The Basics: An Introduction to Indemnification and Advancement

Imagine sitting on the board of directors of a Fortune 500 company.  You might think it’s a life of corporate jets, cushy board meetings, and prestige.  (Although, the press will tell us, it’s not really that way anymore, thanks to Enron.)  But even if corporate service would truly be the good life, what would happen to you if an aggrieved shareholder sued you for allegedly breaching your fiduciary duties to the company?  Would you have to deplete your bank account to pay expensive lawyers for years of costly litigation?

The answer is found in the rights of indemnification and advancement (which we have previously discussed here, here, and here in connection with a trade secret case against a Goldman Sachs employee).  Indemnification and advancement are two overlapping, yet different, rights that corporate directors, officers, and employees may have when it comes to the payment of their legal fees in lawsuits brought against them because of their corporate service. 

Indemnification is the reimbursement of fees after those fees have been incurred.  This right, as the Delaware Supreme Court has written, “allows corporate officials to defend themselves in legal proceedings secure in the knowledge that, if vindicated, the corporation will bear the expense of litigation.”  The words “if vindicated” cannot be emphasized enough – they show that in order to establish a right to indemnification, the officer may have to prevail in the proceeding.

Advancement, meanwhile, is exactly what it sounds like: payment of fees by the company in advance of the final resolution of the proceeding.  Advancement is an important companion to the right of indemnification, because it provides officials with immediate relief from the financial burden of investigations and legal proceedings.  No vindication required – although the official may have to pay back what she receives if the final decision doesn’t go her way.

To determine an individual’s right to indemnification or advancement, courts will first look to the statutes governing the business, which may either require or permit those rights.  Because many companies are incorporated in Delaware, we’ll take a look at what Delaware law has to say on this subject.

First, Delaware corporate law permits a company to agree to repay an official’s reasonable legal fees for legal proceedings brought against her “‎by reason of the fact that [she] is or was a director, officer, employee or agent of the ‎corporation,” so long as she “acted in good faith and in a manner [she] reasonably believed to be in or not opposed to the best interests of the corporation.”  8 Del. C. § 145(a), (b). 

Second, Delaware law requires a company to indemnify an official for her fees when she is successful “on the merits or otherwise” in defending against an action brought against her because of her service to the corporation.  8 Del. C. § 145(c). 

Third, Delaware law permits a company to pay an official’s fees in “advance of the final disposition of such action, suit or proceeding upon receipt of an undertaking by or on behalf of such director or officer to repay such amount if it shall ultimately be determined that such person is not entitled to be indemnified by the corporation as authorized in this section.”  8 Del. C. § 145(e).  In other words, a company can advance an official’s fees, so long as the official signs an undertaking promising to repay the advances if she is later determined to have acted in bad faith or in opposition to the best interests of the company.

Courts will also examine the contracts between the official and the company, which may make mandatory what is merely permissible under the governing law.  For example, a company can adopt bylaws stating that it will indemnify all legal fees to the extent allowed by Delaware law, and that it will also advance all such fees.  See, e.g., Homestore, Inc. v. Tafeen, 888 A.2d 204 (Del. 2005).

Later this week, we’ll take a look at a recent decision in which an official of a Delaware limited liability corporation sought to enforce a contractual advancement right.  The decision provides an interesting look at how the governing law and private contracts can intersect with regard to an official’s rights to recover his fees.  We hope you’ll stay tuned.

• Executive Compensation
• Indemnification and Advancement
• The Basics