Director and Officer Indemnification and Insurance in Turbulent Times

December 3, 2008

Over the past year, turmoil in the financial markets has led to increased litigation, and the high-profile failures of several major financial institutions have focused attention on the protections that are available for directors and officers of public companies.  Fortunately, it is still rare for directors and officers to contribute personally to the settlement of a lawsuit.  However, more than ever before, strong indemnification protections and comprehensive insurance for directors and officers ("D&O insurance") are vital to a company’s ability to attract and retain qualified directors and officers.  This client alert discusses several recent developments in the areas of director and officer indemnification and D&O insurance and then concludes by offering practical suggestions on what companies can do to navigate the complexities involved in these areas.

A.  Recent Indemnification Developments

It is critically important for companies to consider the scope of the indemnification and advancement rights that they intend to grant and to draft their indemnification and advancement provisions carefully.  In recent months, the Delaware courts have decided a number of cases that illustrate the importance of these issues. 

Schoon v. Troy: Retroactive Limits on Advancement Rights

In March 2008, in Schoon v. Troy Corp.,[1] the Delaware Court of Chancery held that a former director of Troy Corporation was not entitled to advancement of his legal fees where, subsequent to the director’s departure from the board, the company revised its bylaws to eliminate advancement rights for former directors.  At the time of the former director’s resignation, Troy’s bylaws expressly provided indemnification and advancement rights to former directors.  Thereafter, however, the board amended the bylaw granting advancement rights to remove the word "former."  The bylaws had no language stating that the rights granted in the indemnification and advancement provisions were contract rights.  Troy later asserted breach of fiduciary duty claims against the former director, who then sought a court ruling that he was entitled to advancement.  The Delaware Court of Chancery strictly construed the bylaws and rejected the former director’s argument that his advancement rights became vested at the time he took office as a director and could not be unilaterally changed thereafter.  Instead, the Court concluded that the right to advancement vested only once litigation was actually filed.  In Schoon, Troy did not file the litigation against its former director until after the director had left the board and the board had amended the bylaws to eliminate advancement for former directors.  Section C below discusses steps that can be taken to prevent the result that occurred in the Schoon case.

Barrett: Enforcing Companies’ Advancement Obligations

In Barrett v. American Country Holdings, Inc.,[2] the Delaware Court of Chancery concluded that a company’s directors and officers had a clear right to advancement under the company’s charter and sharply criticized the company’s attempts to extract a settlement from the former directors and officers by arguing that they had forfeited that right as a result of refusing to settle the company’s claims against them.  The plaintiffs were former American Country directors and officers who were suing for enforcement of their advancement rights in connection with litigation that the company had initiated against them.  The D&O insurer had been advancing fees for the defense of that action, but the policy limits were about to be exhausted, so the directors and officers asked the company to confirm that they were entitled to advancement of their legal fees going forward.  The company failed to respond, and the directors and officers sued.  Despite clear terms in its charter requiring advancement, the company took the position that the directors and officers had forfeited their right to advancement by unreasonably rejecting the company’s offers to settle the litigation against them. 

The Delaware Court of Chancery rejected the company’s arguments, describing the company’s position as "truly astounding," and "stunning for its lack of basis in law, logic or common sense."  According to the Court, the company’s suit against the directors and officers entitled them to "put up a vigorous defense," and to have the company honor its contractual advancement obligations in doing so.  The Court went on to state that "[a]n important part of the policy rationale supporting indemnification and advancement is that corporate officials should be able to defend not only their pocketbooks, but also their good names."  The Court made clear that "a defendant who faces claims of official wrongdoing and who is owed advancement rights is entitled to have those rights honored precisely so that she can defend her good name and personal wealth."

In concluding that the directors and officers had a clear right to advancement, the Court noted, as it has in previous cases, that if companies wish to avoid advancing expenses in certain circumstances, such as where they believe an individual may have acted improperly, then they should draft their advancement provisions differently.[3]

Sun-Times Media Group: Duration of Advancement Obligations

In Sun-Times Media Group, Inc. v. Conrad M. Black, et al.,[4] the Delaware Court of Chancery answered the question of what constitutes a "final disposition" where a company has agreed to provide mandatory advancement of legal fees through the final disposition of a proceeding.  The Sun-Times case involved four former officers of the company who had been convicted of criminal charges at the trial court level and had been sentenced.  After their sentencing, Sun-Times informed its former officers that it would no longer advance expenses to them.  Like many public companies, Sun-Times had undertaken an obligation to pay expenses incurred by its directors and officers "in advance of the final disposition" of an action, suit or proceeding.  At the time that the Delaware Court of Chancery heard the case, the U.S. Court of Appeals for the Seventh Circuit had affirmed the convictions, but the time period in which the former officers could file a petition for certiorari with the U.S. Supreme Court had not yet expired.  The Court held that the "final disposition" of an action, suit or proceeding means a "final, non-appealable conclusion of that proceeding" and that, because appellate proceedings were not yet concluded, Sun-Times remained obligated to advance expenses to its former officers despite their conviction and sentencing.  The Court based its holding on the "final disposition" language of the Sun-Times bylaws and the corresponding provision of the Delaware corporations statute, the Delaware public policy favoring advancement of expenses, and the practical difficulties that would arise if each successive stage of a legal action were considered a separate proceeding in which a "final disposition" could occur. 

The Sun-Times opinion discussed at some length the Delaware Court of Chancery’s earlier decision in Bergonzi v. Rite Aid Corp.[5]  In Bergonzi, the Court held that Rite Aid remained obligated to continue advancing expenses to a former officer who had pled guilty to participating in a criminal conspiracy to defraud Rite Aid.  Rite Aid’s charter included an advancement provision that was identical in substance to the provision in the Sun-Times bylaws.  The Court concluded that, even though the former officer had pled guilty, his proceedings had not reached a "final disposition" because he had not yet been sentenced. 

Jackson Walker: Mandatory Indemnification for Agents

In addition to providing directors and officers with mandatory indemnification and advancement rights, some companies (although a smaller number) extend mandatory rights to employees and to agents as well.  Another recent Delaware case suggests the need to consider whether it remains appropriate to provide agents with mandatory indemnification and advancement rights.  In Jackson Walker L.L.P. v. Spira Footwear, Inc.,[6] the Delaware Court of Chancery held that Spira’s outside litigation counsel was an "agent" under the company’s indemnification bylaw.  The Court defined the term "agent" in the indemnification context to include individuals and organizations, such as a law firm, that act on behalf of a company in relations with third parties.  The Court distinguished between different types of legal services that can result in agent status for indemnification purposes, stating that the concept of "agent" would not include a lawyer who acts as a legal advisor to a corporate client but does not act on the client’s behalf with respect to third parties.  Conversely, the Court concluded that attorneys representing a client in litigation would be considered agents because they have the ability to bind their clients in dealings with the court and other parties to the litigation.  Based on this definition, the Court held that Spira had to advance expenses to its outside litigation counsel under a bylaw provision that mandated advancement of expenses to directors, officers, employees and agents.  In reaching its decision, the Court observed that "Delaware courts understandably proceed with caution in granting advancement and indemnification to agents in general, and to attorneys in particular," but that Delaware law gives companies the option of indemnifying and advancing litigation expenses for their agents.  In light of this, the Court cautioned that companies are free to craft narrower bylaws and to provide narrower indemnification and advancement rights in their agreements with outside contractors.

Levy v. HLI Operating Co.: Indemnification in the Private Equity Context

Finally, in a case that may have ramifications for private equity investors, the Delaware Court of Chancery in Levy v. HLI Operating Co.[7] addressed the relative indemnification obligations of a private equity fund and one of its portfolio companies.  Private equity funds routinely appoint fund representatives to serve on the boards of directors of their portfolio companies.  Prior to Levy, the expectation was that a portfolio company would be primarily liable for satisfying indemnification obligations if a fund representative were sued in his or her capacity as a director of the portfolio company.  The Delaware Court of Chancery, however, held in Levy that the private equity fund and its portfolio company owed concurrent indemnification obligations and each was therefore responsible for half of the amounts paid in respect of these obligations to the fund representatives serving on the board of directors of the portfolio company.  A subsequent case confirmed that parties can contract around this result by making explicit that indemnification obligations of a private equity fund are secondary to the obligations of a portfolio company.[8]

B.  Recent D&O Insurance Developments

Today, it is not uncommon for D&O insurance programs at large public companies to include multiple layers of excess coverage, each issued by a different insurer, in addition to the primary insurance policy.  There are also new types of policies designed to protect non-management directors.  D&O insurance is a complex field where minor language differences can mean the difference between having coverage and not having coverage.  Several recent cases demonstrate the importance of reviewing policy language carefully and understanding exactly when D&O insurance policies will provide coverage.  

Excess Insurance Policies

In the excess policy area, two recent cases suggest that companies should pay particular attention to "trigger" language, which establishes when coverage becomes available under an excess policy.  Excess policies will often state that coverage attaches only after the underlying insurance has been exhausted by the actual payment of losses by the insurers.  This language can be problematic where an underlying insurer does not pay, whether due to a coverage dispute, financial inability or insolvency, or otherwise.  For example, if an insured settles a claim within the limits of its primary policy, pays the difference on the claim up to the primary policy limits, and seeks coverage from its excess insurers for payments in excess of those limits, coverage may not be available because the policy language stipulates that the insurers must have paid up to the underlying policy limits. 

This outcome occurred in a case involving Qualcomm, Inc.,[9] in which a California appellate court held that Qualcomm’s excess insurer had no legal obligation to cover a claim where the company had settled with an underlying insurer for a payment that was less than the full policy limits.  There, Qualcomm’s primary insurance had an aggregate limit of $20 million, and the settlement with the insurer resulted in a payment of $16 million, leaving a "gap" of $4 million.  Although it was undisputed that Qualcomm had additional settlement and defenses costs of over $12 million, the Court concluded that the excess insurer should bear no coverage obligation for any of that amount.  The Court stated that "[t]he exhaustion clause here compels us to conclude that the parties expressly agreed that [the primary insurer] was required to pay (or be legally obligated to pay) no less than $20 million as a condition of [the excess insurer’s] liability."  The Qualcomm decision followed a similar ruling by a Michigan court in mid-2007 in a coverage dispute involving an excess policy issued to Comerica Inc.[10] 

In another case involving an excess policy, a court held that an excess insurer was not bound by the actual or implied coverage decisions of the primary insurer.  In Allmerica Financial Corp. v. Certain Underwriters at Lloyd’s, London,[11] Allmerica sought payment from its primary and excess insurers following settlement of a class action lawsuit.  Like many excess policies, the excess insurance policy at issue in the case was a "follow-form" policy.  Excess policies generally are "follow-form" of a primary policy, meaning that they provide coverage on the same terms as the primary policy, except to the extent that any provisions in the follow-form policy are more restrictive than those in the primary policy.  The primary insurer in Allmerica paid out the full amount of the policy, but the excess insurer denied coverage on the basis that certain policy exclusions applied.  The Supreme Court of Massachusetts held that the excess insurer was not bound by the actual or implied coverage decisions of the primary insurer.  The "follow-form" nature of the policy did not change the fact that the excess policy was a distinct agreement.

Insurer’s Consent to Settlement

D&O insurance policies typically contain a provision requiring the consent of the insurer before an insured enters into a settlement, often coupled with a proviso that consent may not be "unreasonably withheld."  Earlier this year, a court enforced the consent provision in a D&O insurance policy and held that, as a result, The Bear Stearns Companies, Inc. had no coverage under the policy for settlement amounts it agreed to pay without the insurer’s prior consent.  In Vigilant Ins. Co., Inc. v. The Bear Stearns Cos.,[12] the New York Court of Appeals held that Bear Stearns violated the consent provision in its D&O insurance policy by entering into a settlement with the SEC, in which it agreed to pay $80 million to resolve an outstanding investigation into alleged analyst conflicts of interest, before notifying its D&O insurer or obtaining the insurer’s approval.  The Court of Appeals, applying New York law, therefore granted the insurer’s motion for summary judgment and held that Bear Stearns could not recover the settlement proceeds from the insurer.  Importantly, the Court focused on the language of the D&O insurance policy exclusively; it did not require the insurer to demonstrate that it had suffered any prejudice from Bear Stearns’ failure to obtain prior consent.

C.  What Companies Should Do Now

Recent cases involving indemnification and D&O insurance demonstrate the complexities involved in this area and the need for regular, thorough reviews of the protections provided to a company’s directors and officers.  Accordingly, companies should:

1.  Periodically review the indemnification provisions in their charters and bylaws to assess whether they are state-of-the-art.  Recent Delaware cases illustrate that courts will enforce indemnification and advancement provisions in a company’s organizational documents as written.  In light of this, companies should carefully consider the nature and extent of the protections they intend to provide to their directors and officers.  In particular, companies should assess whether their charters and bylaws accurately reflect those protections and confirm that the charter and bylaws are consistent if both documents contain indemnification provisions.  To the extent that a company wishes to limit rights in particular situations, it should build those limitations into the charter and bylaws.  For example, we are aware of a handful of large companies that give discretion to the board of directors or another decision-maker to curtail the advancement of expenses to directors and/or officers if a determination is made, based on the facts and circumstances, that an individual acted improperly.  Delaware courts have declined to impose such a limitation after-the-fact where a company’s organizational documents mandate advancement to the fullest extent permitted by law. 

It is particularly important for companies to review the indemnification provisions in their charters and bylaws if they do not have indemnification agreements.  In the absence of agreements, more detailed provisions may be appropriate in the organizational documents, including provisions that address procedural matters such as the process and time frames for obtaining indemnification and advancement.  In light of the Schoon decision, it is also important for companies that are relying on indemnification bylaws to make sure that the bylaws include language stating that the rights of directors and officers vest upon commencement of service, that these rights are contract rights, and that the bylaws cannot be retroactively amended in ways that diminish those rights. 

2.  Consider whether it is appropriate to enter into indemnification agreements with directors and officers.  There is an emerging trend among Fortune 500 companies toward adopting indemnification agreements, although some companies have instead opted to add more detailed provisions to their charters or bylaws.  Indemnification agreements have a number of advantages over including indemnification provisions in the organizational documents, including the following:

  • Fewer enforceability issues.  Indemnification agreements may be more easily enforced by directors and officers because these agreements are bilateral contracts reflecting bargained-for consideration in the form of an individual’s agreement to accept or continue service with the company.
  • Protection against unilateral amendment.  Indemnification agreements are not subject to unilateral amendment or rescission by the company.  This may be of particular importance to directors and officers following the Schoon decision (although this can be addressed in the bylaws, as discussed above).
  • Ability to address rights in more detail.  Indemnification agreements are typically more thorough than charter or bylaw provisions.  They often include detailed procedures and timeframes for determining when individuals are entitled to indemnification and offer clarity on the types of claims and proceedings that are covered (such as hearings and investigations).  Indemnification agreements can provide rights that go beyond those granted in a company’s organizational documents, but care should be taken to ensure that rights granted in an indemnification agreement are otherwise consistent with those set forth in the charter and/or bylaws.    
  • Psychological impact.  Indemnification agreements may provide a degree of comfort to directors and officers that is not present with a generally applicable charter or bylaw provision.

Companies also should consider who should receive indemnification agreements.  Among those companies that have agreements in place, most provide agreements to both their directors and officers, but practices do differ.  Companies with large numbers of officers often limit indemnification agreements to a group consisting of the most senior executives. 

3.  Review D&O insurance coverage annually and seek professional advice.  Companies should assess carefully the amount and scope of coverage in their D&O insurance program.  They should be mindful that terms and conditions differ from one policy to the next, and that policy forms are negotiable.  For companies purchasing excess coverage, it is important to keep in mind, as evidenced by the recent cases discussed above, that terms and conditions in excess D&O insurance policies do not automatically "follow form" over the underlying primary policy.  Policy language matters, so it is critical to scrutinize the language carefully and understand what is and is not covered.  Due to the complexity of policy language and the issues involved, expert advice from qualified insurance and legal professionals can be important in obtaining a thorough understanding of the coverage available under a company’s D&O insurance program.  A growing number of boards of directors are seeking comprehensive analyses of their companies’ D&O insurance programs, undertaken with the assistance of experts, in connection with the purchase or renewal of D&O insurance coverage.

4.   Consider priority issues in situations involving multiple sources of indemnification.  In situations where individuals have may indemnification rights from multiple sources – such as where a private equity fund appoints a representative to sit on a portfolio company board of directors – the parties involved should examine these rights and consider how they work together.  Appropriate agreements should be implemented in order to reflect the parties’ intentions regarding the priority of the indemnification obligations. 

  [1]   Schoon v. Troy Corp., 948 A.2d 1157 (Del. Ch. 2008).

  [2]   Barrett v. American Country Holdings, Inc., 951 A.2d 735 (Del. Ch. 2008).

  [3]   See id. at 747 n. 39 ("One wishes that the tsunami of regret that swept over corporate America regarding mandatory advancement contracts would have been followed by the more careful tailoring of advancement provisions, with a diminishment (especially as to officers) of the mandatory term that seems to so bother directors faced with the responsibility of actually ensuring that the corporation honors its contractual duties once a (typically) former officer is sued or prosecuted for fraud or other serious wrongdoing.  Although it is uncomfortable to cause the corporation to advance millions in fees to a former officer the current board believes engaged in serious misconduct, it does stockholders no service for a board to refuse to do so when the advancement obligation is clear.  If the directors in such a situation truly wish to serve the stockholders, they should fix what they can by revising the corporation’s advancement obligations on a going-forward basis.  To breach a contract because you do not like its terms while refusing to change it when you have the authority to do so is hard to explain as an act of appropriate fiduciary fortitude.").

  [4]   Sun-Times Media Group, Inc. v. Conrad M. Black, et al., 954 A.2d 380 (Del. Ch. 2008).

  [5]   Bergonzi v. Rite Aid Corp., 2003 Del. Ch. LEXIS 117 (Del. Ch. Oct. 30, 2003).

  [6]   Jackson Walker L.L.P. v. Spira Footwear, Inc., 2008 Del. Ch. LEXIS 82 (Del. Ch. June 23, 2008).

  [7]   Levy v. HLI Operating Co., Inc., 924 A.2d 210 (Del. Ch. 2007).

  [8]   Sodano v. American Stock Exch. LLC, 2008 Del. Ch. LEXIS 92 (Del. Ch. July 15, 2008).

  [9]   Qualcomm, Inc. v. Certain Underwriters at Lloyd’s, London, 73 Cal. Rptr. 3d 770 (Cal. Ct. App. 2008).

[10]   Comerica Inc. v. Zurich American Ins. Co., 498 F. Supp. 2d 1019 (E.D. Mich. 2007).

[11]   Allmerica Financial Corp. v. Certain Underwriters at Lloyd’s, London, 871 N.E.2d 418 (Mass. 2007).

[12]   Vigilant Ins. Co., Inc. v. The Bear Stearns Cos., Inc., 884 N.E.2d 1044 (N.Y. 2008).

 Gibson, Dunn & Crutcher LLP 

Gibson, Dunn & Crutcher lawyers are available to assist in addressing any questions you may have about these developments.   For more information, please contact the Gibson Dunn attorney with whom you work, or any of the following: 

John Olson (202-955-8522, [email protected]),
Jonathan Dickey (212-351-2399, [email protected]),
Amy Goodman (202-955-8653, [email protected]),
Gillian McPhee (202-955-8230, [email protected]) or
Jennifer Boatwright (214-698-3427, [email protected]).

© 2008 Gibson, Dunn & Crutcher LLP

Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.