Indemnity

Defining Indemnity

In general, corporate officers and directors act responsibly and perform the fiduciary duties that are required of them under the law. However, it is foreseeable that some individual directors (or even whole boards) may act in a tortuous or criminal manner and subject the company to liability. Whether that liability is accidental or criminal is ultimately an important question, but the immediate issue is whether or not the company should have to pick up the tab for such actions on the part of its employees?

This question, though simple on its face, is fairly complex. On the one hand, it seems fairly clear that if a corporate employee has intentionally acted in a criminal or tortious manner, then she should be responsible for her own legal costs. However, can a single individual, such as a CEO, be held wholly responsible for all the loss of a company based on her tortuous act? Moreover, how should this work when it comes to the director who got into trouble only by accident or on the basis of a genuine belief that she thought what she was doing was legal and correct?

In the final analysis, indemnity is the legal system that has evolved to help remedy this situation. Typically, a company will identify a group of its most powerful individuals – usually the board and any chief executives – and insure both the company and the employee for actions that cost the company money. The purpose of this insurance is two-fold:

- Litigation Expense: Everyone knows that lawsuits are expensive. Indemnity insurance usually serves to cover the expenses of the company, and occasionally those of the directors and officers, if a suit is brought against the company or management due to the executives’ actions.

- Loss / Damages: Insurance for indemnity purposes will also often cover damage awards and potential loss to the company associated with management’s missteps.

Indemnity, like any system of insurance and responsibility shifting, is a complicated issue. However, it is important to understand its basic function as a tool to help protect the company and management from accidents or events that cost the company money because the directors and officers failed to fully perform their duties.

EXAMPLE: While ABC Co. felt that its board was very well equipped to handle most corporate choices, the firm was worried that, because it competed in a high-tech market and had a large public float, the management could easily make a choice that cost the company a great deal of money and might give reason for investors to sue. As such, the firm decided to purchase indemnity insurance in order to protect its directors and itself from any such situation.

When May the Company Indemnify Employees?

As was mentioned above, there are certain circumstances when it seems either appropriate or inappropriate to indemnify corporate directors and officers for their actions and legal expenses. The law, however, has largely made these choices for companies. Most states have created rules that govern when, and to what extent, a company may indemnify its directors. While the rules vary from state-to-state, the general standards are as follows:

Permissible Indemnification
(a) Except as otherwise provided in this section, a corporation may indemnify an individual who is a party to a proceeding because he is a director against liability incurred in the proceeding if:

1. (i) he conducted himself in good faith; and 
   (ii) he reasonably believed
   - in the case of conduct in his official capacity, that his conduct was in the best interests of the corporation; and
   - in all other cases, that his conduct was at least not opposed to the best interests of the corporation; and
   (iii) in the case of any criminal proceeding, he had no reasonable cause to believe his conduct was unlawful;
   
   or
   
   
2. he engaged in conduct for which broader indemnification has been made permissible or obligatory under a provision of the articles of incorporation.

- Intentional / Willful Acts: If a corporate director or officer has acted willfully or intentionally in failing to complete her duties, most states deny the protection of indemnity insurance in such situations. Thus, an individual director who has blatantly stepped outside the bounds of his or her employment will likely be responsible for the full extent of the resulting bill, for both legal expenses and for damages to the firm resulting from the intentional or willful acts.

- Legal Expenses: Generally, a firm is allowed to indemnify its directors and officers for legal expenses incurred in trying cases associated with management actions. Moreover, in most states, companies are allowed to advance directors' legal expenses prior to actual completion of the action. However, in such states, it is generally the rule that if the director is found guilty of the charges or the suit, then he or she must reimburse the firm for the total amount of the legal expenses advanced.

- Court Costs and Fines / Penalties: In most states, court costs and any fines or civil / criminal penalties that are awarded against a director or officer, cannot be advanced or indemnified.

See 8 Del. C. § 145.

EXAMPLE: After committing a tortuous act during his tenure as a director for HighTop Co., Glen was sued by shareholders and ultimately lost the suit. His legal bill was over $40,000 and he faced court costs and fines of nearly $200,000. Because both he and the firm believed that Glen had really done the right thing, Glen approached the firm for indemnification. However, due to state law stating that guilty directors cannot be indemnified by the company, Glen was left on his own to raise the funds to pay his attorneys, the fines, and the court.

D&O Insurance in a Post-Enron World

Director and Officer Insurance (D&O Insurance) is generally considered the bedrock of an indemnity plan. D&O insurance is the main insurance which protects corporate directors and managers, along with the firm itself, from mismanagement. However, given the debacles of corporate management that have arisen since the late 1990’s, D&O insurance is changing rapidly in the modern business world.

D&O insurance has become a must-have element of any company’s board. It is simply impossible to imagine any respectable businessperson willingly accepting a board position in which the firm failed to pay for D&O insurance. The reason for this is that directors are generally paid very little, and while D&O insurance costs are on the rise, it is the least a company can do to protect its directors. Moreover, it is important to understand that in the event of corporate mismanagement, it is likely that the entire corporate board will be sued, as opposed to just individual directors. Given this situation, and the fact that no single director can control the entire board, a director should demand protection from the rest of the board just to protect his personal interests.

Of final important note is the fact that D&O insurance premiums are rapidly rising. Thus, if you are working with a firm that is considering expanding its board or altering its D&O insurance policy, be sure that they are well aware that any such change is likely to entail heavy expense.