Indemnification and Expense Advancement

A recent decision from the Delaware Chancery Court has called into question the reliability of advancement and indemnification rights for directors of corporations that are incorporated in Delaware. Under the decision in Schoon v. Troy Corp, the Court enforced a bylaw amendment that eliminated a corporation's advancement obligations to a former director for an indemnification claim, even though the director seeking advancement had served under the corporation's prior bylaws and had left the board before the bylaw amendment.  The Court held that the former director's right to advancement did not attach until an indemnificable claim was asserted and the director named as a defendant.  Prior to the assertion of such a claim, the corporation was entitled to amend its bylaws to eliminate a director's right to advancement of expenses. 

Based on the Schoon ruling, until such time as a director is named in a proceeding for which advancement is available, the director has no vested legal right to advancement, and the director's rights can be lawfully terminated prior to a claim being filed.  This holding has the potential to disrupt director protections under Delaware law. Prior to Schoon, the commonly held notion was that a director's rights to advancement and indemnification vested by virtue of the director's service as a director and at the time of such service. It was understood, therefore, that advancement and indemnification rights could not be eliminated unilaterally by the director's corporation.  Schoon disrupts this settled expectation.  This disruption is significant since the advancement of expenses in corporation-related lawsuits, along with broad indemnification, is an important feature of director protection.  The decision may leave former directors, in particular, vulnerable to retroactive bylaw amendments affecting their right to advancement of expenses.

While the Schoon decision is still subject to appeal, it is recommended that all forms of business entities and the indemnified directors and officers review their indemnification and expense advancement provisions in their corporate documents to ensure that management is provided their intended level of protection and their rights to advancement and indemnification are not unduly exposed to retroactive amendments.  The following are some suggestions to consider in order to protect against retroactive elimination of directors' rights:

• Prohibit the retroactive amendment of indemnification and advancement provisions that would diminish or eliminate previously granted rights.  This can be done in the form of a savings clause: "any repeal or modification of the foregoing provisions [granting advancement and indemnification rights] shall not adversely affect any right or protection of a director or officer of the corporation with respect to any acts or omissions of such director or officer occurring prior to such repeal or modification.";
• Provide that the indemnification and advancement provisions are a contract between the corporation and the indemnified person; or
• Have the director or officer enter into a separate indemnification agreement with the corporation that would prohibit retroactive amendments.

Another key aspect of the Schoon decision is that the director in the case lost his anticipated rights after he left the board.  For directors and officers who have resigned or terminated their service with a corporation and are concerned that events could conspire that would leave them unprotected (whether through by-law revision, or as a result of discontinuance or exhaustion of the D&O insurance), a former director or officer may consider a so-called former director and officer liability insurance policy. This kind of coverage is buyer-specific; that is, it belongs exclusively to the individual director or officer, and would not be subject to termination or discontinuance by the action or inaction of others.

If you have any questions about these laws or any other corporate related matters, please contact Brian Collins at 312 261 2247.  Brian is a member of Pedersen & Houpt's Corporate and Business Counseling Group.

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