Emerging Views®

How Thick is the Armor Protecting Your Management?

Among the many truisms defining the American culture is the proposition that we live in a litigious society. As a matter of sound public policy designed to motivate highly qualified individuals to accept the risks associated with acting as directors and officers of corporations, the law provides mandatory and permissive indemnification rights. The range of such rights and corporate obligations should be understood before a triggering event occurs.

INDEMNIFICATION

Most if not all states confer certain statutory indemnification rights to executives. Since many states model their corporate laws on the precedents set by Delaware, this article is based on the Delaware Corporations Law and the cases decided under the Delaware General Corporations Law (the “DGCL”) by the Delaware courts. Section 145(c) requires corporations formed in Delaware to indemnify present or former directors and officers against expenses (including attorneys’ fees) actually and reasonably incurred in connection with any action, suit or proceeding against persons by reason of their position with the corporation (or a subsidiary) to the extent any such person has been successful on the merits or otherwise in defense against the action, suit or proceeding.

In addition to the mandatory rights, Delaware law also creates the opportunity for Delaware corporations to extend the scope of indemnification. Thus, with the Certificate of Incorporation, By-Laws or an Indemnification Agreement or Employment Agreement, a corporation may confer indemnification even to someone who has not made a successful defense as long as such person acted in good faith and in a manner the person reasonably believed to be in, or not opposed to, the best interests of the corporation. Under certain circumstances, indemnification can even be made available to someone convicted of a crime.

Defending against a claim, even one lacking merit, can be time-consuming and expensive. To create the opportunity for directors and officers to defend claims rather than simply settle them (as would often be the case if personal resources had to be spent in defense), Delaware allows corporations to provide “advances” to indemnified persons by paying defense expenses as they are incurred and in advance of the final disposition of the case, if the indemnitee agrees to repay such amounts in the event it is ultimately determined that indemnification for the individual was not permissible. Since advancements are not mandatory, the right must be created by an appropriate corporate instrument. That instrument can and should also state whether or not the corporation will require a form of security, such as a mortgage or other right of interest, for the undertaking. Ambiguity as to the form of undertaking exists if the security issue is not addressed ahead of time.

Litigation can create tensions between indemnities and the corporation. Lawsuits to enforce indemnification rights are not uncommon. Since the indemnification right is necessarily diminished if an indemnitee has to incur costs to receive the benefit, many corporations provide for the right to recover “fees on fees” if a claim is asserted to secure the right. That award is only available if it is provided for in the corporate documents.

INSURANCE

While indemnification by the corporation is important, it will not protect directors and officers in the event that the corporation is insolvent (or may become insolvent as a result of claims made against it or its directors). It is therefore crucial that a corporation also maintain adequate directors and officers insurance coverage (“D&O”). The following issues should be considered in any D&O policy evaluation:

Shared Policy Limits.

A typical D&O policy has several coverage components, providing coverage for (i) claims made against individual directors and officers (Side A coverage); (ii) claims by a company for reimbursement of indemnification payments made by it (Side B coverage); and (iii) entity coverage for claims against the company (Side C coverage). However, all insureds share the policy limits, i.e., a $1 million policy does not provide $1 million of coverage for each insured. To make matters worse, in a corporation’s bankruptcy, if an insurance policy includes Side C coverage, a court can freeze the D&O policy as a part of the bankrupt corporation’s estate, making it temporarily (if not permanently) unavailable to the directors and officers. As a result, the available coverage may be significantly reduced or exhausted before a claim is made by a director against the policy. Directors and officers should look for a policy which is dedicated or “stand-alone” (i.e., protects only directors and officers), or alternatively, an “order of payments” provision, specifying that the directors and officers shall have first claim to the policy proceeds.

Rescission.

Many D&O policies permit rescission of the policy if the application itself included any false representations (without regard to whether the director or officer seeking coverage knew of the misrepresentation). To protect against the risk of rescission, the policy should contain a “severability clause” – permitting the insurance to be rescinded only as to an insured with actual knowledge of the misstated facts.

Exclusion for Fraud.

D&O policies generally exclude from coverage claims arising out of criminal or fraudulent acts. Based on such limits, a director could be denied coverage based on a plaintiff’s allegations, or an insurance company’s self-serving assertion of misconduct by a director. It is important to make sure that the standard for the conduct exclusions in the D&O policy are spelled out clearly, such as requiring a final adjudication that the fraudulent conduct occurred.

CONCLUSION

Indemnification is a valuable benefit for corporate executives which, if properly designed, can work in conjunction with D&O insurance to reduce the distractions associated with corporate litigation. A periodic audit of the indemnification program in place with your corporation can ensure that appropriate protections exist. Considering the risks at stake, and the difficult issues raised, directors and officers may want to require that the corporation retain independent, outside legal counsel to review the corporation’s indemnification documents and D&O policy and assist with negotiating D&O coverage. Not surprisingly, price and coverage terms are better when there are serious competitors vying for the corporation’s insurance business months before renewal. For further information, please contact Mark S. Gregory via email or at (203) 973-5260.


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