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Director and Officer Indemnification - How to Protect Former Directors and Officers After Their Resignation

West, Glenn D.

(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.[1] 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 to coverage.

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.[2]

Indemnification and Advancement of Expenses

Under the General Corporation Law of the State of Delaware, or DGCL, a corporation is required to 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.[3] 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.[4] 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.[5]

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.[6] 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.[7] 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.”[8] 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.[9] 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 days prior 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.[10] 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 case, 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.[11] 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.

Conclusion

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.

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  1. 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.
  2. 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.
  3. 8 Del. C. A4145(c).
  4. 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.
  5. 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.
  6. 8 Del. C. A4145(e).
  7. Beneficial Industrial Loan Corp. v. Cohen, 170 F.2d 44, 50 (3d Cir. 1948) (applying Delaware law).
  8. 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.”).
  9. 1992 Del. Super. LEXIS 564 (Del. Super. Oct. 8, 1992).
  10. 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).
  11. 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.
   
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