Kang Haggerty News
Not all indemnification and advancement rights are created equal. While many companies provide broad and mandatory advancement rights to covered persons, some companies provide permissive advancement rights.
In the May 18, 2023 edition of The Legal Intelligencer, Edward T. Kang wrote “Officers and Directors Should Seek Mandatory Advancement Provision“
Advancement and indemnification are distinct but related legal concepts. Both work in tandem to encourage corporate action by officers and directors for the benefit of the company without fear of personal liability. Indemnification is the company’s promise to reimburse executives for out-of-pocket expenses and losses incurred in defending themselves against claims arising from their corporate action. Indemnification alone is not sufficient in many situations as the company’s duty of indemnification does not get triggered until the end of a lawsuit, which could force the executive to pay out of pocket for what could be very costly litigation during the lawsuit. This is where advancement comes into play. Advancement provides immediate relief to ensure that executives have the necessary resources to defend against claims. Since most cases settle before trial, advancement provides executives with a greater benefit to allay costs. This column serves as a compliment to my earlier column discussing these topics.
Not all indemnification and advancement rights are created equal. While many companies provide broad and mandatory advancement rights to covered persons, some companies provide permissive advancement rights. Permissive advancement provides that the corporation may pay for the legal fees for executives in advance. Too many times, permissive advancement is advancement in name only as the advancement obligation is highly discretionary, which makes the advancement language perfunctory—i.e., companies have the discretion to make advancement anyway without the permissive advancement language. In situations where the executive is sued along with the company by a third party, advancement is much more likely to be provided to protect both parties. But in situations where a dispute arises between the company and the executive, permissive advancement language is sometimes useless. This is due in part to companies not wanting to advance funds to an officer or director they have sued for some alleged wrongdoing.
Companies should not have such arbitrary advancement discretion. Not only does this expose their officers and directors to personal liability, but officers and directors often accept positions with the expectation of being protected for their services to the company. This is especially true for directors who are sometimes not even compensated for their services. Too often is the case that corporations will try to narrowly tailor their bylaws to avoid having to advance funds to executives. This is unfair to officers and directors who, rightfully so, anticipate an adequate level of financial protection when facing claims for actions carried out in their officer/director capacity.
In Brick v. Retrofit Source, C.A. No. 2020-0254, 2020 WL 4784824 (Del. Ch. Aug. 18, 2020), the court addressed whether a plaintiff was entitled to the advancement of legal fees as a member of the board of managers of TRS Holdco, LLC, which owned membership interests in Retrofit, despite his challenged conduct arising from his employment as COO of Retrofit. The plaintiff was accused of misleading the Holdco board by failing to disclose Retrofit’s customs policies for foreign imports. Eventually, the Holdco board opted to terminate the plaintiff’s employment with Retrofit, which prompted the plaintiff to demand advancement from Holdco. The court noted an important distinction between the two LLC’s bylaws: advancement for Holdco board members was mandatory, while advancement for officers of Retrofit was not. Accordingly, the court rejected the plaintiff’s claim for advancement citing that the claim related solely to his capacity as an officer of Retrofit, of which he was responsible for supply chain management and order fulfillment requiring compliance with customs policies. In other words, Holdco refused to advance expenses because it believed the challenged conduct arose from the plaintiff’s capacity as an officer of Retrofit, where advancement was permissive. The court agreed with Holdco and dismissed the plaintiff’s claim. This case demonstrates the danger of discretionary indemnification and advancement rights. Such discretionary advancement clause provides “benefits” in name only sometimes. Companies can often exercise as much or as little discretion as they choose, when making decisions related to indemnity and advancement. The prospect that such discretion will be exercised favorably upon an executive could be unlikely, which is why officers and directors need to review the language of the companies’ governing documents carefully.
Executives and directors face another hurdle when it comes to corporate discretion when bylaw provisions include language that advancement approval requires review by an “independent counsel.” This may occur even in situations where the director or officer has acted appropriately and therefore the executive should be given advancement. Generally, to receive advance expenses, the officers and directors only need to submit an undertaking letter—i.e., a letter promising to repay the company for all advancement payments should the court find the officer or director’s conduct not indemnifiable. But when the company has an independent counsel provision for advancement obligations, the executive could face significant hurdles before getting advancement. Given that this “independent” counsel is retained by the company to determine whether it will advance large sums of money to its officers and directors, there is a reasonable question as to the counsel’s impartiality. In other words, independent counsel may review such indemnification and advancement requirements in favor of the corporation and determine that an executive is not entitled to such protections and prevent the corporation from paying, whereas a court could disagree. To that end, “independent counsel” is contrary to the purpose of advancement, which is to protect officers and directors from the expenses of defending against claims before any adjudication as to the right of indemnification.
Keeping this in mind, executives should opt for a separate, written indemnification and advancement agreement which may provide a better understanding of their protections as compared to corporate bylaws. Otherwise, if there arises an issue as to impartiality or general disagreement, the director or officer’s only legal remedy is to file suit before the Delaware Court of Chancery. This generally is a summary proceeding taking place within 45 to 60 days. To ensure that their executive clients are afforded the utmost liability protection before or during their corporate service, practitioners should be aware of the following relatively recent revisions to Delaware corporation law. Section 145 of the Delaware General Corporation Law (DGCL) allows corporations to indemnify or protect present and former directors and officers from expenses incurred from legal proceedings that arose out of their service to the company or at the company’s discretion. In July 2020, the Delaware General Assembly made several revisions to 8 Del. C. Section 145, which authorizes (and at times requires) a corporation to indemnify its directors, officers, employees and agents for certain claims brought against them. This revision sought to provide greater clarity as to who exactly qualifies as an “officer” entitled to mandatory indemnification. The amendments clarify an “officer” to mean “the corporation’s president, chief executive officer, chief operating officer and the like, an individual identified in public filings as one of the most highly compensated officers of the corporation, or an individual who has provided written consent to be identified as an officer.” This section further provides that a corporation may indemnify “any other person who is not a present or former director or officer of the corporation against expenses actually and reasonably incurred by such person to the extent he or she has been successful on the merits … of any action, suit or proceeding.” This change is notable as before Dec. 31, 2020, the term “officer” in DGCL Section 145(c) went undefined.
More recently, in February 2022, Section 145(g) of DGCL was amended, authorizing a Delaware corporation to use captive insurance to protect its current and former directors, officers, and other indemnifiable persons rather than traditional, commercial D&O liability insurance. Captive insurance is generally provided by a subsidiary funded by the corporation as an alternative to purchasing commercial insurance. But there remain certain coverage restrictions when it comes to D&O exposure. The scope of D&O coverage allowed through a captive may not mirror the scope of coverage afforded in the commercial D&O market.
Together, mandatory advancement and indemnification along with commercial D&O policy offer officers and directors the best chance at protection against personal liability. Practitioners should be aware of recent revisions and review language in corporate documents and bylaws with their executive clients to appreciate the extent of personal risk. Additionally, they should recognize the dangers of bylaws granting excessive discretion to the company and of “independent counsel” making any determinations before proper adjudication by the court.
The Delaware Supreme Court has made clear in Homestore v. Tafeen, 886 A.2d 502, 502 (Del. 2005) that for advancement “to be of any value to the executive or director, advancement must be made promptly, otherwise, its benefit is forever lost” and the failure to advance fees may affect the executive’s choice of counsel and the litigation strategy they may afford. It makes little sense that the company is allowed to render the right to advancement illusory. It makes even less sense for an officer or director to self-fund the ongoing costs of defense arising from their corporate service. After all, litigation between the company and its officers and directors is often unfair to the officers and directors since the company has far-reaching advantages such as extensive financial funding.
To ensure that an officer or director has adequate coverage to limit their liability exposure, they should seek mandatory advancement provisions through bylaws, employment agreements or other documents. They should also seek commercial D&O insurance from a reputable carrier. By seeking traditional D&O insurance, executives could mitigate the risk of any uncertainty related to the untested nature of captives and protect themselves where a company is unable or unwilling to advance funds. This would put executives and the corporation they serve on an even playing field. Officers and directors are entitled to an adequate form of indemnification and advancement to limit the financial exposure associated with their corporate role. Practitioners representing officers and directors should advocate for the highest level of protection from personal liability by ensuring such benefits are actually conferred upon them, and not rendered illusory.
Edward T. Kang is the managing member of Kang Haggerty. He devotes the majority of his practice to business litigation and other litigation involving business entities. Contact him at ekang@kanghaggerty.com.
Reprinted with permission from the May 18, 2023 edition of “The Legal Intelligencer” © 2022 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited, contact 877-257-3382 or reprints@alm.com.