When the SEC sued Robert Happ for illegal insider trading in October 2000, he thought his defense costs would be covered. Happ had an indemnification agreement with Galileo, an optical manufacturing company on whose board he served. The agreement said the company would cover any liabilities associated with Happ's duties as long as his conduct was in the company's best interest.
After a court found Happ liable for about $35,000 in unlawful gains from insider trading, the company sued for repayment of Happ's legal-defense bill. The ensuing legal battle might have dragged on with a jury trial and cost hundreds of thousands of dollars, but it didn't because of Galileo's smart strategy of conditioning Happ's indemnification on his exoneration.
"It made it cost-effective to go after the money on a summary-judgment basis," says Jonathan Sablone, a partner with Nixon Peabody in Boston, who represented Corning NetOptix (successor to Galileo) in the 1st Circuit appeal. "As a practical matter, that is the whole ball game."
Like many companies, Galileo used the language of Delaware law in its by-laws and contracts, including its indemnification terms for directors and officers. The Delaware language covers job duties performed "in good faith and in a manner reasonably believed to be in or not opposed to the best interests of the company." Because the statute's "not opposed" language leaves potential wiggle room, many companies--including Corning--wisely clarify those terms before extending legal fees to directors and officers.
When the SEC sued Happ, Corning negotiated an auxiliary contract--or "undertaking"--that disqualified him from indemnification if he was found liable. Happ resisted, but ultimately signed the undertaking, and Corning advanced almost $900,000 to cover his legal defense fees, knowing that if a jury found Happ guilty, it would be entitled to get that money back.
In October 2003 a Massachusetts jury found Happ violated insider-trading laws. Specifically, after learning material, non-public information that indicated the company was having financial difficulties, Happ sold 4,000 shares of Galileo stock. When the information became public, Galileo stock lost nearly two-thirds of its value. Happ then re-acquired 5,000 shares--avoiding a loss of about $35,000.
Upon the verdict, Corning sued Happ to recover the $878,000 it had advanced. A Massachusetts district court granted Corning summary judgment and ordered Happ to repay the funds. Happ appealed the ruling to the 1st Circuit, arguing he entered the undertaking under duress and that summary judgment was inappropriate because the terms of the indemnification agreement were unclear. But according to the
1st Circuit, Corning's contract language was airtight. The court rejected all of Happ's arguments in October 2006 and ordered him to repay the $900,000.
Mind The Gap
Happ first argued the court should throw out the undertaking because he accepted it under duress--essentially he had no choice but to sign the agreement if he wanted to mount a defense against the SEC lawsuit. But the 1st Circuit wasn't convinced, observing that under Massachusetts law, Happ would have to show he was the victim of a wrongful act or threat that deprived him of his free will in order to prove duress. Even if Happ had been able to prove he was in financial peril, Corning's hard bargaining did not equate to a wrongful act or threat. And in any case, the court said Happ waited too long to make this argument.
"If you believe truthfully the undertaking language is forcing you to give up rights you don't need to give up, the way to approach it is to take the matter to a judge," Sablone says. "Don't take the money and then argue there was duress and you had no choice."
Additionally, Happ claimed the company was obligated to pay his fees under the indemnification agreement, regardless of what the more restrictive undertaking said.
Under the language of the indemnification agreement, Happ could have argued that he was entitled to fees because insider trading is not necessarily opposed to the company's interests. The 1st Circuit acknowledged that language adopting Delaware law could take precedence over an undertaking if the undertaking was deemed invalid. But the court rejected such a doctrine in this case, saying it couldn't undo the perfectly clear intention of the contract Happ signed.
"The arguable gap between what Delaware law might permit and what Corning was willing to do explains why Corning sought an undertaking more restrictive than the by-law and contract obligations," wrote Chief Judge Boudin in his opinion for a three-judge panel of the 1st Circuit.
Avoiding A Fight
The 1st Circuit's decision in Happ v. Corning NetOptix offers at least three lessons for general counsel, as well as corporate officers and directors. First, it suggests when companies are asked to fulfill indemnification obligations, they should not rely on generic by-laws to protect their interests.
If Corning hadn't insisted on specific conditions in the undertaking, it would have had to argue with Happ in court over whether insider trading was opposed to the company's interests.
"Corning avoided that fight, so it could get summary judgment once the verdict came down," Sablone says.
Second, the case illustrates the importance of ensuring directors and officers understand the conditions being placed on indemnification. In a dispute over indemnification obligations, courts will use the more specific language of an undertaking as the controlling test.
And finally, doubts about the validity of an undertaking should be resolved before such a contract is executed--and before money is spent on legal fees. "If Happ understood he might have to pay the money back," Sablone says, "he might not have spent nearly $1 million to avoid $35,000 in disgorgement."