doing business in washington state - granof international

DOING BUSINESS IN WASHINGTON STATE

A GUIDE FOR FOREIGN BUSINESS AND INVESTMENT

(FIFTH EDITION)

PUBLISHED BY

INTERNATIONAL PRACTICE SECTION

WASHINGTON STATE BAR ASSOCIATION

2010

NOTICE

This book is intended as a guide to general principles of law and regulation in Washington State, U.S.A. It is not intended as a legal treatise or a substitute for consultation with a qualified legal advisor. Any questions concerning the content should be directed to the author(s) of the material.

Published by

International Practice Section

Washington State Bar Association

1325 4th Ave., Ste. 600

Seattle, WA 98101-2539

United States of America

(206) 733-5918 / http://www.wsbacle.org

Edited by

Randy J. Aliment

Williams Kastner

© Washington State Bar Association and the individual authors. All rights reserved. Except as permitted by the Copyright Act of 1976, no part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written permission of the Washington State Bar Association.

http://www.wsbacle.org/

STATE OF WASHINGTON

OFFICE OF THE GOVERNOR

P.O. Box 40002 Olympia, Washington 98504-0002 (360) 902-4111 Fax (360) 753-4110

CHRISTINE O. GREGOIRE

Governor

April 15, 2010 Washington State is rich with investment opportunities. Our geographic location on the Pacific Coast, excellent transportation facilities, low-cost energy, productive and innovative work force and beautiful environment make it an attractive location for trade and industry. Equally important is the way in which our state and local governments support economic development. Here in Washington, we are committed to nourishing new businesses and sustaining established ones. International investment is welcomed in Washington State. All laws, regulations, incentives and market opportunities are equally available to domestic and foreign corporations. Foreign companies can conduct business in Washington State on the same basis as a U.S. company. Companies are often attracted to our strong entrepreneurial spirit among the people and businesses already located here. This “Innovation Spirit” drives companies who are based in Washington and known throughout the world, such as Boeing, Microsoft, Amazon and Starbucks. Each of you has received a guidebook – in it you will find useful information that will assist you in establishing investments in Washington State. It will introduce you to the basics of what you need to know when conducting business here. We are open for businesses and we invite you to come see for yourself what Washington State has to offer. Sincerely, Christine O. Gregoire Governor

I am pleased to send greetings from the People of the State of Washington. This book is an excellent source of information as you seek partners in trade and investment in Washington State. Washington State is home to the world’s leading aerospace, high-tech, agricultural, marine and engineering firms. In addition to those industries, our strategic location and long history of foreign trade has led to the development of experienced legal, accounting, insurance and port operations professionals who are readily available to assist our global trade partners. We are also a destination point for those traveling from Asia and the world that are looking not only to invest, but see some of the most beautiful sights in America: from the urban centers of Seattle, Spokane and Tacoma, to the vast mountain ranges, sweeping agricultural and wine-growing areas. Not only will you find this state a great place to do business, but also a fantastic vacation destination. The Office of Secretary of State oversees the incorporation of businesses, both foreign and domestic, which do business in Washington State. More than 20% of the 400,000 corporations in this state are foreign owned which attests to the strong confidence those around the world have in doing business here. This guide will help you as you look to expand your business into Washington State. I hope you will find it helpful, and I wish you and your organization success in the future. Sincerely,

SAM REED Secretary of State

STATE OF WASHINGTON

DEPARTMENT OF COMMERCE

128 – 10th Avenue SW PO Box 42525 Olympia, Washington 98504-2525 (360) 725-4000 May 2010 Greetings: Thank you for your interest in investing in Washington State. Washington is home to some of the most innovative companies in the world. We attract and nurture groundbreaking businesses and entrepreneurs in a broad range of industries. Washington is a great state for business and getting better all the time. It shows in our business growth: the number of registered businesses in Washington more than doubled over the last 15 years and their gross income increased 121 percent. According to an analysis of U.S. data, our state has a higher growth rate for research-and-development jobs over the past five years than any other state in America. And recently, it was reported the Tri-Cities region in the eastern part of our state led the nation in job growth in the second half of 2009. We invest in our people because companies need great talent to innovate and grow. Washington has more adults with at least 12 years of education (over 30 percent with bachelor's degrees) than any Western state and ranks sixth among all U.S. states. Washington ranks high for startup companies, is a leader in patents and home to a venture-capital system that disburses more funding for new companies than almost any other state. A 2009 report ranked Washington number two in the U.S. for innovation capacity. Washington's tax structure is ranked fifth best in America by the nonprofit Small Business and Entrepreneurship Council, and the Tax Foundation ranks our business climate in the top 10. Comparing our regulatory environments, Forbes magazine places Washington in the top five “best states for business.” We encourage international businesses to look deeper into the reports and statistics and visit Washington to see our unique advantages. Our high-value features including a knowledge-based economy, access to inexpensive and clean energy, superior talent, and a culture of innovation provide businesses the edge they need to compete in the 21st century global marketplace. Sincerely,

Rogers Weed Director

Contents

I. About the WSBA International Practice Section v

Jacqueline F. Pruner, Chair, 2009-2010

II. Intent and Purpose of the Deskbook vii

Randy J. Aliment

Chapter 1

Choosing a Legal Entity 1

Richard M. Rawson and Brian J. Todd Chapter 2

Establishing a Washington Corporation 10

Christopher R. Helm and Jim Young Chapter 3

Business Licenses and Registrations 20

Michael A. Herbst, J.D. Chapter 4

Distribution and Alternatives in Washington State 26

Fraser Mendel and Benjamin Nivison Chapter 5

The Uniform Commercial Code 36

Jane H. Kaufman Chapter 6

Real Property Law 49

Ellen Szymanski and Roberto O. Soto

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DOING BUSINESS IN WASHINGTON

Chapter 7

Banking in Washington 56

Richard L. Goldfarb and Jerry C. Chiang Chapter 8

State and Local Taxation 62

George C. Mastrodonato Chapter 9

Federal Taxation of Resident Aliens 74

Jennifer A. Mace Chapter 10

Federal Taxation of International Transactions 83

Daniel Cassidy Chapter 11

Overview of Transfer Pricing Guidelines 96

Tracey Zheng Chapter 12

Federal Reporting for Foreign Investments in the U.S. 103

Denny F. Wong Chapter 13

Trademark, Copyright and Trade Secret Protection and

Rights of Privacy and Publicity 112

Jonathan I. Feil, Jennifer L. Jolley, and Melvyn J. Simburg Chapter 14

Patent Protection for Domestic and Foreign Inventions 122

Al AuYeung and Yixiong Zou

ii

Contents Chapter 15

Commercialization of Intellectual Property Assets 134

Douglas L. Batey and Yury M. Colton Chapter 16

Investor Immigration in the United States

An Introduction of Immigration Options for Investors 143

Stephanie Ko Chapter 17

Clean Technology 151

Janet F. Jacobs Chapter 18

Customs and International Trade Laws 159

Joel R. Junker and William Baldwin Chapter 19

Antitrust Laws 172

L. John Stevenson, Jr. Chapter 20

Securities Regulations 179 John W. Creighton III Chapter 21

Product Liability Law 186

Christian Moller Chapter 22

Industrial Insurance and Workplace Safety 195

Judd H. Lees

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iv

Chapter 23

Labor and Employment Relations 199

Sheryl J. Willert and KoKo Ye Huang Chapter 24

Bankruptcy and Creditor Protection 207

Laurin S. Schweet Chapter 25

Directors’ and Officers’ Liability and Insurance 219

Perry S. Granof Chapter 26

Commercial Litigation 230

Randy Aliment and Manish Borde Chapter 27

Alternative Dispute Resolution 240

Philip E. Cutler Appendix: Participating Service Providers App–1

Chapter 25

DIRECTORS’ AND OFFICERS’ LIABILITY AND INSURANCE Perry S. Granof1 25.1 POTENTIAL LIABILITIES OF CORPORATE DIRECTORS AND OFFICERS

There are five major groups of constituents for whom directors and officers, of U.S. corporations, and U.S. subsidiaries of foreign corporations, owe duties and responsibilities, and are subject to liability. They are the corporation itself, shareholders, creditors, corporate employees and governmental regulators/law enforcement agencies.

25.1.1 Duties to the corporation

Directors and officers of companies incorporated within the U.S. have three long-standing recognized duties to the corporation itself. They are the Duty of Care, the Duty of Loyalty and the Duty of Obedience. These duties are typically grounded in state law. The Duty of Care requires corporate directors and officers to exercise their corporate responsibilities in good faith, with the care of an ordinary prudent person in a like position, and in a manner one reasonably believes to be in, and not opposed to, the best interest of the corporation. The Duty of Loyalty requires that directors and officers exercise their powers in the primary interest of the corporation, rather than out of self-interest, and do not usurp corporate opportunities for their own benefit, at the expense of the corporation. The Duty of Obedience requires that corporate directors and officers issue all corporate financial reports in a timely manner, issue dividend checks properly and adhere to the articles of incorporation, bylaws and guidelines of the corporate charter.

When a corporate director or officer fails to adhere to any of the above responsibilities he or she is accountable to the corporation, typically in the form of a derivative action. Derivative actions are lawsuits filed by shareholders on behalf of the corporation, against its directors and officers for malfeasance, misfeasance or nonfeasance. Typically corporate directors and officers may rely on the Business Judgment Rule to protect themselves from liability. The Business Judgment Rule is a presumption, which courts invoke when considering a lawsuit pled against 1 As Principal of Granof International Group, and Of Counsel at Williams Kastner, Perry Granof specializes in Director and Officer Liability (D&O), Professional Indemnity (PI), and Financial Institution (FI) insurance, with particular emphasis in evaluating coverage and liability for securities lawsuits, insolvencies and financial institution exposures.

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corporate directors and officers. It presumes that the defendants have exercised proper business judgment with due care and those corporate directors and officers operate with an understanding of the corporate business model, which courts cannot fully appreciate. Therefore courts won’t second-guess the “business judgments” of the corporation’s directors and officers. The presumption can and has been successfully rebutted. When a plaintiff factually establishes a breach of the Duty of Loyalty, a lack of Due Care, or nonfeasance, the presumption is rebutted. Indeed, directors and officers can be found liable based upon any of the following actions or inactions, among others: by abdicating their functions or failing to act, Aronson v. Lewis 473 A.2d 805 (Del. 1984); by ratifying material transactions without appropriate analysis and consideration, Smith v. Van Gorkom 488 A. 2d 858 (Del. 1985); and by failing to implement reporting systems allowing directors to monitor corporate compliance and make informed decisions. In re Caremark International Inc. Derivative Litigation, 698 A. 2d 959 (Del. Ch. 1996).

As stated above, in a derivative action, liability can only be established for the benefit of the corporation. Therefore, when a shareholder sues corporate directors and officers in a derivative proceeding and prevails, any damages awarded against the directors and officers are recoverable by the corporation itself and not by the shareholders.

When a derivative action is filed, it must either be accompanied or preceded by a demand made against the board of directors, by shareholders, to either sue themselves, or selected officers and/or members of the board. Corporate boards will generally appoint a Special Litigation Committee comprised of disinterested directors or prominent disinterested third parties, to consider whether it is in the best interests of the corporation to sue its own directors or officers. The Committee would typically consider the legal, economic and business implications in suing the directors or officers and be charged with determining whether it is indeed in the best interests of the corporation to so sue such parties. A court will typically rely on the findings of a Special Litigation Committee in considering whether to dismiss a derivative action on motion. In considering the Special Litigation Committee’s findings, a court will primarily focus on whether the Special Litigation Committee was truly independent of the board of directors, and of any named defendants.

25.1.2 Duties to Shareholders

In addition to the responsibilities described above, directors and officers of U.S. publicly traded companies, whether incorporated in the U.S. or not, have a duty to provide their shareholders with open, honest and timely disclosures of the company’s financial condition and well being. A breach of this duty is more commonly referred to as a misrepresentation and is codified in several U.S. statutes. They include the Securities Act of 1933, the Securities and Exchange Act of 1934, and the Public Company Accounting and Investor Protection Act of 2002 (also known as the Sabanes-Oxley).

Congress enacted the Securities Act of 1933 (SA) following the stock market crash of 1929. The 1933 Act has two basic objectives: (1) requiring that investors receive financial and other significant information concerning securities being offered for public sale; and (2) prohibiting deceit, misrepresentations, and other fraud in the sale of securities. In order to achieve these goals, the 1933 Act requires issuers of stock to disclose important financial

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DIRECTORS’ AND OFFICERS’ LIABILITY AND INSURANCE

information through the registration of securities with the FTC, later becoming the SEC. The registration forms call for the following information: (1) a description of the company’s properties and businesses; (2) a description of the security to be offered for sale; (3) information about the management of the company and (4) financial statements certified by independent accountants. This information enables investors to make informed decisions about whether to purchase a company’s stock and has the added benefit of discouraging misrepresentations, and encouraging transparent communications. There are repercussions for misstatements in public offerings. Director and officer liability under the SA falls under three statutory sections.

Under Section 11 of the Act, a shareholder may sue the corporate directors and any other party that signs a registration statement filed with the U.S. government, which contains material misrepresentations. The elements of liability are: (1) An offer to buy-sell securities; (2) in a registration statement; (3) a misrepresentation (negligence is sufficient) and (4) damages. The corporate directors are entitled to a due diligence defense, but the corporation is strictly liable for any misrepresentations under Section 11. As respects the due diligence defense, a director or officer not purporting to be an expert can assert that, after making a “reasonable investigation,” he or she had reasonable grounds to believe that the statements made in the registration statement were true and that there were no omissions of material facts.

Section 12(2) creates liability to directors and officers for misrepresentations in a prospectus or public offering. It is similar to Section 11, but applies to the actual selling of a public offering through an oral communication, or a prospectus, which is a sales brochure. Unlike Section 11, directors have a good faith defense under Section 12(2). In addition, Section 15 of the SA establishes liability of any person who controls any director or officer liable under Section 11 or 12(2). In order to lower the cost of offering securities to the public, small size stock offerings were exempted from the above-mentioned registration requirements.

The Securities Exchange Act of 1934 (SEA) established the Securities and Exchange Commission (SEC) and gave the SEC the power to establish an anti-fraud rule, governing the daily trading of stock, which eventually led to the establishment of securities class actions. Section 10(b) is the enabling legislation that led to the SEC creating Rule 10b-5, which established a private cause of action for misrepresentations in the sale and purchases of stock. The elements of liability under 10b-5 are: (1) the sales or purchase of securities; (2) causation/misrepresentation; (3) scienter (recklessness); (4) materiality; (5) reliance; and (6) damages. Section 14(d)(7) of the SEA and Rule 14d-10 provide a cause of action for unequal treatment in proxy statements or tender offers, which have also led to securities class actions. Section 20(a) is similar to Section 15 of the SA and applies to “Controlling Persons.” Finally, Section 20A establishes liability for insider trading, which can also form the basis of securities claims.

The 2002 Sarbanes – Oxley (SOX) statute is intended to: increase corporate shareholder disclosures and audit committees’ responsibilities; as well as a host of regulatory reporting requirements and oversights. It was enacted in the aftermath of Enron, Worldcom and HealthSouth. As respects the disclosure requirements under SOX, directors are required to disclose in quarterly and year-end reports that: the CEO and CFO have reviewed the financials; that to their knowledge, the financials do not contain material misrepresentations or omissions; that internal controls have been evaluated and the auditors along with the board have been

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notified of any weaknesses; and that certain frauds have been reported to the board. To the extent the disclosure is false, senior management will potentially face increased liability in the context of securities class actions, due to this affirmative disclosure. In addition to its disclosure requirements, SOX provides other restrictions and obligations to the audit committee of the board of directors as well as a corporation’s outside attorneys and outside auditors.

25.1.3 Duties to Creditors

As respects the duties corporate directors and officers owe to the company’s creditors, in the U.S., directors and officers are substantially insulated from liability due to the protection of the corporate veil. Most state courts have determined that creditors’ only recourse in collecting outstanding obligations is limited to the terms of its contracts with the corporation; creditors have no privity from which to assert direct causes of action against corporate directors and officers. However, this protection is far from absolute. When a corporation publicly issues a debt obligation, in the form of a corporate bond or debenture or other debt securities instruments and subsequently defaults on such obligations, its directors and officers face the same liability arising from misrepresentations to its creditors, as to its equity securities holders, referenced above. In addition, depending upon the state in which a company is incorporated, when a corporation is insolvent, the directors’ and officers’ duties and obligations to creditors can take on new priorities. In the case of American Catholic Educational Programming Foundation., Inc. v. Gheewalla, et al., 2007 WL 1453705 (Del. May 18, 2007), the Delaware Supreme Court, which is perhaps the most significant court for U.S. corporate law, ruled that: “individual creditors of an insolvent corporation have no right to assert direct claims for breach of fiduciary duty against corporate directors.” This extends to preclude creditors from bringing direct or indirect claims against corporate directors when a company is in the zone of insolvency. However, the Delaware Supreme Court recognized a creditor’s right to step into the shoes of the shareholders, in the event of corporate insolvency, and thus creditors have standing to maintain derivative claims against directors of insolvent companies for breaches of fiduciary duty.

25.1.4 Duties to Employees

Further, directors and officers of U.S. corporations have duties and thus face potential liabilities to corporate employees and prospective employees in the context of hiring, firing, promoting, paying and providing reasonable accommodations for them. Employment related claims against directors and officers can take the form of lawsuits for wrongful termination, sexual harassment, discrimination of various forms, as well as possible violations of such U.S. statutory provisions as: Title VII of the Civil Rights Act of 1964, the Equal Pay Act, the Age Discrimination in Employment Act, the Family and Medical Leave Act, the American’s with Disabilities Act, and a variety of state statutory provisions.

Often such liabilities are combined with contractual obligations owed directly by the corporation to its corporate employees. Such contractual obligations don’t directly extend to corporate directors and officers, but breach of contract claims will indirectly impact the liability of corporate directors and officers, through such common law principles as wrongful interference with contractual relationships, breach of fiduciary duty, intentional or negligent misrepresentation, common law fraud and tortuous inducement, to name a few.

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25.1.5 Duties to Governmental Regulators and Law Enforcement Agencies

Finally, directors and officers of both publicly and privately traded companies have responsibilities and potentially face liability to such federal and state regulatory and law enforcement agencies as the SEC, the Federal Trade Commission (FTC), the U.S. Justice Department and a host of state attorney generals’ offices. The SEC is empowered to seek fines and penalties against corporate directors and officers for civil violations of the SA, the SEA, SOX, and the Foreign Corrupt Practices Act (FCPA). The FTC is responsible for the enforcement of all U.S. antitrust statutory provisions and deceptive or unfair trade practice violations, and has the authority to seek civil penalties for violations of such statutory provisions as the Hart-Scott-Rodino Premerger Notification Act. The U.S. Justice Department is responsible for the criminal enforcement of such statutory violations. State Attorney General officers are also empowered to and have also sought civil and criminal remedies against corporate directors and officers for violations of state commercial statutory and regulatory provisions. In addition, regulatory and law enforcement authorities throughout the world are empowered to bring civil and criminal actions against corporate directors and officers and to levy fines, penalties and imprisonment, for violations of their respective statutory obligations.

25.2 DIRECTORS AND OFFICERS LIABILITY INSURANCE

Directors and Officers can seek full or partial protection arising from violations of their civil obligations, duties and responsibilities, and can seek defense costs reimbursement in the US and abroad, in the form of Director and Officer Liability Insurance (D&O insurance/policy). D&O insurance became a popular form of U.S. commercial insurance coverage, since the early 1970’s and gained prominence as a necessary commercial insurance product during the financial crisis of the mid-1980’s. There is no standard D&O insurance policy form. Each carrier offers its own terms, conditions and definitions.

25.2.1 Common characteristics

Some of the common characteristics of D&O policies are as follows:

• They are typically “Claims Made” as opposed to “Date of Occurrence” policies;

• They are typically “Pay On Behalf Of” and not “Duty to Defend” policies;

• They typically provide “Advancement of Defense Costs” at the insurer’s option.

• They typically have a self-depleting “Limit of Liability”;

• They typically have as many as four “Insuring Clauses”.

Most D&O policies are “Claims Made” policies, which means that for a claim to be triggered under a D&O policy, it must be asserted against a director or officer during the policy period, unless expanded coverage is provided by endorsement. A claim is typically a defined term in the policy, as discussed below, often a lawsuit served on a director or officer or a written demand for monetary relief. In most D&O policies, insureds are afforded the opportunity to provide the insurer with notice of circumstances which will likely give rise to a claim. If such

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notice is provided during the policy period, or an expanded “Discovery Period,” and a claim is subsequently made, based upon the circumstances described in the notice, the claim is deemed to have been made during the policy period. The Discovery Period is a feature found in most Claims Made policies and allows insureds to provide notice of claims and circumstances for a limited time beyond the termination of the policy period.

In addition, most D&O policies are “Pay on Behalf of” policies, which means that the insured is required to retain its own counsel, subject to the insurer’s consent. Thereafter, as the insured’s counsel bills for services rendered, the insured is typically obligated, unless otherwise stipulated, to pay the defense costs directly and the insurer reimburses the insured for covered payments, either at the conclusion of the litigation or on a contemporaneous basis, as agreed upon among the insured, the insurer and defense counsel. If the parties agree to the later arrangement, that would constitute an Advancement of Defense Costs. Such advancements are typically made at the option of the insurer, as set forth in the policy. Also, defense costs advancements are typically provided in exchange for an undertaking made by the insured to refund any amounts advanced, if it is ultimately determined that the insured’s conduct has been rendered uninsurable.

Further, coverage under a D&O policy typically provides that both defense costs and any liability payments reduce the Limit of Liability by the aggregate amount of payments. Therefore, to the extent that defense costs paid fully exhaust the Limit of Liability, there will be no amount left under the policy to pay for any liability incurred. This feature distinguishes a Pay on Behalf of policy from a Duty to Defend Policy, where amounts paid in defense costs do not reduce the available Limit of Liability.

The Insuring Clauses typically found in a D&O policy are: Direct Coverage to directors and officers, commonly referred to as “Side A coverage”; Company Reimbursement Coverage for amounts indemnified to directors and officers, commonly referred to as “Side B coverage”; Entity Coverage for securities claims, such as securities class actions, commonly referred to as “Side C coverage”; and Investigative Coverage, for Special Litigation Committees arising from derivative demands, commonly referred to as “Side D coverage.” Although the most common form of coverage triggered in a D&O policy is Side B coverage, the origin of D&O insurance is to protect corporate directors and officers from personal liability to assure that their personal assets are protected while serving at the behest of a corporation. Side A coverage is typically triggered when a corporation is insolvent or when a director or officer is not entitled to indemnification, which potentially arises in such situations as derivative actions. When corporate indemnification is available or presumed, Side B coverage is typically triggered, which only extends to amounts paid to the corporate directors and officers in the form of corporate indemnification. There is no direct, derivative or vicarious coverage, under Side B for claims asserted against the corporation itself.

Sides A and B coverage are the most typical forms of D&O coverage and form the historical foundation of D&O insurance. In recent years, adverse court decisions and recognized market demands gave way to the establishment of Side C and D coverage. Side C coverage is only intended to respond to securities litigation such as securities class actions and individual securities cases. It provides partial or full entity coverage, depending upon the terms of the policy issued, and together with insuring clauses A & B, may provide full coverage for entity and

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individual corporate defendants or coverage for a significant potion of the liability that results from such securities litigation. Side D coverage is at times offered to cover the full or partial costs of an investigation arising from a shareholder demand in the context of a derivative lawsuit. It is intended to pay for the cost of convening a Special Litigation Committee only, and is not intended to cover the directors’ and officers’ defense costs or any liability resulting from a derivative action. Typically, Side D coverage has a reduced sub-limit, which is substantially less than the Limit of Liability set forth in the policy. Once exhausted, the policy, and specifically Side D, will no longer respond to cover costs incurred in connection with the Special Litigation Committee.

The introduction of Sides C and D coverage has changed the character of D&O insurance and has created a corporate coverage, which can create competing interests between the corporation and its directors and officers. By providing corporate protection, D&O policies are more apt to become depleted in a corporate crisis such as a securities class action and resulting insolvency. This could potentially leave the directors and officers unprotected, after having exhausted the policy limit defending and settling a securities class action on behalf of the corporation, while being left to defend an insolvency action without the benefit of corporate indemnification.

25.2.2 Key Definitions

The key definitions are typically found in the Insuring Clauses that give guidance as to the intended application of coverage. Typically, the terms: “Insureds,” “Loss,” “Claims,” “Policy Period,” “Wrongful Acts,” and “Limit of Liability” are found in Sides A and B of the Insuring Clauses. Similarly the terms “Securities Claim” and “Investigative Coverage,” or some variation thereof, are typically found in Sides C and D of the Insuring Clauses, and give clarity as to the coverage available under a D&O policy. The purview of coverage under a typical D&O Insuring Clause can only be fully understood if read in conjunction with the definitions, which immediately follow the insuring clauses in most D&O policies.

25.2.3 Key Exclusions

Some of the key exclusionary provisions found in most policies and applications include: the Dishonesty/Personal Profit Exclusions; the Pollution Exclusion; The Bodily Injury/Property Damage Exclusions; the Insured vs. Insured Exclusion; and The Right to Rescind Coverage provision.

The Dishonesty/Personal Profit Exclusions preclude coverage for directors and officers who caused financial losses to the entities they served, as a result of their own dishonesty, criminal conduct, personal profit or advantage that they may have realized, for which they were not entitled. These exclusions are typically triggered upon the establishment of such conduct, through a judicial decree or factual findings. Before dishonest conduct or personal profit is established, defense costs may be advanced pursuant to an undertaking as described above. Many D&O policies have bifurcated listings of exclusions, which apply depending upon whether Side A or Side B coverage is triggered. Where bifurcated, the Dishonesty/Personal Profit Exclusions typically apply to Side A coverage only, and not to coverage provided when Side B, Company Reimbursement, is triggered. Public policy, as typically addressed in the definition of

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“Loss,” would also preclude coverage for fines and penalties assessed by law enforcement and regulatory authorities, as well as matters deemed uninsurable as a violation of law.

The Pollution Exclusion applies to preclude coverage for direct claims of pollution-related events or environmental losses including, in the same or as a separate exclusion, nuclear energy-related losses. The exclusion typically extends to the “actual, alleged or threatened discharge…of Pollutants,” and to any “loss or expense arising out of any direction or request…(to) test for, monitor, clean up (or) remove …Pollutants” (Federal Insurance Company Policy). Depending upon the wording of the Pollution Exclusion, coverage may be available for shareholder actions alleging indirect loss due to mismanagement, arising from pollution events. Unlike the Dishonesty and Personal Profit Exclusions, the Pollution and Nuclear Energy Exclusions would typically apply to both Side A and Side B coverage.

The Bodily Injury/Property Damage Exclusions (BI/PD) are often characterized as a single exclusion. It significantly varies from policy to policy. However, the gist of this exclusion is to preclude coverage for physical injuries incurred due to the wrongful conduct of directors and officers. Its application is premised on the notion that a D&O policy is intended to cover financial losses, while a general liability policy is better suited to cover BI/PD exposures. Still, there have been court rulings that allowed coverage for claims of emotional distress, despite the existence of a BI/PD exclusion. Such rulings are typically based upon the wording of the exclusion at issue; whereby courts require the language to expressly exclude emotional distress claims. Like the Pollution Exclusion, the BI/PD Exclusion typically straddles both Side A and Side B coverage grants.

The Insured vs. Insured Exclusion is a provision that was commonly included in D&O policies beginning in 1985 when Bank of America sued several bank officers for incurring a U.S. $95 million loss in connection with mortgage-backed securities transactions. It sought to recover the entire loss against its D&O carriers. The Insured vs. Insured Exclusion was subsequently added to most D&O insurance policies to prevent collusive lawsuits filed for the sole purpose of recovering transactional losses incurred by internal personnel. It has been applied to preclude coverage for claims of deposit insurance funds and regulatory agencies suing directors and officers in the name of the corporation to recover losses incurred by the entity. It has also been applied to preclude coverage for securities class actions filed in the names of controlling persons.

The Right to Rescind coverage is not typically found in the exclusionary provisions of a D&O policy. Rather, it is set forth in the application, commonly referred to as a Proposal Form, which is often referenced towards the end of a typical D&O policy. It is often characterized as a right the insurer possesses to so act, based upon material misrepresentations and omissions made by company representatives in the Proposal Form. When considering whether to issue a D&O policy, and the terms upon which coverage will be afforded, a D&O underwriter will typically ask a representative of the proposed insureds questions about the financial viability of the company at issue as well as any potential liabilities. To the extent that the signer of the Proposal Form makes misrepresentations as to the company’s performance, and as to potential liabilities, the underwriter could face an exposure it never intended to underwrite. A material misrepresentation, by itself, often gives the insurance carrier a right of action in equity to rescind the policy as void ab initio — that is, to void the policy as though it never existed. Notwithstanding this equitable right, most D&O policies have a provision in the Proposal Form,

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often immediately following a representation provision, or warranty statement, stating in effect that if any representations made are proven to be untrue, the policy will be considered void.

Notwithstanding this provision, the concept of rescission is at times difficult to enforce, and rescission decisions can be inconsistent. An issue which courts typically face when considering rescission is whether insurers should be entitled to rescind against “innocent directors or officers,” those individuals who committed no wrong doings, made no misrepresentations and were not aware of the company’s condition. The issue is at times dependent upon the Warranties and Misrepresentation language of the policy and Proposal Form and the underlying equities of the case. When rescission is allowed, it is often based upon the premise that the matter misrepresented by the insured was so fundamental to the issuance of the policy that it materially increased the risk of loss Barry R. Ostrager and Thomas Newman, INSURANCE COVERAGE DISPUTES (9th ed. 1998), citing Shapiro v. American Home Assurance Co. 584 F. Supp. 1245 (D. Mass. 1984).

25.2.4 A Short Sampling of Key Issues

Since the 1980’s, when D&O insurance gained prominence as a necessary commercial insurance product, the D&O insurance industry has faced several issues over the scope of available coverage. Historically the issues included the obligation to advance defense costs, the limitations of Claims Made coverage and the application of the Insured vs. Insured exclusion. Some seminal issues have been resolved through policy modifications and industry practices. Others remain, to be resolved on a case-by-case basis. A few issues worth noting are: Indemnification; Allocation of defense costs and liability; and whether certain settlements constitute a “Loss” as defined under the policy.

As respects Indemnification, New York and Delaware corporate laws provide liberal indemnification enabling statutes, by which individual corporations can establish indemnification rights in their by-laws. Because indemnification is so widely accepted under U.S. law, most D&O policies contain a “Presumptive Indemnification” provision, which insurance companies heavily rely on in adjusting D&O claims. This implies that coverage will be treated as falling under Side B coverage, with the effect that the Dishonesty and Personal Profit exclusions will not be applicable, but a deductible higher than under Side A coverage will typically apply. Generally both the corporation and the insurer accept this approach. However, problems arise where an insured’s conduct is so egregious that indemnification would appear to be unavailable under state law; indemnification wasn’t properly enacted, due to faulty ratification procedures; or the lawsuit at issue is venued in a foreign jurisdiction, where indemnification is inapplicable. Disputes can arise with respect to all three situations, which can impact whether the Side A exclusions or the larger Side B deductible would apply.

As respects Allocation, with the exception of Side C coverage, when the corporation and its directors and officers are jointly sued, the policy is only intended to cover the defense costs and ultimate liability of the individual directors and officers. Therefore, in the event that one attorney or law firm represents the parties, defense costs will need to be allocated between covered and uncovered parties. In addition, to the extent a judgment or settlement is paid on behalf of both the corporation and the directors and officers, an allocation between covered and uncovered wrongful acts is required. This issue has been the subject of contentious debate.

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However, several court decisions have been rendered that give guidance as to the parameters of the debate.

With respect to defense cost allocation, many courts have adopted the “Reasonably Related Test.” According to this test, to the extent the corporation’s defense costs are reasonably related to that of its officers and directors, they are covered by the D&O policy. Safeway Stores, Inc. v. National Union Fire Insurance Co., 64 F.3d 1282 (9th Cir. 1995). Other courts have adopted the “Relative Exposure Test.” In applying this test, a court will consider certain criteria in determining an appropriate allocation of defense costs, based upon the relative exposures of the defendants. They include: “(1) Whether the claim is principally directed against the corporation or the D&O’s; (2) The number of claims in the complaint; (3) The percentage of defendants who are directors and officers and (4) Who will principally benefit from the resolution of the action,” Perini Corp. v. National Union Fire Ins. Co., Civ. A. No. 86-3522-S (D. Mass. June 2, 1988), as described in Barry R. Ostrager and Thomas Newman, INSURANCE COVERAGE DISPUTES (9th ed. 1998). As respects indemnity payments, allocation methods are divided between the “Larger Settlement Rule” and the “Relative Exposure Test” described above. According to the Larger Settlement Rule, allocation is permitted to the extent that any settlement was made larger by the wrongful actions of uninsured persons, Harbor Ins. Co. v. Continental Bank Corp. 922 F.2d 357 (7th Cir. 1990), as described in Barry R. Ostrager and Thomas Newman, INSURANCE COVERAGE DISPUTES (9th ed. 1998). The larger settlement rule appears to be more widely accepted than the Relative Exposure Test.

In addition to the guidance the D&O industry has received from U.S. and non-U.S. courts, as described above, D&O underwriters have responded to this conflict by offering such solutions as Side C coverage and “Predetermined Allocation” arrangements built into the policy. However, where there is no underwriting solution, the parties must arrive at appropriate and just allocations by relying on established case law and through negotiations.

As respects Loss, there have been numerous cases addressing the issue of what constitutes a “Loss” as defined in a D&O policy. The following are a few examples of cases with published rulings on the issue of “Loss.” In Reliance Group Holdings Inc. v. National Union Fire Ins. Co., 594 N.Y.S.2d 20 (App. Div. 1993), the court ruled that: “Damages are not ‘Loss’ when they represent the return of ill-gotten gains.”

Further, in Safeway Stores, Inc. v. National Union Fire Ins. Co., 64 F.3d 1282 (9th Cir. 1995), the court agreed that Safeway’s early pay-out of an $11.5 million dividend in connection with a leveraged buyout did not constitute “Loss”; rather it was the fulfillment of its obligation to pay dividends in due course. In addition, in Level 3 Comm., Inc. v. Federal Ins. Co., 272 F.3d 908 (7th Cir. 2001), the court held that payments made by defendant securities issuers to resolve claims represented the return of ill-gotten gains, and thus did not constitute “Loss.” Finally, in CNL Hotels & Resorts, Inc. v. Twin City Fire Ins. Co., et al., D.C. Docket No. 06-00324-CV-ORL-31UAM (11th Cir. Aug 18, 2008), the United States Court of Appeals for the 11th Circuit, in an unpublished opinion, affirmed the decision by the U.S. District Court for the Middle District of Florida, which held that a settlement payment in connection with a Section 11 claim did not constitute “Loss” under a D&O policy. Rather, the settlement amounted to a refund for the difference between the price paid for stock and its reported value.

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In view of the above, we see that courts have widely applied the principle that damages are not “Loss” where they represent a disgorgement or the return of “ill-gotten” gains. Also, amounts that would otherwise be payable in the course of a normal business activity would not be considered a “Loss” under a D&O Policy. In addition, some courts have concluded that damages under Sections 11 and 12 are precluded from coverage, because of the restitutionary nature of the remedy available. Finally, non-recourse settlements would not normally constitute a “Loss” under a D&O Policy.

Although the D&O insurance industry has benefited from some favorable case law on this issue, it has introduced underwriting solutions to clarify that there is no coverage in situations where directors and officers are sued for a return of profits. An example of that solution is set forth below:

Loss does not include: (g) any amount that represents or is substantially equivalent to an increase in the consideration paid (or proposed to be paid) by an organization in connection with its purchase of any securities or assets.

Executive Protection Portfolio SM/Executive Liability and Entity/Securities Liability Coverage, Section 14-02-7303 (Ed. 11/2002).

This policy provision is commonly referred to as a “Bump-up exclusion,” and it applies to preclude coverage for a return of a profit or advantage improperly obtained in connection with the consideration paid in a merger or acquisition. Other policies have provisions clarifying that the insurer will not assert that Section 11 settlements are uninsurable. Notwithstanding these underwriting solutions, the issue of what constitutes a Loss under a D&O policy is often an unresolved issue and will be the subject of further negotiations and at times litigation.

25.3 CONCLUSION

The above is only a partial overview as to the issues of director and officer liability and D&O insurance. It would take a multivolume work to adequately address all of the issues impacting liability and coverage. However, it should be apparent even from an overview that the issues surrounding D&O liability and coverage are dynamic and are far from resolved, as is exemplified by the lack of a standardized D&O policy. Therefore, when faced with coverage and liability issues it is incumbent upon corporate directors and officers and their risk managers to consult with D&O practitioners when contemplating the purchase of insurance, the scope of coverage available or the handling of a claim.

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