Director & officer indemnification and advancement provisions under Delaware law

May 2021 | EXPERT BRIEFING | BOARDROOM INTELLIGENCE

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Section 145 of Delaware General Corporation Law permits companies to commit to advance directors and officers (D&Os) for indemnifiable legal expenses. It also permits and requires indemnification of certain expenses to officers. At the threat of impending litigation, directors, officers or employees who have been granted mandatory advancement by their employers may request advancement of their litigation expenses to avoid out-of-pocket cost. In general, the director or officer is only obligated to repay the advanced funds if a court makes a final determination that the director or officer was not entitled to indemnification, for example because he or she acted in bad faith.

Advancement provisions are intended to protect corporate employees from dispensing personal funds and enhancing their abilities to mount a strong legal defence. Like the business judgment rule, advancement provisions are fundamental to Delaware’s policy of extracting maximum benefit for shareholders because these provisions allow officers to make business decisions without the risk of shouldering the personal cost of legal expenses should their decisions result in litigation.

Delaware courts will not ignore the broad language of indemnification and advancement provisions. These provisions are usually included in a corporation’s articles of incorporation, corporate bylaws or employment agreements. In determining whether to compel a company to advance legal fees or indemnify officers, courts treat these provisions as contractual obligations. As such, the breadth and scope of such provisions are determined by the language of the provisions. Accordingly, as broad advancement agreements become increasingly common, companies must be aware that they could be required to pay the litigation expenses of employees in a wide array of lawsuits, including lawsuits where the company is suing the director or officer for wrongdoing.

This article discusses the breadth and scope of broad, yet very common, indemnification and advancement provisions and the potential exposure for companies as it explores key Delaware decisions. It also provides practical guidance as to how a company can offer its D&Os advancement, but still protect itself from the ramifications and surprises of an overly broad provision.

The Delaware Court of Chancery and Delaware Supreme Court’s posture on indemnification and advancement positions

In Delaware, courts make advancement determinations in summary proceedings during the early stages of litigation. An order requiring a corporation to advance legal expenses is entirely independent of whether the officer or director is likely to prevail in his or her defence, or whether they will likely be entitled to indemnification.

Relatedly, while D&Os can never be indemnified for ‘bad faith’ actions, that limitation does not preclude advancement or bad acts in the event a court is unable to reach a final disposition on the merits of the allegation. The ‘bad faith’ limitation means that if there is a final disposition that the officer acted in bad faith he or she will not be indemnified. However, when there is no final disposition as to the former officer’s misconduct, but companies are left with the financial and public consequences of the officer’s conduct, companies can be compelled to indemnify their former employees nevertheless.

The Court of Chancery and the Delaware Supreme Court rely on the “by reason of the fact” language set forth in section 245 to determine whether the litigation or threat of litigation comes within the relevant indemnification and advancement provision. The standard is interpreted broadly and in favour of indemnification and advancement. The requisite connection is established “if the corporate powers were used or necessary for the commission of the alleged misconduct”, according to Freeman Fam. LLC v. Park Ave.

The most notable consequences of broad indemnification and advancement provisions are that even if the corporate officer abused their corporate role to act exclusively for personal gain, so long as they were acting in their capacity as a corporate officer, they will be entitled to advancement and indemnification, barring a final disposition as to the officer’s misconduct, and the corporation may be required to pay an officer or director’s legal fees to defend against claims asserted by the corporation – in other words, the corporation could be required to pay legal expenses on both sides of the litigation.

The decisions in Merritt–Chapman & Scott v. Wolfson, Perconti v. Thornton Oil Corp., Homestore v. Tafeen and Pontone v. Milso illustrate the breadth of the ‘by reason of the fact’ standard the Court of Chancery and Delaware Supreme Court apply to determine whether they should compel a company to advance legal expenses. First, in Merritt–Chapman & Scott v. Wolfson, Mr Wolfson, a former officer of Merritt–Chapman, sought indemnification for criminal proceeding where the government alleged that he participated in a scheme involving the purchase of the corporation’s stock which was aided by the use of inside information. In essence, Mr Wolfson was accused of committing fraud against the corporation’s shareholders because personal trading in the corporate stock was not related to the scope of the officer’s employment or his corporate responsibilities. Nevertheless, the court required the company to indemnify Mr Wolfson for legal expenses because he participated in the scheme using inside information which he possessed by virtue of his corporate status, and therefore the ‘by reason of’ requirement was satisfied.

Again, in Perconti v. Thornton Oil Corp., Mr Perconti, former chief executive of Thornton Oil Corp. traded commodities contracts with Thornton’s funds. Mr Perconti faced criminal charges for embezzlement and making false statements to hide improper conduct. At trial, the jury did not reach a unanimous verdict, therefore the court declared a mistrial, and the Department of Justice (DOJ) dismissed all charges. Mr Perconti sought indemnification for legal fees of approximately $300,000 arguing that the allegations in the criminal complaint were premised upon breaches of fiduciary duty that occurred by “reason of his status as [CEO]”. Thornton Oil argued in response that Mr Perconti’s conduct was purely for personal gain and should not be indemnified for his legal expenses. After reviewing the allegations in the criminal indictment, the Court of Chancery agreed with Mr Perconti that he is entitled indemnification for his legal expenses because the criminal allegations arose “out of the core of his duties to the corporation”.

Next, in Homestore v. Tafeen, Peter Tafeen was former officer of Homestore and head of the department that was responsible for transactions that resulted in accounting restatements. After the restatements, an onslaught of litigation ensued, including Department of Justice (DOJ) investigations, Securities and Exchange Commission (SEC) investigations and administrative proceeding, shareholder lawsuits and lawsuits by insurers. Homestore alleged that Mr Tafeen acted for this own personal gain of $15m and argued that he also acted with unclean hands by sheltering his assets in Florida, a creditor-friendly state, prior to seeking advancement. The parties cross-moved for summary judgment and the Court of Chancery denied both motions finding a material question of fact as to whether Mr Tafeen intended to shelter assets. On appeal, the Delaware Supreme Court affirmed the Court of Chancery’s holding that “if there is a nexus or causal connection between any of the underlying proceedings...and one’s official capacity, those proceedings are ‘by reason of the fact’ that one was a corporate officer, without regard to one’s motivation for engaging in that conduct”.

In Pontone v. Milso, Scott Pontone, former president and executive vice president (EVP) of York and its parent company Milso Industries, sought advancement of legal expenses for an action where the companies asserted claims against him. In the underlying litigation, the companies alleged that in his role as EVP, Mr Pontone had access to proprietary information and after this employment, misappropriated that information to solicit business for his new employer. The companies asserted claims for breach of contract, tortious interference, unfair competition, unjust enrichment, and trademark infringement and Mr Pontone asserted counterclaims. Milso argued that the claim asserted in the underlying litigation were not ‘by reason of’ Mr Pontone being an officer of the company because he was no longer an employee of the companies when he misappropriated their information.

Milso also argued that the counterclaims were not asserted in defending against the action, therefore he was not entitled to advances for legal fees. The court disagreed with Milso on both points. The court found that the allegations of misusing proprietary information that Mr Pontone acquired as an officer of the company were sufficient to establish that he was a party to the underlying action ‘by reason of’ being an officer of the company. In addition, the court held that Mr Pontone’s defamation counterclaim was asserted in ‘defending’ against the underlying litigation and concluded that Mr Pontone was entitled to advancement in asserting his defamation counterclaim against the companies.

Based on the foregoing decisions, the ‘by reason of fact’ standard would generally encompass claims of self-dealing, breach of fiduciary duty, misappropriation of company funds, breach of contract, asserted by the corporation or the government, for former officers that engaged in egregious misconduct. In addition, while the foregoing decisions are from the Court of Chancery which has exclusive jurisdiction over advancement cases, given the court’s role as the nation’s mother court for corporation governance, the impact of these decisions are certainly felt beyond Delaware.

Best practices for businesses offering mandatory advancement

As the Court of Chancery has warned companies, they should exercise business judgment when drafting indemnification and advancement provisions. Delaware law permits great flexibility for officers and companies to shape the terms of their governing relationship. Thus, companies can tailor indemnification and advancement provisions to avoid surprises when the threat of litigation arises. While businesses tend to rely on advancement offers to attract suitable candidates, companies should obtain a release of advancement obligations upon termination. Companies should also consider carving out specific exceptions for ‘bad actors’ rather than relying on a court’s final disposition concerning the officers’ bad acts.

In addition, where companies, rather than the government, institute legal proceedings against D&Os, a thoughtful litigation strategy may also aid companies in avoiding advancement obligations, or at least devastating consequences of those provisions. To the extent it is possible to do so, assert claims about post-termination conduct rather than claims such as breach of fiduciary duty, self-dealing, and misappropriation and misuse of confidential information which meet the ‘by reason of’ test. Specifically, the Court of Chancery has deemed claims for post-termination defamatory conduct and breach of non-compete or non-solicitation provisions to be personal disputes between an employer and a former employee and therefore do not come within the scope of the ‘by reason of fact’ standard.

Moreover, where companies do not foresee the threat of a request for advancement prior to the start of litigation, Delaware law also permits companies to amend their pleadings to alter their claim in a manner that eliminates advancement obligation.

Julia Beskin is a partner and Tenisha Williams is an associate at Quinn Emanuel Urquhart & Sullivan, LLP. Ms Beskin can be contacted on +1 (212) 849 7482 or by email: juliabeskin@quinnemanuel.com. Ms Williams can be contacted on +1 (212) 849 7264 or by email: tenishawilliams@quinnemanuel.com.

Julia Beskin and Tenisha Williams

Quinn Emanuel Urquhart & Sullivan, LLP