The following article appeared in the June 2004 edition of ISS's SCAS Alert:

The Cost of Indemnification
By Bruce Carton, Executive Director

The cost to public companies of indemnifying officers and directors against liability rose sharply last week, but not necessarily in the way these companies might have expected. On May 17, Lucent Technologies Inc. agreed to pay the U.S. Securities and Exchange Commission $25 million to settle an enforcement action resulting from Lucent's alleged "lack of cooperation" with the SEC's investigation into certain accounting issues at Lucent.

According to the SEC's press release and its public statements, a critical component of Lucent's perceived lack of cooperation was its decision to indemnify certain employees who were also the subject of SEC scrutiny.

The SEC's press release stated:

After reaching an agreement in principle with the staff to settle the case, and without being required to do so by state law or its corporate charter, Lucent expanded the scope of employees that could be indemnified against the consequences of this SEC enforcement action. Such conduct is contrary to the public interest.

In a news article about the settlement, an SEC official further explained that, in the SEC's view, Lucent's offer to pick up the legal tab for employees who would not normally be covered by such benefits was equivalent to handing these employees "a blank check to litigate with us, with no consequences." The SEC's action turned these consequences around on Lucent, requiring a $25 million payment for lack of cooperation even though no payment had been required under the initial settlement agreement in principle between the SEC and Lucent. The SEC did not specify whether Lucent's offer to indemnify certain employees violated its prior agreement in principle with the SEC.

The SEC first adopted its policy requiring settling parties to forgo any rights they may have to indemnification, reimbursement by insurers, or favorable tax treatment of penalties in 2003, following high-profile settlements in its cases against research analysts and with executives of Xerox where defendants were able to obtain indemnification for the SEC's civil fines. Following these cases, the SEC began including language in its settlement agreements preventing defendants from using insurance or indemnification for any civil fines. At the May 2004 ALI-ABA Securities Litigation conference, SEC officials stated that they were not aware of any court that had ruled on the legality of this policy.

The SEC's action against Lucent should be a real eye-opener for public companies in similar situations as it reveals the SEC's position that companies indemnifying employees that they are not required to indemnify are (a) outright failing to cooperate with the SEC, (b) acting contrary to the public interest, and (c) subject to extremely stiff fines. The case also highlights several other interesting questions, the answers to which may begin to take shape in the second half of 2004. These include:

--Will companies have increased difficulty getting qualified individuals to serve as officers and directors because the SEC's policy against indemnification will leave these individuals personally exposed to significant liability? Common sense suggests they will, as the risks will begin to outweigh the rewards for some candidates.

--Will the SEC's policy deter officers and directors from settling in significant numbers, thereby taxing the SEC's litigation resources? This potential problem is exacerbated by the record-high settlement amounts currently being demanded by the SEC, a development which itself may begin to deter settlements. SEC officials at the ALI-ABA Securities Litigation conference indicated that the percentage of SEC enforcement actions filed without pre-arranged settlements stood at 44% thus far in 2004, up slightly from past years.

--Will lead plaintiffs in private class actions, a role increasingly filled by institutions seeking to make an impact through their participation, begin to insist as a matter of policy that their private settlements with officers and directors sued in such cases also prohibit indemnification? Doug McKeige of the law firm Bernstein Litowitz Berger & Grossmann LLP, which frequently represents institutional investors in securities class actions, indicated that certain institutions have attempted for years to obtain settlement dollars, where possible, directly from the pockets of individuals. Indeed, he noted that some institutions have agreed to pay their attorneys higher fees on dollars obtained from individuals. McKeige observed that the number of institutions attempting to obtain unindemnified settlement contributions from directors and officers appears to be growing.

We will be interested to see what, if any, impact the SEC's anti-indemnification policy has on these and other issues in the near future.