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Developments in Indemnification & Advancement Rights in Delaware

Introduction

October 2009 marks the eight-year anniversary of the infamous Enron scandal, which sparked a transformation in the landscape of corporate America. Despite the enactment of the Sarbanes Oxley Act of 2002 and various other attempts at reform, the post-Enron era has been plagued by scandals ranging from the fall of corporate players like WorldCom and Adelphia to the recent subprime mortgage crisis, extensive government bailouts, and Ponzi scheme investigations. Attracting and retaining qualified directors and officers has never been more important for a company than it is in the present – a time when corporate America suffers from a mix of well-publicized scandals and turbulent economic times. However, the post-Enron era is marked by a heavily scrutinized and increasingly litigious business environment, making the risk of serving in such capacities greater than ever before. The topics of director indemnification and advancement of defense costs have been thrust to the legal forefront as a result of a prominent 2008 Delaware Court of Chancery decision and a subsequent amendment to Delaware’s corporate statutes enacted in response to the case. As a result of the amendment, it remains possible to utilize the protections afforded by statute and other contractual mechanisms to significantly reduce the risk that directors and officers will, if sued for actions taken while acting in their corporate capacity, have to use their own personal funds for their legal defense.

Schoon v. Troy Corporation Sends out Tremors

In 2008, the Delaware Court of Chancery rendered a decision that significantly eroded the effectiveness of advancement protections provided to directors as part of the indemnification provisions contained in corporate charter documents and bylaws. Note that the terms “indemnification” and “advancement” refer to the rights that a director has to be compensated for expenses incurred as a result of legal proceedings related to his service as a director of the company. The statutory authority for indemnification rights for directors, officers, employees, and agents of Delaware corporations is Section 145 of the Delaware General Corporation Law (the “DGCL”). This section provides for mandatory indemnification in certain situations, while permitting (but not requiring) such indemnification in others. Advancement, while similar to indemnification, differs in that a director or officer who is entitled to receive advancement has the right to have his legal expenses paid on an as-incurred basis, rather than at the conclusion of litigation (as is typically the case with indemnification). However, if a director or officer receives advancement and a court later determines that the director or officer was not entitled to indemnification (i.e., that the director was not entitled to have his expenses paid after the conclusion of the litigation), then the advanced amounts must be repaid. In Schoon v. Troy Corporation, 948 A.2d 1157 (2008), the court allowed the board of directors of Troy Corporation (“Troy”) to amend Troy’s bylaws to revoke a former director’s right to receive advancement even though the bylaws that were in place during his service expressly stated that the director’s right to receive advancement would continue even after his tenure on the board ended.

Before Schoon, it was commonly believed that a director’s right to require a company to provide advancement vested upon the director’s service and could not be singlehandedly terminated by the company after the director’s tenure ended. This belief was at least in part based on a prior Delaware Superior Court case where the court stated that the director’s “right to advancement…[was] a vested contract right which [could not] be unilaterally terminated.” Schoon, 948 A.2d at 1165, quoting Salaman v. National Media Corp., 1992 WL 808095 (Del. Super. Oct. 8, 1992), at 6. The plaintiff in Salaman was a former director who sought advancement for expenses incurred while defending two claims related to his service as a director of National Media. After initially advancing a portion of Salaman’s expenses and fees, National Media amended its bylaws to repeal the company’s mandatory obligation to provide advancement and subsequently refused to provide further advancement. The court held that Salaman’s right to receive advancement had vested before the amendment and accordingly that the company was obligated to continue to provide advancement.

Nearly 15 years later, William Bohnen, a former director of Troy and one of the plaintiffs in Schoon, was deprived of his right to receive advancement under seemingly similar circumstances. Bohnen then cited Salaman as precedent to support his position that Troy’s bylaw amendment could not unilaterally terminate his right to receive advancement. In a decision that took the corporate world by surprise, the Schoon court determined that the bylaw amendment effectively severed Troy’s obligations to provide advancement for Bohnen. The court held that a director’s right to receive advancement provided for in charter documents does not vest until a “triggering event” occurs. In its examination of what constitutes a “triggering event,” the court stated that the filing of a lawsuit would typically be the triggering event, but left open the possibility that even the threat of litigation could suffice. The court distinguished Schoon from Salaman by noting that Salaman’s right to receive advancement was upheld only because he was a named defendant before National Media’s bylaws were amended. Schoon, 948 A.2d at 1166. In contrast, a triggering event had not occurred prior to the bylaw amendment in Schoon, and consequently, Bohnen’s right to receive advancement had not vested at the time of the amendment. The Schoon decision was appealed to the Delaware Supreme Court, but the case was settled prior to a final decision.

Life After Schoon:Indemnification Agreements and Statutory Change

Statutory Change

In Schoon’s aftermath, while companies rushed to appease directors and officers with indemnification agreements and other protective mechanisms (as discussed in more detail below), legal practitioners and other affected constituents urged the Delaware legislature to resolve the uncertainty created by the Court of Chancery’s decision. In response, the Delaware legislature amended Section 145(f ) of the DGCL to adopt a rule that was contrary to the holding in Schoon.

As revised, Section 145(f ) provides that a director’s right to receive indemnification or advancement pursuant to a company’s charter or bylaws generally may not be impaired or eliminated after the occurrence of the act or the omission that is the subject of the indemnification or advancement. Note, however, that an exception to this rule occurs if the company’s charter or bylaws as in effect at the time of the act or omission contains a provision that expressly authorizes such elimination or impairment after the occurrence of the questioned act or omission. The amendment resolves the uncertainty surrounding the occurrence of a “triggering event” by clarifying that the right to receive indemnification or advancement vests upon the occurrence of a potentially litigious act, rather than upon the filing of a lawsuit or the threat of litigation, thus creating a more definitive vesting point. To illustrate the difference that the statutory amendment makes, under current law William Bohnen (the Schoon plaintiff ) would have been entitled to receive advancement from Troy, as the subsequent bylaw amendment occurred after the litigious act and, as such, would have been ineffective to relieve Troy of its obligations. Thus, the Schoon case appears to no longer be accurate law.

Indemnification Agreements

With no appellate review of the Schoon decision and the accordant uncertainty regarding the durability of advancement and indemnification provisions contained in charter documents, and despite the revisions to Section 145(f ), directors and officers who had previously relied on such provisions were no longer confident that they were adequately protected in a post-Schoon world. In response to their growing uncertainty, directors and officers began to look for other mechanisms that could provide additional protection. With increasing frequency, indemnification agreements have become a popular method for directors and officers to address these concerns. Unlike charter documents which, according to Schoon, could be unilaterally amended to change a company’s obligations, the consent of both parties is required to change the terms of a contractual indemnification agreement, thus providing directors and officers with more durable and certain protection.

While indemnification agreements should be drafted to address the specific needs of a particular situation, certain provisions are fairly typical in these agreements. For example, indemnification agreements generally contain provisions that define the type of expenses and proceedings for which the indemnitee is entitled to receive indemnification (and advancement, if any). Depending on how these provisions are drafted, an indemnitee could be entitled to receive indemnification for a broad range of proceedings and expenses including actions like testifying as a witness or attending depositions; or the indemnitee could have such rights only in regards to a smaller scope of proceedings like those in which the indemnitee is the named defendant in a legal claim. Similarly, many agreements will explicitly list the types of actions for which the indemnitee is not entitled to receive indemnification (such as in situations where the director acted in bad faith). Indemnification agreements also typically address the priority of indemnification if the indemnitee is entitled to receive indemnification from multiple sources such as other indemnitors or from the company’s insurance carriers. Such provisions are particularly common in situations where a director sits on the board as a representative of an investment fund, as the director may be entitled to receive indemnification from both the company and from the investment fund. In such cases, the agreement would need to address which source would be primarily responsible for paying any indemnified amounts. Finally, indemnification agreements typically include a provision that describes how a company makes a determination of whether the indemnitee is entitled to indemnification (or advancement) and the avenues of recourse for the indemnitee, should it be determined that she is not entitled to such protections.

Note that the National Venture Capital Association provides a sample form of indemnification agreement, which is available on its Web site at http://www.nvca.org.

Where are we now?

As a result of the DGCL amendment, which took effect Aug. 1, 2009, most of the questions left open in the wake of the Schoon decision have been resolved. Codifying advancement and indemnification provisions in charter documents remains a viable means of offering protection to directors and officers. As amended, Section 145(f ) provides much-needed assurance that such protections cannot be unilaterally changed after the potentially litigious act occurs. Consequently, as long as the current statutory provisions remain in effect and unchanged throughout the director’s tenure, the director will be entitled to the same protection that the corporate world had assumed was available in a pre-Schoon world.

Despite the apparent victory for protective charter provisions resulting from the Delaware statutory amendment, the Schoon experience has been a valuable wake-up call for companies, directors and officers, and legal practitioners. Because charters and statutes retain the flexibility to be amended and modified, indemnification agreements are an increasingly attractive option for directors and officers, as the bilateral nature of such agreements provides the parties with certainty regarding the company’s obligations-without the worries that a company will attempt a Schoon-like maneuver.

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Originally published by the NCBA’s Business Law Section Section; Vol. 31, No. 1; October 2009; www.ncbar.org 


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