White Collar & Government Investigations - Recent Developments in Paying Legal Expense
Late last month, the Second Circuit unanimously affirmed dismissal of an indictment of 13 former KMPG partners for tax fraud, holding that federal prosecutors had violated the defendants’ Sixth Amendment right to counsel by
coercing KMPG into terminating advancement of legal expenses for the former partners. On the same day, the Department of Justice issued yet another retreat from its 2003 Thompson Memorandum which had given prosecutors in the KPMG
case guidance to advise the firm that they regarded the payment of legal fees as a sign of non-cooperation.
Beyond the appearance from its new Filip Memorandum that the Justice Department will now be less heavy handed in addressing payment of legal expenses, the revised policy and the Second Circuit KPMG decision highlight the importance
of considering in advance whether, and, if so, how to provide for paying legal expenses of company personnel while controlling the risk of a finding that the payment was a wrongful manipulation.
Paying Legal Expenses of Organizational Personnel:
Striking the Balance
The August 28, 2008 Second Circuit affirmance of the dismissal of an indictment against 13 former KPMG tax partners 1 and the Justice Department’s simultaneous issuance of its fourth version of prosecution guidelines for government
“cooperation” 2, sharpen the focus on the conflicting considerations in deciding whether and, if so, how to pay legal expenses of organizational personnel.
In every investigation or litigation against a business organization, the primary question is whether the allegedly wrongful actions of individuals have bound the organization. In order to determine whether the actions of individuals
were wrongful and are separable from the organization, the company needs the cooperation of its personnel, both to inform its own understanding, and to present exculpatory proof to government investigators and opposing litigants.
As the Second Circuit’s decision and the saga of the Justice Department’s Thompson/McCallum/McNulty/Filip memoranda show, however, one observer’s legitimate joint defense may be a prosecutor’s or opposing
counsel’s obstruction.
There are two countervailing concerns in paying legal expenses:
(1) Fairness to company personnel subject to scrutiny for their business conduct, plus any requirements for indemnification of such personnel under company policy and applicable state law;
(2) The expense of paying for competent outside counsel for every director, officer or employee who apprehends exposure in an investigation or litigation.
To these must be added a more subtle concern:
(3) Risk of loss of the cooperation of personnel who request indemnification of their legal expenses.
Should there be a policy to pay legal expenses of any personnel:
- Applicable state law may require upper level personnel to be indemnified for legal expenses associated with their work for the company.
- A written company policy removes questions of its particulars and gives concrete assurance of the company’s protection of its personnel.
- As the KMPG case illustrates, an established policy is likely to be enforced in favor of the personnel, even if unwritten.
- But a mandatory policy of reimbursement could bind the company, not only to high expenses, but to payments that conflict with its organizational interest.
Should the policy be limited:
- There is a variety of possible limitations. While they can reduce the financial burden, any policy limitations may risk alienating excluded personnel when their cooperation is most critical and their conduct is still uncertain.
- The risk is intensified if the excluded personnel claim to be whistleblowers.
- Any limitations concerning the choice of personal counsel may risk charges of manipulation and may violate legal ethics rules.
- Conditioning payment on cooperation with the government may alienate the individual and conflict with a legitimate company interest to resist government allegations and demands.
How to strike the balance:
- Subjecting the privilege of payment to the discretion of Board of Directors or senior management can reduce the expense of covering lower level employees and provide important flexibility.
- A discretionary policy avoids the virtually impossible task of anticipating all circumstances in which an organization would properly pay legal expenses of its personnel.
- The discretion to authorize payment must be conditioned on excluding from its exercise any director or officer whose conduct or interest may be subject to scrutiny or conflict with the company’s interest.
- The policy should be adopted in advance in the ordinary course of the organization’s business considerations. Adoption after the cause for demands of legal-expense payment arise can taint whatever the company makes.
- Assuming compliance with applicable law: 3
- If the organization has a strong compliance culture at the top and an effective internal compliance structure, the best course is to issue a written policy that authorizes the Board of Directors to indemnify and advance legal expenses under explicit standards designed to serve the company’s interest.
- Consideration of the standards should include:
- Limitation to legal expenses arising from the individual’s involvement in an investigation or legal proceeding in which his/her conduct for the organization is questioned;
- A condition that the individual beneficiary cooperates with the company;
- Advancement, not merely later reimbursement, of legal expenses;
- Limitation of payment to reasonable legal expenses;
- Termination of payment upon the individual’s taking a position adverse to the interests of the company;
- Termination of payment and agreed disgorgement of prior payments upon:
- A company finding that the individual violated the company’s code of conduct or intentionally acted against the interest of the company; or
- An official finding that the individual engaged in a reckless or intentional violation of law or regulation; and
- Conclusion of the matter giving rise to indemnification.
- In order to assure attraction of well qualified executives, such a policy may be modified to require, and not merely to authorize indemnification of directors and senior management, absent a company finding that the beneficiary has acted improperly. The same standards for administering the indemnification should, however, apply.
- When payment for legal expenses is authorized under discretionary standards, the organization should document:
- the reasons why the company is paying the expenses, e.g., a government investigation seeking information that may relate to the beneficiaries’ conduct;
- the applicable standards for exercise of the discretion to pay legal expenses.
Discretionary authorization for payment carries some risks:
No approach to payment of legal expenses for personnel under investigation is free from risk. While the Justice Department has retreated substantially from its aggressive pronouncements in the Thompson Memorandum, its prosecutors,
and many plaintiffs’ counsel, will still closely examine whether there is a basis to assert that the payment of legal fees has been exercised to unduly restrict access to reliable evidence.
A mandatory policy for selected personnel denies a company the flexibility to respond to unexpected situations. The absence of a policy risks the highest probability that payment of legal expenses for personnel will be found to be
a wrongful obstruction, or will alienate important personnel, or both. Where the organization has an effective compliance system, express adoption of clear standards for the exercise of organizational discretion in paying legal expenses
provides the best assurance that the policy will serve the organization’s interests while avoiding tainting the merits of the matter.
For more information on this Advisory, contact Stuart F. Pierson at stuart.pierson@troutmansanders.com.
1 United States v. Stein, No. 07-3042-CR, (2nd Cir. August 28, 2008).
2 See the Thompson Memorandum, January 20, 2003, its first revision in the McCallum Memorandum, October 21, 2005, its second revision in the McNulty Memorandum, December 12 ,2006, and its third revision in the Filip Memorandum, August
28, 2008.
3 Some states mandate indemnification of legal expenses of upper level personnel in matters relating to their company conduct; others authorize such indemnification. See, e.g., Revised Model Business Act; Del. Code Title 8, §
145; Georgia Code, O.C.G.A., §§ 14-2-850, et seq.