The Corporate Guide: Directors’ and Officers’ Indemnification Rights

How do advancement or indemnification rights arise?

Section 145 of the Delaware General Corporation Law (DGCL) allows corporations to protect present and former directors and officers from expenses incurred in connection with proceedings arising from actions taken in service to the company or at the company’s direction. These rights apply to threatened, pending or completed lawsuits or proceedings, where, by virtue of an individual’s role as a director or officer, the director or officer faces legal exposure or costs.

Does the scope of indemnification or advancement differ based on the type of action?

Yes it does. In a lawsuit or proceeding brought by a third party — those outside of the company and not in a derivative manner on behalf of the corporation — directors and officers may be indemnified for actual and reasonably incurred expenses, including attorney’s fees, judgments, fees and amounts paid in settlement.

If the threatened, pending, or completed proceeding or litigation is initiated by or on behalf of the corporation, the expenses indemnified typically are limited just to those expenses of litigation (including attorney’s fees) actually and reasonably incurred in defending against or settling the action. The corporation is not permitted to indemnify a judgment made against the indemnified party in favor of the corporation.

What types of conduct entitle a director or officer to advancement or indemnification?

The director or officer must have acted in a manner the director or officer reasonably believed to be in the best interest of the corporation. Consistent with this, “no indemnification shall be made in respect to any claim, issue or matter as to which such person shall have been adjudged to be liable to the corporation.” That said, there are some limited occasions where the Court of Chancery, upon application by the director or officer, might conclude, given the totality of the circumstances and despite the adjudication of liability, that the director of officer is fairly and reasonably entitled to indemnification for expenses that the Court of Chancery deems proper.

In a situation where the challenged conduct is personal in nature, the director’s or officer’s actions must not have opposed those of the corporation. In a criminal proceeding, it must appear that the director or officer had no reasonable basis to believe that their conduct was unlawful. Under DGCL Section 145(a), the termination of a criminal action by settlement, conviction or plea of nolo contendere “shall not, of itself, create a presumption” that the person did not act in accordance with the requisite standard of conduct.

When the director or officer has acted appropriately, is indemnification mandatory?

It depends. There are some situations where indemnification is mandatory, but in most circumstances whether a director or officer is entitled to indemnification depends on the plain language of the corporation’s bylaws or certificate of incorporation. In any event, it is a post-judgment decision that must await the outcome of litigation.

Indemnification is mandatory where the director or officer has been successful on the merits of either a third-party claim or a claim brought by or on behalf of the corporation. Otherwise, indemnification can be awarded to directors or officers currently serving the company, in accordance with its bylaws or certificate of incorporation (including in circumstances where the director or officer is unsuccessful):

• By a majority vote of directors who are not party to the proceeding
• By a committee of directors uninvolved in the litigation, who are selected by a majority vote of directors
• By independent counsel in a written opinion
• By the stockholders

With respect to former officers or directors, indemnification can be awarded by any person or persons with corporate authority to make such a decision.

When the director or officer has acted appropriately, is advancement mandatory?

No. It always depends on the scope of the advancement provision in the corporation’s bylaws, certificate of incorporation, or other governing document. Recently, the trend has been for corporations to adopt bylaw provisions for mandatory advancement, subject only to the director’s or officer’s obligation to provide an undertaking to repay amounts advanced if it is determined that the director or officer does not meet the standard for indemnification.

Under Section 145(e), a corporation may advance reasonable expenses, including attorney’s fees, in connection with third-party litigation or suits brought by or on behalf of the corporation. Advancement may occur only upon an undertaking by the director or officer that the director or officer will repay the amounts advanced, if found not to be entitled to indemnification. Even where the director or officer does not sign an undertaking, there is case law indicating that the receipt of advancements carries with it an implicit obligation to repay them if the recipient ultimately is not entitled to indemnification.

• Mariano v. Patriot Rail Co., 131 A.3d 325, 332-37 (Del. Ch. 2016) (opining that although the second sentence of Section 145(e) technically does not mention an undertaking, the receipt of advancements carries with it an implicit obligation to repay them if the recipient ultimately is not entitled to indemnification).

Advancement need not be authorized by the board — only the person or people with authority to act on behalf of the corporation in this matter. The decision to advance fees is not tied to the substantive evaluation of the director or officer’s conduct, unless it is clear that the director or officer would not be entitled to indemnification.

What happens if the director or officer disagrees with the corporation’s decision about advancement or indemnification?

The director or officer can file suit before the Delaware Court of Chancery. This will be a summary proceeding, which can proceed to a bench trial, usually within 45 and 60 days, or longer if the parties can agree to an extension. Given the summary nature of these proceedings, it is advisable to engage Delaware counsel as soon as practicable to ensure that you (as a director or officer) or your company is in the best position to prevail in an action to compel advancement or indemnification.