Serving as a director of a company, particularly a public company, can be no picnic. Earnings disappointments, activist stockholders, government regulation, and difficult succession issues can keep directors awake at night. They should not also have to worry about having to defend their board actions with their own personal funds. Corporations should be able to assure their directors that litigation costs will be paid by the company, subject to well-known exceptions (such as where the director is found to have violated his or her fiduciary duties).
Despite the importance of advancement and indemnification rights, Delaware law is far from certain as to the scope and limitations of these rights. Recent Delaware Chancery Court decisions, which come on the heels of Delaware corporation law amendments related to expense advancement, should trigger a careful re-examination of advancement and indemnification rights. In particular, boards and companies should know that:
• A company's bylaws may impose reasonable restrictions on expense advancements.
• The full scope of advancements and indemnification rights should, but does not necessarily have to, be contained in one document.
• Courts expect a director to be aware of the scope and restrictions of these protections as described in a company's charter and bylaws.
• A director may be entitled to these protections for defending against a company's counterclaim even if the original suit had been brought by the director against the company.
Advancement rights returned to the spotlight in 2008 with a controversial decision by the Delaware Chancery Court (Schoon v. Troy), which enforced a bylaw amendment that retroactively eliminated expense advancements to former directors. These directors, therefore, were on the hook for funding their own legal defenses. In the wake of Schoon, companies amended bylaws and entered into indemnification agreements with their directors to strengthen the advancement and indemnification rights and to prevent changes that would reduce these rights to the detriment of a former director. In response to Schoon, the Delaware legislature amended the corporation law to prohibit elimination of advancement rights after the occurrence of the action giving rise to the litigation, unless a specific provision explicitly authorized elimination. Following this amendment, many of the questions resulting from Schoon were resolved and the pressure to review these rights subsided.
Then, the Delaware Chancery Court issued two other opinions about expense advancement and indemnification rights: Xu Hong Bin v. Heckmann Corp. and Paolino v. Mace Security International, Inc. In Xu Hong, the court analyzed whether a bylaw provision that allowed a company to impose restrictions on the advancement of legal fees was consistent with the company's charter, which included an advancement provision, but not the restriction. In Paolino, a former CEO filed a demand for arbitration for wrongful discharge and breach of his employment agreement against his former company. In response, the company filed counterclaims asserting, among other things, breach of his fiduciary duties. The former CEO sought expense advancement to defend against the company's counterclaims.
As decided, Xu Hong makes clear that a Delaware corporation's bylaws may impose restrictions on advancements, even if not in the charter. The court noted that the bylaws had been adopted simultaneously with the charter and the court assumed that the drafters did not intend for the two documents to conflict. Additionally, both the bylaws and charter were in effect when the director began his service on the board and, accordingly, the director should have been on notice of the bylaw limitations. The court also noted that there is no requirement that conditions on advancements be included in the same document granting the advancement rights. Indeed, if such a requirement did exist, many indemnification agreements between companies and directors might not be enforceable. In Paolino, the court held that the director was entitled to advancement for defending against the company's counterclaims, which were not initiated by him but did include claims related to his fiduciary duties and, thus, were related to his service as a director. Because it was not practical to distinguish between expenses incurred by the director in his affirmative claims and defending against the counterclaims, the court ordered that all of the director's reasonable expenses must be advanced.
The decisions in Xu Hong and Paolino emphasize the need to thoughtfully review expense advancement and indemnification rights and to monitor developments in this area. As noted by the court in Xu Hong, directors are bound by any limitations on advancement and indemnification existing at the time they begin service on the board. Xu Hong also illustrates the importance of having consistent and well-integrated corporate documents that may affect advancement and indemnification rights. Directors who rely solely on the charter may be surprised to learn that they may be responsible for their own legal defense in the future.
If there are any questions, directors should consider indemnification agreements, which can provide clarity. Indemnification agreements can include detailed provisions defining the types of conduct for which advancement and indemnification are available, the method for determining whether a director is eligible for advancement and indemnification, the priority of payments, and the remedies available to directors for nonpayment. Additionally, indemnification agreements generally authorize indemnification to the fullest extent permitted by law as such law may be amended to increase any permitted indemnification. A well-drafted, specifically tailored indemnification agreement can benefit both a company and its directors and may prevent future litigation. â–
The author can be contacted at [email protected]. Audrey Burns, an associate with Drinker Biddle & Reath,assisted in the preparation of this column.
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