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Protecting the Board of Directors

In our initial article [listed below], we discussed the potential impact of some recent Delaware court decisions that highlighted the importance of careful drafting and planning when it comes to providing for protective rights of directors of Delaware corporations. One such decision was Schoon v. Troy Corp., in which the Delaware Chancery Court held that a director’s right to indemnification or advancement of expenses provided for in a corporation’s certificate of incorporation or bylaws could be retroactively eliminated so long as the change to the provision was put in place before the proceeding for which the director was seeking indemnification or advancement of expenses was filed. In that case, the Court held that a former director was not entitled to advancement of his litigation expenses because the bylaw provision granting that right was eliminated in an amendment adopted after the director left office but before claims against him were filed.

After our article went to press, the Delaware legislature introduced legislation to amend Delaware’s corporate statute in response to the Court’s decision in Schoon. The proposed amendment to Section 145 of the Delaware General Corporation Law has now passed. It was signed into law on April 10, 2009 and becomes effective August 1, 2009. The amendment to Section 145 addresses the facts that existed in the Schoon case by providing that corporations cannot impair or eliminate a director’s right to indemnification or advancement of expenses arising under the corporation’s certificate of incorporation or bylaws by amending the relevant provision after the occurrence of the act or omission to which the indemnification or advancement of expenses relates, unless the provision in effect at the time the act or omission occurs explicitly authorizes such retroactive elimination or impairment of the right. This amendment thus will allow directors to make decisions in reliance on their existing indemnification protections without the same concern that such protections will later be taken away.

A couple of closing thoughts, however. First, the fact that this amendment to the Delaware statute still permits a corporation to eliminate or limit the scope of director indemnification and advancement of expenses rights after the fact so long as it does so through an express provision adopted up front illustrates once again the importance of keeping abreast of the latest developments in this ever evolving area of the law. Without doing so, you cannot ensure that your corporate governance documents will continue to serve their intended purposes. And second, keep in mind that in the context of a sale of your company, even carefully crafted bylaws and charter provisions may not be sufficient. In the absence of individual indemnification agreements between the company and each director that prohibit changes without both parties’ consent, these rights may only be preserved after the sale in certain circumstances through successfully negotiating with the acquirer at the time of the sale.  

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Congratulations!  Your biotech company, BiotechOmics, was just acquired by MegaPharma. The papers have been signed, the money has been transferred, and you are ready for a much-needed vacation. Just as you are ready to set sail for your tropical destination of choice, you receive a panicked phone call from a former member of BiotechOmics’s board of directors saying that he and the rest of the Board are being sued for alleged wrongdoing before the sale. After assuring the director that BiotechOmics had top-notch  protections for its board members, you learn that MegaPharma changed the rules and that BiotechOmics’ former directors no longer enjoy the protection that they once had.  So you call your attorney and ask a simple question, “Can MegaPharma do this?” Unfortunately, unless BiotechOmics planned ahead, the answer may very well be “yes.”

In turbulent economic times, attracting and retaining qualified directors and officers is more important than ever.  But with litigation on the rise, potential candidates may be leery of assuming such positions. Savvy directors may insist that the company have D&O insurance and may seek assurance that strong indemnification and expense advancement procedures are in place.  Recent developments in Delaware corporate law have changed the landscape regarding protection of directors, meaning that companies like BiotechOmics – that expect a merger or change of control in the future – should review the protection systems they have in place for their directors.

Schoon v. Troy Corp.:  Retroactive Elimination of Expense Advancement Rights
In 2008, in Schoon v. Troy Corp., the Delaware Court of Chancery Court upheld a bylaw amendment that retroactively eliminated a director’s right to require the company to advance legal defense costs even though the director had served during a period when the company’s bylaws expressly provided this protection. The director probably expected that his right to be protected would last indefinitely. However, the Schoon court held that the right to advancement of expenses did not vest until litigation was filed naming him as a defendant.  Since the amended bylaws (in effect at the time of the litigation) did not provide for advancement rights for former directors, the court held that the director was not entitled to this protection.

Levy v. HLI Operating Company, Inc.: Indemnification Obligations in the Private Equity Context
In 2007, in Levy v. HLI Operating Company, Inc., the same court addressed a situation in which directors were entitled to indemnification by contract from both the company and the investment fund that employed them. When the directors were sued, the fund covered their expenses. In a suit by directors to recover from the company, the court ruled that the directors could not recover from the company because their costs had already been covered by the fund. The court also concluded that both the company and the fund were obligated to indemnify the directors and had to share in the defense and settlement costs.  
 
What should companies do in light of these decisions?
The Levy and Schoon cases have reinforced Delaware’s reputation as a place where courts will enforce the agreement as reached by the parties involved in a corporation – no one should rely on any “implied” rights. If current owners or a corporation desire to provide protection for directors that will survive after a change of control and a change in the composition of the board, these protections must be specifically implemented in a manner that will survive future changes to the charter or bylaws. A common approach to avoid the Schoon problem is for a company to enter into an indemnification agreement with each director, which agreement can not be amended without the consent of the director. Similarly, in response to the Levy ruling, many investors now require indemnification agreements that expressly state that the company has the primary obligation to protect directors. 

The court’s decisions in Levy and Schoon highlight the importance of planning ahead and careful drafting with regard to indemnification and advancement of expenses protections. Companies like BiotechOmics should periodically review (and possibly change) their current indemnification provisions to ensure that they continue to accomplish their desired purposes, even following a sale of the company. Companies and their boards need to consider the scope of indemnification rights they intend to grant and then draft accordingly. Although the answer won’t necessarily be the same for all companies – and will involve a balancing of multiple interests – the process will be worth the effort.


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