Chapter 3: corporate indemnification.
Not long after this, state legislatures began to enact statutory provisions permitting corporate indemnification, many of which are based on the Model Business Corporation Act. The overriding goal of these statutes was to protect directors and officers from personal liability resulting from business decisions. The statutes were intended to encourage capable individuals to serve as directors and officers, secure in the knowledge that they would be insulated from personal liability if corporate actions, taken in good faith, were brought under attack by way of a legal proceeding. Stated another way, "[i]ndemnification under the statute[s] is provided to assure corporate officials that they will not be hampered by financial constraints in mounting a full defense against unjustified suits." (2)
The following material focuses on the salient provisions of the Delaware indemnification statute. (3) Because many, if not most, publicly traded corporations are incorporated in Delaware, the issues encountered regarding director and officer indemnification are often governed by the Delaware statute. However, in evaluating a given issue, the indemnification statute in the corporation's state of incorporation will govern.
Mandatory and Permissive Indemnification
The entitlement of corporate directors and officers to indemnification can be broadly categorized as mandatory or permissive. Mandatory indemnification refers to the absolute statutory entitlement of a director or officer to indemnification of expenses in situations where he or she is "successful on the merits or otherwise" in defending a proceeding brought against him or her. (4) Permissive indemnification, on the other hand, refers to those situations where mandatory indemnification does not apply, such as when a proceeding involving a corporate official is resolved prior to final judgment (e.g., a settlement). The Delaware statute states that a settlement does not, in itself, mean that the person involved had not acted in good faith and in the best interests of the company. In such circumstances, corporations are afforded the power, but not necessarily the duty, to provide indemnification.
The Delaware indemnification statute's mandatory indemnification provision states as follows:
To the extent that a present or former director or officer of a corporation has been successful on the merits or otherwise in defense of any action, suit or proceeding referred to in subsections (a) and (b) of this section, or in defense of any claim, issue or matter therein, such person shall be indemnified against expenses (including attorneys' fees) actually and reasonably incurred by such person in connection therewith. (5)
The purpose of the mandatory indemnification provision is to give vindicated directors and officers a judicially enforceable right to indemnification. The person to be indemnified need not demonstrate his own good faith or that he was free from wrongdoing, but only that the claim asserted against him was defended successfully.
Given that most D&O claims are settled prior to trial, a question in many directors' and officers' minds is whether the mandatory indemnification provision applies to settlements. The answer appears to be that a settlement that is with prejudice and results in the dismissal of the case without any payment or assumption of liability may be considered a "success" within the meaning of that provision. Settlements that are without prejudice to a claimant's right to assert further claims against an officer are not successes under section 145(c) of the Delaware statute.
A key distinction among the various state indemnification statutes is that some states require the person to be indemnified to be "wholly successful on the merits" before mandatory indemnification is implicated. Other states, such as Delaware, allow for mandatory indemnification "to the extent" the person to be indemnified has been successful on the merits or otherwise. Courts have interpreted this latter provision to mean that, so long as the person to be indemnified is partially successful on the merits, she may be partially indemnified for expenses incurred in connection with the claims or allegations that were successfully defended. This is true even if the person to be indemnified was not successful in defending other claims asserted against her.
For example, a former director of a Delaware corporation was entitled to mandatory indemnification of attorneys' fees and costs incurred in successfully defending three counts in a civil complaint, even though he was unsuccessful in defending a fourth count. Of course, such partial indemnification situations give rise to the same allocation dilemmas as occur with regard to the application of D&O insurance when a claim involves covered and uncovered matters.
In situations where a director or officer is not partially or wholly successful on the merits or otherwise, and therefore would not be entitled to mandatory indemnification, indemnification is permissive and thus left to the discretion of the corporation. As a practical matter, given that most D&O claims are settled before trial, a person's right to indemnification likely will be governed by the permissive provisions of the relevant indemnification statute. Even in the permissive context, however, corporations generally will attempt to afford their directors and officers the broadest possible rights to indemnification.
The permissive indemnification provision of the Delaware statute provides:
A corporation shall have power to indemnify any person who was or is a party or is threatened to be made a party to any threatened, pending or completed action, suit or proceeding, whether civil, criminal, administrative or investigative (other than an action by or in the right of the corporation) ... against expenses (including attorneys' fees), judgments, fines and amounts paid in settlement actually and reasonably incurred by the person in connection with such action, suit or proceeding if the person acted in good faith and in a manner the person reasonably believed to be in or not opposed to the best interests of the corporation ... (6)
The language of the statute gives rise to several issues regarding the scope of indemnification.
Who May Be Indemnified?
The Delaware statute permits indemnification of current or past directors, officers, employees, or agents of the corporation, or anyone who is or was serving at the request of the corporation as a director, officer, employee, or agent of another corporation, partnership, joint venture, trust, or other enterprise.
The Capacity Issue
In addition to the position of the person to be indemnified, the capacity in which he or she acts also must be considered. That is, the person to be indemnified must act within the scope of his or her employment in order to be entitled to indemnification. Indeed, a New York court has held a corporate officer's grabbing a piece of a subordinate female employee's clothing and making lewd remarks about her in public was outside the scope of his employment. Accordingly, he was not entitled to indemnification of the costs of defending the female employee's federal lawsuit for sexual harassment.
Timing of Acts Committed
Other courts have held that an individual could be indemnified for losses arising from acts committed before the individual became an officer of the corporation. In this regard, the Delaware statute provides that a corporation through a consolidation or merger may indemnify the acquired company's directors, officers, employees, or agents to the same extent that the acquired company could have. (7)
Actions by or in the Right of the Corporation
In Delaware, as in most other states, the extent to which a person is entitled to permissive indemnification depends upon the type of action or proceeding brought against him or her. Specifically, a distinction is drawn between two types of actions: (i) actions by or in the right of the corporation, (8) and (ii) actions by any other parties. (9) The latter type of action carries relatively few limitations regarding the scope of indemnification that may be afforded. The statute, however, imposes certain limitations on the indemnification afforded in connection with the first type of action.
What is meant by "actions by or in the right of the corporation"? Very simply, in the event a director or officer breaches his or her duties to the corporation, the corporation may pursue a legal action to collect the losses it incurred as a result of such wrongful conduct. The corporation may bring such an action on its own or a shareholder may assert the claim on behalf of (or "in the right of") the corporation. Such a claim is commonly called a "derivative action". Whether the legal action is asserted directly by the corporation or derivatively by a shareholder, the corporation assumes the capacity of a plaintiff asserting claims against its director or officer. Consequently, certain restrictions are placed on that director's or officer's right to indemnification from the corporation.
Some jurisdictions, including Delaware, preclude corporations from indemnifying their directors or officers for any settlement reached in a shareholders' or derivative action or one brought directly by the corporation. The theory is that the corporation would be indemnifying the director or officer for a settlement ultimately paid to the corporation itself as plaintiff. Certain state legislatures, including Delaware's, have determined that such circularity of payment is unacceptable.
New York has a state indemnification statute that allows indemnification of settlements in direct or derivative actions and permits such indemnity so long as a court determines that the person in question is "fairly and reasonably entitled to indemnity for such portion of the settlement amount and expenses as the court deems proper."
The Due Diligence Process
The permissive indemnification provisions of the Delaware statute will be triggered only if the person to be indemnified acted in accordance with the statutory standard of conduct: the person must have acted in good faith and in a manner he or she reasonably believed to be in or not opposed to the best interests of the corporation. That is, separate and apart from the action, suit, or proceeding brought against the director or officer in which their conduct is at issue, the corporation must make its own determination of whether such conduct met the statutory standard of acting in good faith and in the best interests of the corporation. Only directors and officers who satisfy this standard qualify for indemnification.
A literal reading of the statute leads to the conclusion that indemnity cannot be afforded unless the corporation undertakes the due diligence process to determine conformance with the statutory standard. With anything less, the person's right to indemnification could be jeopardized. Indeed, in Waltuch v. Conticornmodity Services, Inc.," (10) the court held that the Delaware statute would not allow indemnification of a person absent a determination that the person acted in accordance with the statutory standard of conduct. (11)
Advancement of Defense Expenses
The corporation may pay the expenses incurred by a director or officer in defending the action in advance of the final disposition of the action. Under the statutory language, advancement of expenses is permissive in nature: the corporation may pay expenses in advance of the final disposition of the action, suit, or proceeding." (12) Also, given that the propriety of the person's conduct may not possibly be ascertained in the early stages of the action, suit, or proceeding, the Delaware statute has taken a realistic approach of not conditioning advancement on compliance with any particular standard prior to advancing expenses. The sole requirement under the statute is that the person seeking expense advancement provide a commitment to repay advanced amounts in the event it ultimately is determined that he or she is not entitled to indemnification." (13) The corporation's board of directors has the power to decide whether the written commitment provided by the director sufficiently protects the corporation's interests.
Under the statute's nonexclusivity provision, the corporation has the power to make the permissive advancement provision mandatory through a bylaw, charter, or contractual provision (i.e., the corporation "shall" advance expenses). As a matter of personal protection, individuals seeking directorship or executive positions should verify whether the corporation they serve would advance expenses on a permissive (discretionary) or mandatory basis. It is important to remember that in addition to the corporation's position on advancement, other factors may impact a director's ability to obtain advancement of defense expenses. Historically, the Department of Justice did not approve of corporate advancement of defense expenses to directors and officers in criminal proceedings interpreting such actions as evidence of non cooperation. However, in recent years, the Department of Justice changed its position so that prosecutors do not typically consider whether a corporation is advancing defense expenses to an individual under investigation or indictment.
Nonexclusivity of Indemnification Provisions
The Delaware statute provides that the rights to indemnification granted by statute "shall not be deemed exclusive of any other rights to which those seeking indemnification or advancement of expenses may be entitled under any bylaw, agreement, vote of stockholders or disinterested directors or otherwise." (14) It is unclear whether the nonexclusivity provision is subject to the policy considerations and various restrictions embodied in the statute, or whether the corporation has unqualified discretion to afford indemnification in any manner it sees fit. The courts have offered very little guidance in this area, as shown in the following cases.
For example, the court in PepsiCo (15) found that the Delaware indemnification statute does not provide the exclusive means for indemnification but is simply a fall backmeasure that can be completely supplanted by the corporation's bylaws." The court held that the corporation's failure to comply with the statute's provisions did not prevent the corporation from indemnifying its directors in accordance with the corporation's certificate of incorporation. (16)
A contrary conclusion was reached by the same court in Waltuch v. Conticommodity Services, lnc., (17) where the court held that the indemnification allowable under the nonexclusivity provision is subject to the limitations on indemnification that public policy imposes (as reflected in the statute). (18) The court, relying on the consensus among knowledgeable commentators who have written on the subject, ruled that indemnification could not be granted unless the director met the statutory standard of care. (19) In this regard, the court explained: "there would be no point to the carefully crafted provisions of Section 145 spelling out the permissible scope of indemnification under Delaware law if subsection (f) allowed indemnification in additional circumstances without regard to these limits. The exception would swallow the rule." The court thus held that indemnification needed to be effected in accordance with the procedural requirements in the statute, regardless of whether indemnity was provided under the nonexclusivity provision.
It would appear that the Waltuch court expresses the better view on this in that statutory prohibitions on indemnification would be meaningless if corporations were always permitted to circumvent them through expansive permissive indemnification. As an example, if the jurisdiction's indemnification laws prohibit indemnification of a criminal fine or penalty, the corporation should not be able to allow indemnification for such through its charter or by-laws.
On the other hand, if indemnification laws are silent, for example with respect to expenses incurred in connection with a proceeding such as a mediation, the corporation should be able to allow for such indemnification through a charter or by-law provision.
Another issue that arises from time to time is whether the nonexclusivity clause would allow the corporation to indemnify its directors and officers for settlements in derivative actions, something not permitted under the plain language of the Delaware statute and other statutes. One court has stated that the statutory provisions do "not mark the exclusive ambit of indemnification rights," thus suggesting that such expanded indemnification could be granted.
The Waltuch court, however, likely would hold that the nonexclusivity provision is subject to limitations explicitly set forth in the Delaware statute. In this regard, if the state legislatures intended to allow corporations to grant such indemnification, they would have incorporated the appropriate provisions into the statutes themselves. For example, the New York legislature has specifically provided for indemnification of settlements or judgments in derivative actions, but only if a court of competent jurisdiction determines that such indemnification is proper under the circumstances. (20)
The Securities and Exchange Commission's Policy on Indemnification
Historically, the Securities and Exchange Commission did not favor indemnification for liabilities arising under the securities laws, declaring it to be against public policy and therefore unenforceable. (21) This policy has received support by several court decisions, including the oft-cited Globus v. Law Research Service, Inc. (22) In Globus, it was held that, regardless of whether the individual involved is an officer, director, or underwriter, the policy underlying the Securities Act of 1933 voids any indemnification agreement to the extent that, as applied, it would cover fraudulent misconduct. (23)
Subsequently, however, the U.S. District Court for the Northern District of California held that a corporation may voluntarily indemnify its officers and directors for settlement payments and defense costs arising from shareholder class action claims for violations of section 10(b) of the Securities Exchange Act of 1934. (24) The court noted that allowing such indemnification would support two competing public policies: encouraging qualified individuals to serve as corporate officers and directors, and encouraging settlement of class action lawsuits. (25) Thus, the court held that the SEC's policy considerations did not prohibit such indemnification. (26)
In recent years, the SEC's position has varied depending on the circumstances of the case. In 2004, the SEC imposed a $25,000 penalty on Lucent Technologies, based partially on its indemnification of employees under investigation by the SEC. In a January 2007 speech by the SEC addressing penalties and sanctions for securities fraud, the SEC noted that while there may be public policy reasons for indemnification, the SEC has great latitude in determining and interpreting public policy on this issue.
The Effect of the Corporation's Bankruptcy on Indemnification
Once a corporation files a bankruptcy petition, it may not pay debts that were incurred before the date the bankruptcy proceedings were instituted without the approval of the bankruptcy court. This restriction includes payments made by the corporation to indemnify its directors and officers for costs incurred in defending litigation. Consequently, directors and officers seeking indemnification from the corporation must file a proof of claim with the bankruptcy court.
(1) This chapter in significant part is adapted from an article by Joseph P. Monteleone and Nicholas J. Conca which appears in The Business Lawyer, Vol. 51, No. 3 (May 1996).
(2) McLean v. International Harvester Co., 902 F.2d 372 (5th Cir. 1990).
(3) DEL.CODE ANN. Tit.8, [section]145 (1997).
(4) Id. [section]145 (c)
(5) Id. 5145 (c).
(6) DEL. CODE ANN. Tit. 8, [section]145 (a) (1997).
(7) Bear in mind that Witco and Emhart, which appear to be completely inconsistent judicial decisions, were decided under different bodies of law and under different factual settings.
(8) DEL CODE ANN. Tit. 8, [section]145(b) (1997).
(9) Id. [section]145(a).
(10) 833 F.Supp. 302 (S.D.N.Y. 1993).
(11) Id. at 311-13
(12) DEL CODE ANN. Tit. 8, [section]145(e) (1997).
(14) Id. [section]145(f)
(15) PepsiCo, Inc. v. Continental Cas. Co., 640 F.Supp. 656 (S.D.N.Y. 1986).
(17) PepsiCo, Inc. v. Continental Casualty Co., 640 F.Supp. 656, 661 (S.D.N.Y. 1986).
(18) Id. at 660-61
(19) 833 F. Supp. 302 (S.D.N.Y. 1993); affd in part and rev'd in part, 88 F. 3d 87 (2d.Cir., 1996). The Second Circuit affirmed the lower court with regard to its holding that 145(a) limited the scope of permissible indemnification to matters in which the indemnitee acted in good faith. However, in considering 145(c) which mandates indemnification in cases of a "successful" defense of a director or officer, the Court held that a dismissal of claims against the indemnitee constitutes a successful defense. The Court stated that it was irrelevant to its decision here that a settlement payment by the corporation/indemnity or may indeed have been the basis for a dismissal of the claims against the indemnitee.
(20) Id. at 306-09.
(21) See Heffernan v. Pacific Dunlop, 965 F. 2d 369 (7th Cir. 1992).
(22) See N.Y. Bus. Corp. Law [section]722(c) (McKinney 1986).
(23) See, e.g., 17 C.F.R. [section]229.512 (h) (3) (1995).
(24) 418 F. 2d 1276 (2d Cir. 1969), cert. denied, 397 U.S. 913 (1970).
(25) Id.; See also Eichenholtz v. Brennan, 52 F. 3d 478 (3d Cir. 1995) (stating that indemnification "runs counter to the policies underlying the 1933 and 1934 Acts").
(26) Raychem Corp. v. Federal Ins. Co., 853 F. Supp. 1170 (N.D. Cal. 1994).
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|Publication:||Directors & Officers Liability Coverage Guide|
|Date:||Jan 1, 2008|
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