Securing protection

You have been a director of a corporation for a long time. Gradual shifts in the composition of the shareholder base and the rest of the board have left you feeling a bit out of place, and eventually you resign from the board. Two weeks after your resignation takes effect, the board amends the corporation’s bylaws to eliminate the requirement that the corporation indemnify former directors (such as you) against liability arising out of their service on the board. A month after that, you (along with the remaining members of the board) are sued by one of the newer shareholders for breach of fiduciary duty. The corporation advances defense costs to all of the remaining directors but not to you, citing the amended bylaw. ‘That amendment cannot possibly apply to this lawsuit,’ you protest. ‘I am being sued for things I did before the bylaws were changed!’ The corporation’s counsel replies, ‘I am sorry, but that’s the law.’

In Schoon et al v Troy Corporation, March 28, 2008, the Delaware Court of Chancery made clear that bylaws – together with director and officer liability insurance, the principal source of protection for corporate directors – may be amended to deprive a director or officer of indemnification rights in respect to a claim arising out of pre-amendment conduct, so long as the claim is brought after the amendment. Accordingly, directors and officers who wish to be sure of their indemnification rights will need indemnification agreements, which cannot be amended without the directors’ or officers’ consent.

The decision also sheds light on the court’s view of the proper approach to allocating defense costs among indemnified and non-indemnified persons and co-indemnitors.

The case in point

William Bohnen was a director of Troy, a performance material manufacturer registered in Delaware. He resigned in February 2005. Later that year, Troy amended its bylaws to eliminate the right of former directors to advance expenses incurred to defend claims. A few months after amending the bylaws, Troy sued Bohnen and another Troy director for breach of fiduciary duty. Bohnen asked Troy to advance his defense costs. Troy declined. Bohnen’s family company, which owned a minority interest in Troy, advanced Bohnen’s defense costs, and Bohnen sued Troy for advancement, agreeing to reimburse the family company out of any recovery from Troy. Bohnen lost. The court held that while a bylaw amendment cannot rescind a vested contract right, Bohnen’s right to advancement was not vested at the time of Troy’s bylaw amendment because no claim had been made against him at that time.

Troy’s bylaw amendment only eliminated Bohnen’s right to advancement. He was still entitled to be indemnified if his conduct met the applicable standards under Troy’s bylaws or Delaware law. However, it is clear under Schoon that the corporation could have deprived Bohnen of all right to indemnification by amending its bylaws before suing him.

The notion that bylaw indemnification rights vest (become non-rescindable) only when a claim is made against an indemnitee will strike many as unfair and, from a social policy point of view, misguided. For one thing, if, as the court acknowledges, the bylaws constitute a contract between the indemnifying corporation and the indemnified director, it seems clear that the bargain struck on this point was: ‘If the director serves, the corporation will indemnify the director against claims arising out of that service.’ The director cannot go back after the amendment and undo the pre-amendment service that could give rise to claims against which the director is suddenly no longer indemnified.

In addition, the ‘no vesting until claim’ rule turns the power to amend the bylaws into a weapon. Corporations intending to sue directors or officers will be motivated to amend their bylaws before doing so to eliminate indemnification rights, in order to increase the pressure on the director or officer to settle.

An appropriate response

The only certain way for a director to avoid Bohnen’s fate in Schoon is to insist that the corporation provide indemnification rights via a separate agreement, which, as a real contract, cannot be amended without the director’s consent.

Corporations may also consider including in their bylaws a provision intended to override the Schoon principle such as a clause to the effect that ‘no amendment to these indemnification provisions shall affect any right in respect of acts or omissions of any indemnified person occurring prior to such amendment.’ There is no downside to including such a provision, but there can be no assurance that it cannot be amended away, just like Bohnen’s right to advancement.

Where feasible, including full indemnification provisions in a corporation’s charter, instead of or in addition to the bylaws, would at least make it necessary to get approval by the shareholders – and not just the board – of an amendment intended to deprive directors of protection. For a closely held corporation, where the shareholders and board may be the same people or at least have a very similar perspective, this may provide little practical comfort. In the case of a public company, it would enhance the protection significantly, but a public company that does not already provide for indemnification in its charter – most don’t – may be reluctant to seek shareholder approval of the amendment that would include it.

Learning your lesson

The Schoon court also held that when a law firm represents both indemnified persons and non-indemnified persons, and the firm’s fees are not recorded and billed completely separately, the allocation of indemnified and non-indemnified fees will be done per capita – ie, if the firm represents two directors, one indemnified and one not, the indemnifying corporation will be required to pay half of the fees – and the court will not seek to allocate fees more precisely.

This rough justice is extra gritty, because it effectively requires the indemnifying corporation to pay for only 50 percent of the work that is common to the two defenses, even though 100 percent of that work would likely have been required had the law firm been representing only the indemnified director.

The court makes this justice even rougher by suggesting that the corporation is only required to pay legal fees relating ‘solely’ to the indemnifiable matter. If strictly applied, this standard could deprive the indemnified director of protection for the cost of work benefiting both indemnified and non-indemnified directors.

Law firms in this situation should pay special attention to their time recording and billing allocations.

In Levy et al v HLI Operating Company, May 16, 2007, the court also limited the reach of the ruling that indemnitees who have recovered their expenses from another source may not pursue an indemnity claim against the corporation.

Directors were denied indemnification in Levy because a private equity fund with which they were affiliated had already reimbursed them. In Schoon, the court rejected Troy’s argument that, under Levy, the fact that Bohnen’s defense costs had already been paid by his family company required that his claim against the corporation be denied. In its opinion, the court noted that the private equity fund in Levy was obligated to indemnify, while the family company in Schoon, apparently, was not. But the court may have also been influenced by the fact that in Schoon, Bohnen made the existence of the prior indemnification known to the court, while in Levy the court appeared miffed that the directors seeking indemnification had not disclosed up front that they had already been indemnified.

In light of the Schoon decision, directors and officers who are not already party to indemnification agreements should consult their own or their corporation’s counsel.

Note: This article is an expanded and edited version of an article that article originally appeared in the Summer issue of the Debevoise & Plimpton private equity Report