for the Third Circuit has provided some answers but has also provoked additional questions.
A recent high-profile decision by the Third Circuit Court of Appeals is a reminder that ambiguity in a company’s by-laws can have a real-world impact when a former employee has been charged with a crime and looks to the company for indemnification. The decision should also prompt in-house counsel to consider the interplay between a company’s indemnification obligations and its D&O insurance coverage.
In Sergey Aleynikov v. The Goldman Sachs Group, Inc., No. 13-4237, the Third Circuit considered Mr. Aleynikov’s attempt to force Goldman, his former employer, to reimburse him for the legal expenses he incurred after being charged by federal authorities with stealing computer code from Goldman. Mr. Aleynikov was convicted of trade secret theft under 18 U.S.C. § 1832, but had this conviction overturned on appeal after a finding that the statute did not encompass the trading software at issue.
Shortly after this success in federal court, Mr. Aleynikov was charged in New York state court on the same alleged facts. Those state charges are pending, and as a result, the Third Circuit was also presented with Mr. Aleynikov’s claim that Goldman must pay or “advance” his legal costs in the state matter pending its resolution.
The key question for the Court of Appeals was whether Mr. Aleynikov, who held the title of Vice President, was an “officer.”
The Third Circuit’s analysis of Mr. Aleynikov’s demands for payment of his legal fees focused on Goldman Sachs’s by-laws. Those by-laws give Goldman Sachs “officers” two valuable rights when accused of wrongdoing in the course of their work. The first is the right to indemnification, i.e. the right to be reimbursed for legal expenses after the employee has been successfully defended. The second is the right to advancement, i.e. the right to have legal expenses paid in advance of a final disposition of a proceeding against the employee. The statutory basis for these rights in the corporate by-laws is Title 8 of the Delaware Code, Section 145.
The key question for the Court of Appeals was whether Mr. Aleynikov, who held the title of Vice President, was an “officer,” as that term was used in the by-laws. The by-laws defined the term “officers” to “include in addition to any officer of such entity, any person serving in a similar capacity or as the manager of such entity.” The Court found this definition to be ambiguous – “circuitous, repetitive, and most importantly, ‘fairly or reasonably susceptible to more than one meaning.’” A major problem with the application of the term in the by-laws to Mr. Aleynikov was the fact that the Goldman Sachs subsidiary where Mr. Aleynikov worked was a limited partnership, and therefore was not required to have any officers. Such a requirement would presumably have resulted in a far more concrete conception of who was or was not serving as an “officer.”
The Third Circuit examined two types of extrinsic evidence that had been offered by Goldman Sachs to clear up the ambiguity in the by-laws. First, the Court considered “course of dealing” evidence. The Court reviewed evidence of the procedures used by the partnership for appointing officers, evidence the district court had discounted because those procedures were not widely disseminated or known within the organization. The Court also noted evidence of Goldman’s track record of providing indemnification and advancement to Vice Presidents. (The court noted that, aside from Mr. Aleynikov, 15 of 16 Goldman Vice Presidents had been provided those benefits after requesting them.) Second, the court considered “trade usage” evidence found in various periodicals, speaking to how titles such as Vice President were viewed in the industry.
The Third Circuit concluded that this evidence had been improperly discounted by the district court, and was sufficient to permit the question of whether the term “officer” in Goldman’s by-laws includes a Vice President to go to trial. In reaching this conclusion, the Court of Appeals also differed with the district court on the key issue of contra proferentum – whether the ambiguity in the by-laws should be construed against Goldman because Goldman was the drafter. The Third Circuit refused to apply this doctrine, reasoning that it had no application where the question was whether a person has rights under the by-laws in the first place.
As the parties consider a trial in this matter, what are the lessons with respect to an organization’s indemnification of its employees? Indemnification and advancement rights, generally found in the organization’s by-laws, may be ambiguous. An organization may decide that such ambiguity allows for a level of discretion in granting indemnification in specific cases, and that discretion of this type is more important to the organization in the long run than the risk of prolonged litigation. Goldman itself had exercised what it understood to be its discretion by indemnifying all but two of the Vice Presidents seeking that benefit. However, if this discretion is challenged, as in this case, millions of dollars in legal fees may be at stake, representing both the amount of indemnification and the fees consumed in a dispute over an employee’s entitlement to the benefit.
Isurance coverage usually is a crucial issue when an employee seeks indemnification from the company for claims made against the employee.
Therefore, corporate entities with complex structures should consider separate indemnification provisions, as opposed to Goldman’s “one size fits all” approach – if the partnership agreement of the Goldman subsidiary had addressed the issue of indemnification of its employees, the ambiguity in this case about who is entitled to the benefit might have been avoided. Another lesson can be drawn from the Third Circuit’s discussion of the Goldman partnership’s procedures for appointing officers. If the availability of valuable rights hinges on whether an employee is a member of a select group, like officers, and the organization has a process for assigning that role, the wide dissemination of how the assignment process works may prevent an employee excluded from that process from claiming he or she should nonetheless be considered a member of that group.
One issue the Aleynikov court did not address was whether Mr. Aleynikov, or Goldman, sought insurance coverage for the former employee’s defense costs. The issue was not before the Third Circuit, possibly because the applicable Directors & Officers Liability (“D&O”) insurance policy held by Goldman may have contained a “misappropriation of trade secrets” or similar exclusion, which is not uncommon. However, insurance coverage usually is a crucial issue when an employee seeks indemnification from the company for claims made against the employee. Companies and employees facing these situations should be aware that the company’s D&O policies may provide broader coverage than the company’s indemnification obligations.
First, assuming the claim was otherwise covered, a company’s D&O policy often insures a broader swath of employees than technically are entitled to indemnification under the company’s by-laws. Many D&O policies now cover not just “directors” and “officers,” but also “employees,” as individual insureds. D&O policies for limited liability partnerships and limited liability companies often include “managers,” or “functional equivalents.” Thus, under the D&O policy, Mr. Aleynikov would not need to worry about whether he was an “officer” of the company; instead, he would be arguing that he was a member of the broader category of managers, or employees.
Second, D&O policies contain what is known as “Side A” coverage, which applies when the company does not indemnify the individual insured, even if the company is permitted or required to indemnify the individual insured under the by-laws. Usually, there is no retention or deductible applied in “Side A” coverage situations, although the carrier may be entitled to seek recovery of a retention if the organization was permitted, but did not, indemnify the individual.
Third, some D&O policies explicitly cover actions against individual insureds where the company’s by-laws are less than clear. For example, some D&O policies now explicitly cover the costs for an individual to respond to a subpoena, a Wells Notice, or a governmental agency interview, while an organization’s by-laws often are not as explicit.
Of course, as noted above, the claim must otherwise be covered. In a situation like the Aleynikov case, where the company and Mr. Aleynikov are at odds, it is not uncommon for the company to have sued the individual in a civil action. (Indeed, Goldman has filed counterclaims against Mr. Aleynikov for breach of contract, misappropriation of trade secrets, and conversion.) Such claims typically are excluded under the so-called “insured v. insured” provision in most D&O policies. Most policies also contain a “bad acts” exclusion, which applies to loss (including defense costs) when there has been a “final adjudication” of criminal or fraudulent activity. The insurance carrier should advance defense costs prior to the final adjudication, but usually reserves the right to seek reimbursement of defense costs if there has been a final adjudication that supports the application of this exclusion. Not all D&O policies specify that the “final adjudication” must be “non-appealable.” Mr. Aleynikov’s situation is precisely why insureds should push their carriers to specify that the final adjudication be a non-appealable one. Mr. Aleynikov was convicted after trial – arguably a “final adjudication” – but this conviction was overturned on appeal. An insurance carrier (and not the company) should pay for the insured’s appeal, and should not be permitted to seek reimbursement of defense costs if the insured is pursuing an appeal of a final adjudication of criminal or fraudulent activity.
Time will tell how the interplay between a company’s indemnification obligations, as addressed by the Aleynikov court, and insureds’ rights under a company’s D&O policies, develops in future cases. The Third Circuit’s determination that the term “officers” is ambiguous, its discussion of the contra proferentum doctrine, and its acceptance of course-of-dealing and trade usage evidence likely will be cited by companies, employees, and carriers in indemnification and coverage disputes to support their respective positions. The most important message to both companies and “officers” in the short term, however, is that they pay closer attention to what the company’s indemnification obligations may be, and consider how those obligations will function, should a crisis similar to the one involving Goldman Sachs and Mr. Aleynikov arise.