(August 2005, Private Equity Alert)
By Glenn D. West and Michael B. Farnell, Jr.
As part of a private equity sponsor’s
oversight role, its partners and associates regularly serve as directors
and/or officers of its portfolio companies. Serving in these capacities
is not without risk because these individuals may be included in derivative
and third-party claims from a number of private and governmental sources.
While a significant amount of attention is placed on protecting current
directors and officers, one aspect of portfolio company board or officer
service that receives less focus is the protection of directors and officers
after they resign or are otherwise removed from these positions.
The most well known layer of protection
is D&O insurance. As has been seen in our discussion of the PinkMonkey
case in the September 2004 issue of the Private Equity Alert, D&O insurance
does not protect directors and officers in all instances. Moreover,
while the typical D&O policy defines the “Insured” to include any
“past, present or future” director or officer of the named entity, once
a director or officer resigns from the corporation, such person is no longer
in a position to influence future decisions concerning renewals and modifications
Corporate indemnification obligations
are in fact the true first line of defense for directors and officers because
they set forth the rights of the directors and officers vis-a-vis the corporation
respecting their right to indemnification and advancement of expenses.
Corporate indemnification obligations are typically set forth in the corporation’s
bylaws, which in most cases can be amended by the corporation’s current
board of directors at any time. In this article, we will review the indemnification
and advancement of expense rights available to current and former directors
and officers of a Delaware corporation, how a former director or officer
can lose these rights and proposed methods for protecting these rights.
Indemnification and Advancement of Expenses
Under the General Corporation Law
of the State of Delaware, or DGCL, a corporation is required
indemnify both the current and former directors or officers of the corporation
against expenses actually and reasonably incurred if the particular current
or former director or officer seeking indemnification is successful on
the merits or otherwise in defense of any action, suit or proceeding brought
by reason of the fact that such person was a director or officer of the
corporation. In addition, a corporation may
indemnify its current
or former directors or officers against (i) judgments, fines, amounts
paid in settlement, and reasonable expenses, including attorneys’ fees,
in the case of a third-party action, and (ii) expenses, including attorneys’
fees (but not amounts paid in settlement or judgments), in the case of
an action by the corporation or a derivative action brought by a stockholder,
in each case incurred in any actual or threatened litigation brought by
reason of the fact that such person was serving in one of the previously
mentioned capacities. In order for an individual to qualify for what
is generally referred to as “permissive indemnification,” an appropriate
body, such as the board’s disinterested directors, must determine that
such individual has met the requisite standard of conduct.
However, the weakness of indemnification,
whether required or permitted by statute, is that the current or former
director or officer must either prevail in the action or have met the requisite
standard of conduct. This means that the director or officer must fund
a defense to reach the required result. In recognition of this, the DGCL
permits a corporation to advance the expenses incurred by a current or
former director or officer in defending third-party or derivative actions
without regard to a standard of conduct. As a condition precedent to
the advancement of expenses, a corporation is required to obtain from a
director or officer to whom expenses are advanced an undertaking to repay
any amounts advanced in the event that it is later determined that such
person is not entitled to indemnification.
Delaware corporations generally
obligate themselves to provide permissive indemnification and advancement
of expenses to their current or former directors and officers by including
these provisions in the certificate of incorporation or bylaws. In so doing,
these corporations create, in effect, contractual obligations to provide
the level of indemnification and advancement set forth in their constituent
documents. In addition, as will be discussed later in this article,
a corporation may directly contract with each director and/or officer to
provide such permissive indemnification and advancement of expenses.
The Risk of Amendment
Because a corporation is permitted
to modify its constituent documents, a significant risk facing a former
director or officer is that the corporation will amend its constituent
documents to modify or eliminate the permissive indemnification and advancement
of expense provisions. However, this power is not without its limitations.
A director’s or officer’s right to indemnification and advancement of
expenses set forth in the corporation’s bylaws is deemed under Delaware
law to be analogous to a contract between a director or officer and the
corporation. As such, these provisions cannot be unilaterally terminated
to the detriment of a current or former director or officer once such person’s
rights have “vested.” The key issue is when the director’s or officer’s
contract rights under the corporation’s bylaws “vest.”
Salaman v. Nat’l Media Corp.
appears to be the only Delaware case addressing this issue. In Salaman
Abraham J. Salaman was serving as a director of National Media. Forty-one
to Salaman’s resignation as a director, National Media
adopted a new set of bylaws that required National Media to provide permissive
indemnification and to advance expenses to current and former directors
or officers that were sued by reason of their service on behalf of the
corporation. Shortly after
his resignation, Salaman was named in
two lawsuits whose facts arose prior
to the adoption of bylaws which
required permissive indemnification and advancement of expenses. For some
time after the commencement of these lawsuits, Salaman submitted litigation
expenses to National Media and was reimbursed in accordance with National
Media’s bylaws. While the cases were still pending, National Media amended
its bylaws to provide for discretionary indemnification and advancement
of expenses - meaning National Media could decline to advance expenses
to or indemnify a current or former director or officer for any reason.
Shortly after National Media amended its “old” bylaws, it notified Salaman
that it was declining to advance any additional expenses because it was
no longer required to do so under its “new” bylaws. Salaman was then
forced to sue National Media to compel advancement of his expenses under
the “old” bylaw provision.
In its opposition to Salaman’s
summary judgment motion, National Media asserted, among other things, that
(i) Salaman was not entitled to advancement of expenses under the “old”
bylaws because the facts giving rise to the lawsuits occurred prior to
the adoption of the “old” bylaws, whose predecessor bylaws did not provide
for mandatory advancement of expenses and (ii) in any event, Salaman was
not entitled to advancement of expenses or indemnification going forward
because the “new” bylaws gave discretion to National Media to decline
advancement of expenses and indemnification. The Superior Court rejected
both arguments. First, the Court noted that the language of National Media’s
“old” bylaws explicitly covered claims against directors or officers
based upon when the claim was made against a director or officer and not
when the facts giving rise to a claim occurred. Second, the Court recognized
that indemnification and advancement provisions are treated like contracts
and cannot be unilaterally terminated once they have “vested.” Consistent with its rejection of National Media’s first argument, the Court held
that Salaman’s right to advancement “vested” when the lawsuits were
filed. In doing so, the Court stated that to hold otherwise “would make
the advancement benefits illusory.”
While the former director succeeded
in the Salaman
case, one can infer that the result could have been
different had National Media amended its “old” bylaws prior to the date
the claims were filed. This is a bigger risk than one might think, particularly
in the context of a sale of the corporation, because most buyers, including
private equity sponsors, amend and/or restate the certificate of incorporation
and/or bylaws at or after the closing. Generally speaking, this occurs
because the buyer’s counsel wants to standardize corporate documents for
all of the entities in a group of companies. As in the Salaman
it may also occur for less benign reasons. The danger is that the new “form”
documents may not provide the level of protection, or more important, the
certainty of protection, that the former director or officer enjoyed prior
to the closing.
Protecting Former Directors’ and Officers’ Rights
There are two ways that former
directors and officers can protect themselves from these potential pitfalls.
The first involves the context of a sale of the portfolio company, when
directors and/or officers leave en masse. In this instance, private equity
sponsors should insist the sale contract provide that the buyer maintain
at least the same level of protection in its constituent documents in effect
at closing for the applicable statute of limitations, generally six years.
One key addition for the effectiveness of this provision is the inclusion
of an express third-party beneficiary right in favor of the former directors
and officers. This permits the former directors and officers to directly
enforce the indemnification and advancement rights. However, a key weakness
of this type of provision and its variants is that the persons who will
ultimately determine whether a former director or officer has met the requisite
standard of conduct are generally not “friendlies.” Because of this,
these persons may or may not, depending on the circumstances, be sympathetic
to the plight of the former director or officer, especially if his or her
conduct was questionable or the amounts incurred are significant.
The best way for directors and
officers to protect themselves from amendments that strip their rights
under a corporation’s constituent documents is to avoid having to deal
with the constituent documents altogether. Instead, a director or officer
(or private equity sponsor) should insist, at the time of joining the corporation,
that the corporation enter into a separate indemnification agreement with
the director or officer. This gives the director or officer the independent
right to review and agree (or not) to any amendment. In addition, these
agreements customarily contain provisions that permit the former director
or officer to choose the method by which his or her entitlement to indemnification
will be determined. A common formulation permits the former director or
officer following a change of control to choose among the disinterested
directors, an “independent” counsel (meaning a law firm that has not
worked for the corporation for some agreed upon period of time) or the
stockholders as the body to determine whether such person has met the requisite
standard of conduct for permissive indemnification. While beyond the scope
of this article, there are also other provisions that are favorable to
current and former directors or officers that can also be negotiated in
a separate indemnification agreement given that these agreements are usually
only provided to directors and key management personnel.
Private equity sponsors should
consider evaluating their portfolio companies’ certificates of incorporation
and bylaws to make sure that they provide an appropriate level of indemnification
and advancement of expenses. In addition, (i) because private equity sponsors
are in the business of selling companies (and resigning from their positions
with these companies) and (ii) because of the frailties inherent in the
indemnification and advancement of expenses provided in a portfolio company’s
constituent documents, we would advise private equity sponsors to consider
implementing separate indemnification agreements for each of the partners
or principals who become officers and/or directors of the portfolio company.
This will provide private equity sponsors, partners and principals with
comfort on both the level and certainty of coverage following the sale
of the portfolio company.
* * *
- TIG Specialty Insurance
Co. v. PinkMonkey.com Inc., 375 F.3d 356 (5th Cir. 2004). In this case,
the 5th Circuit Court of Appeals held (i) that the chairman, chief executive
officer and majority shareholder of a start-up internet company gained
a personal profit by obtaining additional investment in the company and
thereby triggered a personal profit exclusion in the company’s D&O
insurance policy, and (ii) that the D&O insurance policy personal profit
exclusion excluded coverage not just for the insured chairman, CEO and
majority shareholder found to have gained a personal profit, but also for
the other insured directors and officers.
- Other state corporation
laws may vary, but we have focused on Delaware given the frequency with
which Delaware is the chosen law of incorporation for many portfolio companies.
- 8 Del. C. A4145(c).
- 8 Del. C. A4145(a). It
should be noted that the statute permits a corporation to also indemnify
employees or agents and/or persons serving at its request as directors,
officers, employees or agents of another corporation or other entity in
these circumstances. For the sake of simplicity, these persons are not
discussed in this article.
- In a third-party action,
the DGCL permits indemnification only if the individual has acted in good
faith, in a manner he or she reasonably believed to be in or not opposed
to the best interests of the corporation and, with respect to a criminal
proceeding, with no reasonable cause to believe his or her conduct was
unlawful. The good faith/reasonable belief standard also applies to an
action by the corporation or a derivative action brought by a stockholder,
except the corporation is prohibited from indemnifying a director or officer
for any judgment if such person is adjudged liable to the corporation in
an action by the corporation or a derivative action brought by a stockholder,
unless court permission to indemnify is granted.
- 8 Del. C. A4145(e).
- Beneficial Industrial
Loan Corp. v. Cohen, 170 F.2d 44, 50 (3d Cir. 1948) (applying Delaware
- III Ward, Welch & Turezyn,
Folk on the Delaware General Corporation Law, A4109.5 (stating that
“. . . the power to alter, amend, or repeal by-laws cannot confer authority
to make an amendment that amounts to the destruction or impairment of vested
or contract rights.”).
- 1992 Del. Super. LEXIS 564 (Del. Super. Oct. 8, 1992).
- It should be noted, however,
that a Delaware corporation cannot take away a current or former director’s
or officer’s right to indemnification if such person has prevailed in
the litigation because indemnification in such a case is statutorily mandated.
8 Del. C. A4145(c).
- Private equity sponsors
should also consider whether a “D&O tail” policy is necessary depending
on the nature of the company being sold. For instance, a “D&O tail”
policy is generally purchased in connection with the sale of a public corporation
because of the additional risk associated with public security holders
and the SEC.