May 24, 2005

Clawback Provisions for Legal Fees of Convicted Officers

A week or so ago, the WSJ carried an article about Merrill Lynch’s decision about paying millions of dollars in legal fees for former officers that had been convicted of wrongdoing. This is a controversial topic and I will be blogging some thoughts from’s advisory board in the coming days. Here is an excerpt from the article:

“Merrill Lynch’s onetime investment-banking chief, Daniel Bayly, and three others were convicted of fraud in a federal court in Houston last fall in connection with the so-called Nigerian barge transaction. Merrill bought a stake in some Enron electricity-producing barges off the Nigerian coast in 1999, allowing the energy company to book a $12 million profit. The jury agreed with prosecutors’ arguments that the transaction was fraudulent because Enron had secretly guaranteed Merrill against any loss.

Mr. Bayly was sentenced to 30 months in prison in April; another former Merrill official, James Brown, got 46 months. The other two, Robert Furst and William Fuhs, face sentencing tomorrow. All four are appealing.

Merrill has been paying the four men’s legal bills — $17 million as of Dec. 31, court records show. Corporations routinely pay the legal bills of directors and employees in civil or criminal proceedings arising out of their employment. Companies have the right to recover the money if the individuals are found to have violated their employment duties.

“If you are convicted of crime and it damaged the company, the company shouldn’t pay your legal expenses,” says Charles Elson, director of the John L. Weinberg Center for Corporate Governance at the University of Delaware.
[Daniel Bayly]

Merrill’s bylaws say it pays an employee’s legal bills until a “final disposition” of their cases, but they don’t say what constitutes final disposition. Some corporate-law specialists say a case isn’t final until appeals are exhausted. Others argue that Merrill could ask for its money back now that the employees’ presumption of innocence has ended.

“Once convicted, you no longer meet the standard” for financial aid, says Lawrence Hamermesh, a professor at Widener School of Law in Delaware.

When U.S. District Judge Ewing Werlein Jr. sentenced Messrs. Bayly and Brown, he refused their requests to remain free pending their appeals, suggesting he doesn’t think much of their chances. The two are expected to report to prison within weeks.

In an April 8 letter to Judge Werlein, federal prosecutors said Merrill had informed them it planned to pay the defendants’ legal fees through their appeals. A person close to the issue says Merrill is considering a cap on appeals costs. A Merrill spokesman says the question of whether Merrill will try to recoup the money “is premature in light of the pending appeals.”

The prosecutors complained about how much Merrill had spent to defend the men.

“Mr. Bayly alone now has four separate law firms representing him,” the letter said. In a hearing, prosecutors estimated Mr. Bayly’s wealth at upward of $60 million. Lawrence Robbins, a Bayly attorney, said he didn’t know his client’s wealth. “If I did I would keep it private and I would find it appalling for the government to make that information public,” he said. He added that Mr. Bayly’s team is down to three firms.

The prosecutors’ also questioned whether Merrill failed to abide by state law governing such matters in Delaware, where Merrill is incorporated. The state’s code says that before paying an employee’s legal bills, the company must first secure an agreement from the individual “to repay such amount if it shall ultimately be determined that such person is not entitled to be indemnified.” The prosecutors said Merrill hasn’t obtained such a commitment. The Merrill spokesman said the firm doesn’t believe that it is in violation of Delaware law, but declined further comment.

Under Delaware law, a conviction doesn’t automatically require the company to seek reimbursement because that doesn’t necessarily create the presumption that a “person did not act in good faith and in a manner in which the person reasonably believed” to be in the company’s best interest. Several former top Merrill executives signaled that they think that the past record of Mr. Bayly, for one, is worthy of support by asking Judge Werlein to show leniency.

Merrill might have difficulty arguing that the barge deal didn’t harm shareholders. The company in 2003 paid $80 million to settle a Securities and Exchange Commission complaint that it helped Enron commit fraud through that deal and others. It also settled with the Justice Department to avoid indictment.

The SEC lately has taken a harder line on companies paying employee legal fees. Last May, it fined Lucent Technologies $25 million for not cooperating in an investigation, partly citing the company’s legal-fee payments for employees. Lucent didn’t admit or deny wrongdoing.

In a recent speech, the SEC’s outgoing enforcement chief Stephen Cutler — his last day is today — said paying employees’ legal fees insulates them from the consequences of wrongdoing. “If an individual can look to his/her employer to pay the freight,” said Mr. Cutler, “what good have we done?”

Is Reimbursement of Legal Fees Spent on Contract Negotiations a Perk?

On a somewhat related point to the story above, I recently debated a member about whether reimbursement of legal fees for contract negotiations should be considered a perk. I think it should be – and this article supports that view, noting that a large union. AFSCME, is withholding its support for the head of the Cendant’s compensation committee citing the CEO high pay and perks, including a $165,000 reimbursement for legal fees in connection with his contract negotiations.

The reasoning behind considering reimbursement of legal fees as a perk is that it is not directly related to job performance. As a result, it arguably must be disclosed under Item 402 of Reg. S-K as “other annual compensation,” subject only to the minimum threshold requirements.

Another issue is whether there is a difference between reimbursement and simply paying the fees directly to the law firm. I think there is an argument that if the company pays the firm directly, the counsel works for the company and not the executive – a conflicts issue; but then again I am reminded that the rules regarding the existence of an attorney/client relationship is not a function of who pays the bills.

From a disclosure standpoint, I don’t think that it makes any difference as to whether the company pays the law firm directly or reimburses the executive – if the law firm is representing the executive, and the company ultimately pays the bill – then I think it gets picked up and must be disclosed. Let me know if you have different thoughts on any of these points.

Deceased Woman Deemed “Qualified Purchaser” By SEC Staff

Got your attention, huh. Same way Jay Gould of White & Case got my attention with his law firm memo about a recent no-action response from the SEC’s Division of Investment Management that addresses whether a settlor of a trust – who had been deceased for over 45 years – should be considered a qualified purchaser under the ’40 Act.

According to the law firm memo, this no-action response “appears to have expanded the universe of what the SEC considers to be a qualified purchaser. This is good news for hedge funds and those who market on behalf of hedge funds, as the letter, Trusts Under the Will of Marion Searle (pub. avail. March 29, 2005) should allow more individuals, dead or alive, to satisfy the qualified purchaser standard who did not meet the $5 million threshold at the time of contribution.”