Securities Law | Expert Legal Commentary

October 5, 2009

In Re HealthSouth: Settlement Extinguishes Contract Rights of Non-settling Defendant


By Josh Lawler of Zuber Lawler & Del Duca and Joel Ginsberg

In Re HealthSouth: Settlement Extinguishes Contract Rights of Non-settling Defendant

The U.S. Court of Appeals for the Eleventh Circuit extended the PSLRA further than any prior court, allowing the entry of a settlement bar order that extinguished a non-settling party’s contractual claims for indemnification and advancement of defense costs against a settling party. In In re HealthSouth Corp. Securities Litigation, 572 F.3d 854 (11th Cir. 2009), the Court determined that such an extension of the PSLRA was reasonable in light of the policy supporting settlements and against indemnification. The decision may have had a lot to do with the non-settling party at issue – HealthSouth’s former CEO Richard Scrushy, who had become particularly reviled in the proceedings, was thought to be a primary perpetrator of the fraud at issue, and was actually serving jail time on unrelated bribery, money laundering and racketeering charges at the time the order was entered. Despite the particular “villain,” however, the result leaves the corporate world wondering how to structure indemnification agreements with corporate directors and officers to better protect their rights from extinguishment.

BACKGROUND

In 1994, HealthSouth entered into an indemnity agreement with its then-CEO and chairman Richard Scrushy. That agreement, governed by Delaware law, required HealthSouth to indemnify Scrushy to the fullest extent allowed by law for any judgment rendered against him in his capacity as CEO of HealthSouth so long as he acted in good faith and believed he was acting in the best interest of the company. The agreement also entitled Scrushy to receive an advancement of attorneys’ fees as they became due, provided that he had to repay the amount advanced if it is later determined that he is not entitled to be indemnified.

In 2003, HealthSouth announced that it had materially misstated its income and assets in previous public financial statements. Shortly therefore, HealthSouth, Scrushy, and several other HealthSouth officials were sued in a series of securities class actions that were later consolidated. In 2006, HealthSouth and its insurers agreed to enter into a partial settlement with the plaintiffs in the total amount of $445 million – HealthSouth would pay $215 million of the total and the insurers would pay the rest. Scrushy, individually, was not party to that settlement.

The partial settlement terms proposed several bar orders for the court’s approval. Pursuant with the mandates of the Private Securities Litigation Reform Act (the “PSLRA”), the terms included a reciprocal contribution bar order – non-settling parties would be barred from claiming contribution from any settling parties and vice versa. 15 U.S.C. section 78u-4(f)(7)(A). The PSLRA requires such contribution bar orders to encourage settlements, as they allow defendants to “buy peace” from both the plaintiffs and their non-settling co-defendants. The PSLRA does preserve the right of non-settling defendants who ultimately prevail in the action to pursue contractual indemnity claims to recover successful defense costs against settling defendants. 15 U.S.C. section 78u-(f)(2)(B)(ii). As is common with settlement bar orders, the proposed order also provided that any non-settling defendants would receive a judgment credit against any judgment entered in favor of the plaintiffs at trial, essentially deducting the settlement amount from that judgment amount.

But the HealthSouth bar order went even further, barring all of Scrushy’s contractual claims to indemnification and advancement of defense costs. Scrushy challenged the bar order, arguing that: 1) the PSLRA’s mandatory reciprocal contribution bar was exclusive and precluded the barring of any other kinds of claims, including his contractual claims; 2) his contractual claims against HealthSouth were independent of and not based on his potential liability to the plaintiff and therefore went beyond the proper scope of a bar order; and 3) the partial settlement did not compensate him for the loss of his contractual rights.

The District Court entered the bar order in full over Scrushy’s objections, and he appealed. The Eleventh Circuit upheld the bar order in its entirety. In re HealthSouth Corp. Securities Litigation, 572 F.3d 854 (11th Cir. 2009),

The PSLRA’s mandatory contribution bar is not exclusive

As to Scrushy’s argument that the PSLRA’s contribution bar is exclusive, precluding bars against other claims, the Court disagreed, finding that the statute does not indicate any such “exclusivity” and Scrushy failed to point to any case law supporting his argument of exclusivity. “The statute merely mandates a contribution bar, but is silent with respect to barring similar indemnification claims.” 572 F.3d at 860.

The Court reviewed opinions of other circuits and the cases decided at the time of the enactment of the PSLRA, noting that “established case law… had approved bar orders precluding such indemnification claims.” Id. The Court concluded that “the background of case law against which the PSLRA was enacted clearly established that the barring of [contractual] indemnity claims is permissible.” Id. at 861.

The contractual claims are related to Scrushy’s liability to plaintiffs

The Court also rejected Scrushy’s arguments that his contractual claims could not be barred because they arose independently of his liability to plaintiffs. The Court conceded that no circuit court had yet addressed this issue, but the Court disagreed with Scrushy’s argument. The Court acknowledged that even though the advancement fees would not be paid directly to the plaintiffs, they would be “paid on account of liability to the underlying plaintiffs or the risk thereof” and therefore “clearly cannot be considered to be independent of his liability to the underlying plaintiffs.” Id. at 864.

As a result, the Court held: “We believe that the nature of Scrushy’s claim for advanced attorneys’ fees is so close to the nature of the claims which established case law holds are appropriately barred that our application of that case law here constitutes a minimal and reasonable extension thereof…. We hold that Scrushy’s claim is not a truly independent claim that might be per se inappropriate to bar.” Id. at 864-865.

Scrushy argued that this result contravened public policy that supports the advancement of litigation fees for officers and directors “to ensure that they will resist unjustified claims, and to encourage qualified individuals to serve.” Scrushy urged that innocent officers might lack the individual resources required to mount a credible defense in complex litigation. Id. at 865.

The Court acknowledged that its result might present difficulties for some innocent officers or directors as Scrushy suggested, but “these policy arguments supporting advancement of legal fees must be balanced against countervailing policies in favor of settlements and against indemnification in the securities litigation context. HealthSouth might well have been reluctant to contribute $215 million for the settlement if it thought it would continue to be liable for endless legal fees to fund Scrushy’s individual defense against the same violations…” Id. at 865. Ultimately, the court decided that the public policy favoring settlements trumped the public policy favoring advancement.

Scrushy was adequately compensated for the preclusion of his contract rights

Scrushy argued that he should have been compensated for the preclusion of his contractual indemnity claim against HealthSouth, but the Court determined that the judgment credit built into the bar order constituted adequate compensation. The Court stated: “[T]he judgment credit is very significant compensation to Scrushy in the context of a settlement with the underlying plaintiffs.” Id. at 861.

Specifically, the court noted that it gave Scrushy important leverage in settlement negotiations, because all parties would know that the plaintiffs would get nothing from Scrushy unless the verdict exceeded $445 million. “We conclude that the judgment credit provides adequate compensation to Scrushy for the extinguishment of his potential claim against HealthSouth for indemnification for any amounts he might pay in settlement to the underlying plaintiffs.” Id. at 862.

CONCLUSION

After HealthSouth, corporate officers, directors, and legal practitioners are left wondering what practices can be put in place to more solidly preserve indemnification rights. But when future courts consider this issue, it’s likely that HealthSouth will go down as a fact-specific case that does not have nearly as broad and unsettling an application as it might at first appear. In other words, because Scrushy himself was so bad, the courts found it easy to substantiate the results in this case.

All courts addressing the HealthSouth issues have been in agreement that Scrushy himself was the primary bad guy in the overall scheme. The 11th Circuit Court made a couple of comments indicating its opinion of Scrushy’s guilt – even though he had been acquitted on the criminal charges related to this case and the civil trial had not yet taken place. For example, the Court said: “Scrushy made no showing in the district court that he was merely an innocent bystander with respect to the violations at issue here.” Id. at 865. The Court also noted, with approval, that “a party in HealthSouth’s shoes might well have been more willing to leave extant the contractual claims for advancement of fees on the part of an outside director who could adduce evidence of excusable ignorance of the violations.” Id. at n.12.

And indeed, on June 18 – the day after the 11th Circuit opinion came out – an Alabama state court entered a $2.8 billion judgment against Richard Scrushy in favor of the company shareholders following an 11-day bench trial. The Alabama court in that case stated, “Scrushy’s protestations of innocence and ignorance are not credible.” Tucker v. Scrushy, No. CV02-5212 (Ala. Cir.  Ct. June 18, 2009).

This result may place even more emphasis on the likelihood that the 11th Circuit panel was swayed to uphold the bar order in its entirety – even if it had to stretch a bit to do so – given the identity of the defendant in question and the extent of his unethical and unlawful conduct. The primary advice practitioners should probably give their officers and directors who are concerned about their indemnification rights after HealthSouth is simply to act ethically, in good faith, and in the best interest of the company, pursuant to their fiduciary and legal duties.

About the Authors

Joel Ginsberg is Deputy General Counsel at Guidance Software, an industry leader in digital investigative solutions.

Image Credit: ©iStockphoto.com/molibra

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Josh Lawler
Joel Ginsberg

Companies Mentioned

Central States Group

HealthSouth Corp.

New Mexico Group for Stockholder Litigation

Retirement Systems of Alabama for Bondholder Litigation

Also See:

Amgen Inc. v. Connecticut Retirement Plans & Trust Funds: Supreme Court Sides with Investors in Securities Fraud Class Action

Gabelli v. SEC: Unanimous Supreme Court Rejects Extending Statute of Limitations in SEC Enforcement Actions

In re Rigel Pharmaceuticals, Inc.: Ninth Circuit Increases Difficulty for Investors to Sue Drug Companies Based on Clinical Trial Results

Mastick v. TD Ameritrade, Inc.: Court Upholds Use of California Arbitration Act in Contracts Governed by California Law

Lawson et al. v. FMR LLC: Sarbanes-Oxley’s Whistleblower Protection Is Limited to Employees of Publicly Traded Companies

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Companies Mentioned

Securities Law

The following companies are mentioned in Securities Law Updates:

Securities and Exchange Commission

Harris Associates, L.P.

Banc of America Securities LLC

Citicorp USA, Inc.

The Public Employees’ Retirement System of Mississippi

Morgan Stanley & Co., Inc.

Jan Charles Finance S.A.

Park East, Inc.

CIBC World Markets Corp.

Citigroup Inc.

Barclays Capital Inc.

Citigroup Global Markets, Inc.

Guardian Capital Management

ABN AMRO Bank N.V.

Vesta Insurance Group, Inc.

Free Enterprise Fund

Banc of America, N.A.

Torchmark Corp.

Beckstead and Watts, LLP

Barclays Bank PLC

KPMG Peat Marwick, LLP

Deloitte & Touche LLP

Public Company Accounting Oversight Board

BNY Capital Markets, Inc.

Florida State Board of Administration

Credit Suisse Securities (USA) LLC

Credit Lyonnais Securities (USA) Inc.

The Cleaners & Caulkers Local 1 Pension Fund

Credit Suisse, New York Branch

Ameriprise Financial, Inc. f.k.a. American Express Financial Corp.

Deutsche Bank AG

California Department of Corporations

The Royal Bank of Scotland plc

RiverSource Investments, LLC

Harris Nesbitt Corp.

Consolidated Management Group, LLC

The Bank of Nova Scotia

Asset Management Holding AG

Deutsche Bank

Toronto Dominion Texas, LLC f.k.a. Toronto Dominion Texas, Inc.

Alex Brown, Inc.

Tellabs, Inc.

Deutsche Bank Securities, Inc.

Mizuho International PLC

SG Cowen Securities Corp.

Makor Issues & Rights, Ltd.

ABN AMRO Inc.

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Tribune Company

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