The International Law Firm of Fulbright & Jaworski - Corporate Governance
Kim F. Tyson, Anthony Shih, Gregory M. Matlock, Jasper G. Taylor, III, Zack A. Clement and Victor Hsu
June 26, 2009
- Constructive Trust Imposition May Protect Assets of Defrauded Employers from IRS Claims
- Eleventh Circuit Finds PSLRA Does Not Bar HealthSouth Settlement Extinguishing Former Chairman and CEO Richard Scrushy's Indemnification Claims
- Legislation Expanding Shareholder Rights Introduced in Congress
- Obama Administration Makes Proposals for Regulatory Reform
Constructive Trust Imposition May Protect Assets of Defrauded Employers from IRS Claims
With the increase of alleged Ponzi schemes and other fraudulent arrangements, investors have become used to seeing the establishment of receiverships. However, such proceedings–and the successful assertion of a constructive trust argument–can be of great value to an employer who discovers theft, or other fraudulent takings, by an employee or a third party (in other words, an employer-employee relationship is not required).
Once the fraud is discovered, a legal scramble for the money between the IRS and the employer can begin. The IRS takes the position that the proceeds of the theft or fraudulent transaction are income to the employee and therefore subject to income tax. As a result, the IRS claims a tax lien for unpaid taxes against the employee and any recovered ill-gotten gains in competition with the claims of the employer. When the IRS intervenes with a competing federal tax lien, any potential recovery by a defrauded employer may seem hopeless. However, the imposition of a constructive trust can, in some cases, be utilized to prevent the Government from being unjustly enriched by taking both the property and the proceeds to satisfy the wrongdoer’s tax debt.
A constructive trust can be judicially imposed to place a defrauded employer in the same position as if it had a secured claim, so that it has priority over an IRS tax claim against the employee. The result of a constructive trust is a decree ordering the employee to convey the wrongfully obtained property to the employer. This decree is retroactive in effect to the date when the unlawful holding of the property began.
To obtain a constructive trust, an employer must commence an adversary proceeding. The employer seeking to recover assets may bear the burden of proving its entitlement to funds by clear and convincing evidence. Generally, courts have held that there must be evidence of wrongdoing and an ability to trace the funds upon which a constructive trust is sought. In cases where the trust funds have been commingled with other funds, the ability to trace assets becomes much more difficult. Even in cases where funds have not been commingled, a judge usually assigns a receiver to aggregate the employee’s assets and determine who is entitled to the money collected. Employers can then submit claim forms to the receiver, documenting the amount owed to them.
The IRS often agrees that tax liens do not attach to property subject to a constructive trust. Thus, a federal tax claim may not be enforceable against property held in a constructive trust for the benefit of a defrauded employer. As such, the imposition of a constructive trust may seem like a very beneficial remedy. However, some bankruptcy courts refuse to impose a constructive trust under any circumstances. The reluctance of bankruptcy courts to impose constructive trusts typically stems from the belief that elevating one unsecured claim above the other claims “thwarts the policy of ratable distribution.” For this reason, whether bankruptcy cases serve as a basis for using constructive trusts to defeat a federal tax lien remains unclear. Nevertheless, a constructive trust may be a viable option in many cases for employers seeking to recover funds lost in fraudulent actions by employees. top
Eleventh Circuit Finds PSLRA Does Not Bar HealthSouth Settlement Extinguishing Former Chairman and CEO Richard Scrushy's Indemnification Claims
The Court of Appeals for the Eleventh Circuit upheld a bar order in a class action settlement between the plaintiffs and HealthSouth Corporation barring non-settling defendant Richard Scrushy's claims for advancement of legal defense costs and for indemnification of settlement payments.
The appeal arose from a $445 million partial settlement between the plaintiffs and HealthSouth in the HealthSouth securities fraud litigation. HealthSouth acknowledged in 2003 that its financial statements substantially overstated its income and assets. HealthSouth investors filed class actions alleging violations of the Securities Act of 1933 and Securities Exchange Act of 1934. Scrushy was alleged to be the mastermind behind the plot to defraud the investors. The bar order and partial settlement agreement barred Scrushy’s claims for contribution to any future settlement or judgment and for advancement of defense costs. Scrushy had previously entered into an agreement with HealthSouth requiring it to indemnify him to the fullest extent permitted by law for any judgment or settlement in which he was sued for his actions as an officer or director. The agreement also provided for advancement of defense costs, provided Scrushy agreed to repay the advance if it was determined that he was not entitled to indemnification. These types of agreements are typical of those made by corporations and their officers and directors. On appeal, Scrushy maintained that the district court erred in allowing the bar order to bar Scrushy's contractual rights for HealthSouth to reimburse him for good faith settlement amounts and for advancement of his defense costs in the litigation.
The Private Securities Litigation Reform Act of 1995 (the "PSLRA") generally requires securities class action settlement agreements to contain a bar order prohibiting contribution claims against the settling parties. Scrushy argued that the PSLRA bar was exclusive, e.g., that it applied only to contribution claims, not to indemnity claims, including indemnification for any amounts Scrushy might pay in settlement. The Court disagreed, holding that the bar order was not inconsistent with the PSLRA, a question of first impression for the Court. The Court reasoned that there was no provision in the PSLRA that prohibited a bar of indemnity claims or language suggesting that the contribution bar was exclusive. There is case law approving bar orders that bar indemnification as well as contribution claims. The Court also found that the PSLRA was enacted against a background of case law approving bar orders precluding indemnification claims.
Subsequently, a Jefferson County, Alabama judge ordered Scrushy to pay the plaintiffs over $2.8 billion in damages. This may be the largest securities-related financial penalty ever levied against a single executive. top
Legislation Expanding Shareholder Rights Introduced in Congress
Following the most severe stock market meltdown since the Great Depression, the theme of shareholder rights is getting a full airing in the 111th Congress. There are currently two pending bills (one introduced in the Senate, the other in the House) granting shareholders of public companies a greater say in corporate governance, covering the nomination and election of directors, executive compensation and related matters.
On May 19, 2009, Senators Charles Schumer (D-NY) and Maria Cantwell (D-WA) introduced a bill titled the “Shareholder Bill of Rights Act of 2009.” This bill proposes certain amendments to the Securities Exchange Act of 1934 (the “’34 Act”) and requires public companies to observe the following key provisions:
(i) annual meeting proxies shall include advisory shareholder votes on executive compensation packages, and merger proxies shall include advisory shareholder votes on “golden parachute” arrangements (a so-called “Say-on-Pay” measure);
(ii) shareholders who have held at least 1% of the company’s voting securities for at least two years shall be granted access to proxy materials in order to nominate directors;
(iii) directors shall be elected by a majority of the vote in uncontested elections and by a plurality of the vote in contested elections;
(iv) directors shall face re-election annually;
(v) the positions of CEO and Chair of the Board may not be held by the same individual, and the Chair shall be an independent director who has not previously served as an executive officer of the company; and
(vi) the board shall create a risk committee consisting only of independent directors, with responsibility to oversee the company’s risk management policies.
On June 12, 2009, Representative Gary Peters (D-MI) introduced a bill titled the “Shareholder Empowerment Act of 2009.” This bill proposes amendments to the ’34 Act similar to the Shareholder Bill of Rights Act of 2009, and also proposes additional public company shareholder rights measures. These include the following:
(i) brokers may not vote the shares they hold if the beneficial shareholders have not provided specific voting instructions;
(ii) compensation advisors retained by the board shall be independent, shall report solely to the board or the compensation committee, and may not perform other consulting work that involves reporting to company management;
(iii) companies shall establish policies to recover or cancel bonus, incentive or equity payments to executives awarded on the basis of fraudulent or faulty earnings statements;
(iv) a prohibition on severance payments for senior executives terminated for poor performance; and
(v) increased disclosure of performance targets used by companies to determine executive bonuses and other incentive compensation.
These bills echo several prior initiatives by Congress, the SEC and the major stock exchanges, some of which already have been adopted in one form or another. Given the continued visibility of the issues involved, we would expect further initiatives seeking to expand the rights of certain shareholders at the expense of directors and executive officers. top
Obama Administration Makes Proposals for Regulatory Reform
The Obama Administration's proposals for regulatory reform are far reaching, but are not the revolutionary proposals that some had hoped for or feared. Highlights from the Administration White Paper outlining the proposals include:
- Changing and expanding the powers and responsibilities of the Federal Reserve. This includes the power to designate a new category of systemically important firms designated "Tier 1 FHCs," which are firms that could pose a threat to the financial system if they failed. Tier 1 FHCs would have to meet enhanced regulatory requirements compared to other institutions.
- Creation of a Financial Services Oversight Council chaired by the Treasury Secretary and including members from each financial regulatory agency. The Council would have responsibility to identify gaps in regulation and to detect emerging risks to the financial system. It would act only in an advisory capacity, making recommendations to the Federal Reserve which would be required to consult with the Council before taking certain actions.
- Issuance by federal regulators of standards to align compensation practices at financial firms with long-term shareholder value and stability.
- Requiring hedge funds and other private pools of capital to register with the SEC if assets under management exceed a relatively low, unspecified threshold.
- Requiring originators of asset-backed securities to retain a financial interest in securitized loans and meet enhanced disclosure requirements.
- Enhanced regulation of credit rating agencies.
- Regulation of credit default swaps and other OTC derivatives.
- Creation of the Consumer Financial Protection Agency. Its role would be to ensure that consumer protection regulations are enforced, improve coordination among state regulators, address concerns about mandatory arbitration harmful to consumers, and ensure consistent regulation of similar products.
From a corporate governance standpoint, there appears to be little doubt that there will be an enhanced role for Chief Risk Officers and an increase in board-level risk committees as a result of the reforms. The Federal Reserve and possibly the Financial Services Oversight Council may have a corporate governance role in Tier 1 FHCs.
No doubt the proposals will be hotly debated over the next few months and many changes and compromises will be reflected once the final legislation is passed.
Kim F. Tyson
Gregory M. Matlock
Jasper G. Taylor, III