Delaware Chancery Court Decisions Stress Need For Scrutinizing Indemnification Arrangements For Portfolio Company Directors

January 2009

Business Law Update

Funds that have representatives serving on portfolio company boards should review their indemnity arrangements because recent Delaware cases have changed the indemnity landscape. Delaware companies may now be able to take away certain indemnification rights of current and former directors and funds may be unsuspecting co-indemnitors of their designated portfolio company directors.

Schoon v. Troy Corporation: Court Allows Retroactive Repeal of Director Advancement Rights
In Schoon v. Troy Corporation [1], the Delaware Chancery Court upheld amendments to a corporation’s bylaws that eliminated the rights of former directors to advancement of legal fees for legal proceedings arising out of the former directors’ service to the board. The alarming impact of Schoon is that advancement rights can be cancelled by the corporation, even after the occurrence of the events or actions giving rise to the claim.

Brief background: During director William J. Bohnen’s (“Bohnen”) tenure on Troy Corporation’s (“Troy”) board of directors, Troy’s bylaws permitted advancement of legal expenses to current and former directors. After Bohnen resigned, he sought access to the books and records of Troy pursuant to Section 220 of the Delaware General Corporation Laws. After the records request was made by Bohnen, Troy amended its bylaws to eliminate advancement of legal expenses for former directors, including Bohnen. Troy then filed an action against Bohnen and others alleging various breaches of fiduciary duty. Bohnen sought advancement of his defense expenses from Troy, arguing that the amendments did not terminate his right to advancement for events or actions occurring prior to the amendment of the corporation’s bylaws.

In March 2008, the Schoon court held that Bohnen was not entitled to fee advancement in defending against the Troy breach of fiduciary duty claim because his advancement rights did not vest until the time at which the director was named as a defendant in a proceeding for which advancement and indemnification are available or at least until Troy had discovered or was aware of the wrongful actions that gave rise to such a proceeding, even if the events or actions giving rise to the claim occurred prior to the bylaw amendment.

Levy v. HLI Operating Company, Inc. and Sodano v. American Stock Exchange: Director Indemnification Rights Slide Backwards; Private Equity Fund Indemnification Obligations Reordered
In a blow to settled expectations around advancement and indemnification rights affecting private equity funds, among others, the Delaware Chancery Court in Levy v. HLI Operating Company, Inc. [2] held that, as a matter of Delaware law, (i) a director is not entitled to payment of his or her fees and expenses incurred while pursuing a failed indemnification claim against the corporation and (ii) once a director has been indemnified by a third party, such as a sponsoring private equity fund, the director cannot seek indemnification from the corporation on behalf of such third party seeking reimbursement; rather, the third party may pursue a contribution claim against the corporation. But, most unsettling is the holding that since HLI Operating Company (“HLI”) and the private equity fund each owed “concomitant” indemnification obligations to certain of the HLI directors, each was responsible for part of the indemnification obligations as “co-indemnitors” instead of the respective primary-secondary relationship as was the widely-held expectation in the private equity marketplace.

Brief background: In Levy, a private equity firm (Fund) owned approximately 34% of one of its portfolio companies, HLI. Four of the Fund’s designees served as members of the board of directors of HLI and had entered into indemnification agreements with HLI, which provided, among other things, that HLI would advance expenses in connection with any suit that the directors brought to enforce their rights to indemnification, regardless of whether the directors prevailed in such litigation. The Fund-designated directors had separate indemnification agreements with the Fund as well. As a result of a shareholder and bondholder suit against HLI and certain of its officers and directors, the Fund, on behalf of its designated directors, contributed $4.8 million toward the settlement of the suit. Those directors then sought indemnification and reimbursement from HLI for the $4.8 million that was contributed for the settlement. When HLI refused, the directors sued HLI. At first, HLI advanced expenses to the Fund-designated directors in connection with their indemnification claim against HLI, but after learning that the Fund had paid the settlement amount on behalf of the directors and that amounts were not paid personally out of the directors’ pockets, HLI stopped advancing fees and demanded reimbursement for amounts already advanced.

The Levy court held that the directors did not have standing to pursue indemnification from HLI because the Fund paid the settlement obligations in full, not the director designees themselves, and as a result, the directors suffered no personal losses. Further, the Levy court held that notwithstanding language in each director’s indemnification agreement to the contrary, under Delaware law, a company is not permitted to bear the expenses of a director’s unsuccessful claim for indemnification, and as a result, the directors were required to reimburse HLI for the expenses already advanced. Although the Chancery Court found that the designated directors were not entitled to maintain their indemnification claim against HLI, the Fund could bring a contribution claim against HLI seeking reimbursement for HLI’s equitable share of the $4.8 million payment, making the Fund a “co-indemnitor” instead of a secondary indemnitor as was the settled expectation.

In July of 2008, the Delaware Chancery Court, in Sodano v. American Stock Exchange LLC [3], provided additional guidance and relief from its Levy decision. The Sodano court enforced an indemnification prioritization term in a parent company’s charter documents making a parent corporation’s obligation to indemnify its director designees secondary to its subsidiary’s obligations to indemnify the directors. In Sodano, both the American Stock Exchange (“AMEX”) and its parent company, the NASD, owed indemnification obligations to Salvatore Sodano (“Sodano”). However, the NASD’s organizational documents included an indemnification prioritization/set-off provision which, according to the Sodano court, showed a clear intent to render the NASD’s obligations secondary to the indemnification obligations of any other company, including AMEX. As a result, the Sodano court held that the NASD and AMEX are not co-indemnitors with coequal indemnification obligations. Rather, the AMEX is required to indemnify Sodano first and the NASD is obligated to indemnify second, and then only if AMEX were financially or legally unable to make such payment.

Schoon, Levy and Sodano Takeaways
These three cases are a warning to private equity and other investment funds and the directors and officers serving or looking to serve Delaware companies on behalf of such funds. Funds and their representative portfolio company directors should review their indemnification arrangements to ensure that they provide the protections everyone expects.

The Schoon holding makes quite clear that the right to indemnification fee advancement provided under a company’s bylaws or certificate of incorporation may be taken away at any time before the obligation to advance particular fees vests. To protect against the loss of such rights, consider the following:

• Include veto or consent rights to such amendments to the bylaws or certificate of incorporation;
• Enter into a written indemnification agreement between the director and the portfolio company specifically providing for fee advancement rights;
• Include a bylaw or certificate provision that expressly states that the vesting of all of a director’s indemnification rights occurs immediately upon joining the board of directors; and
• Include a bylaw or certificate provision that expressly provides that subsequent amendments to the bylaws or certificate will 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.

The Levy and Sodano decisions make clear that, absent clear contractual priority of indemnification obligations between a fund and a portfolio company, (i) if the fund provides for indemnification of designated portfolio company directors, the fund will be at risk of being a co-indemnitor and be required to pay an equitable share of the obligations despite a portfolio company’s obligation (contractually and at law) to indemnify its directors, (ii) if a fund provides indemnification payments, designee directors lose their standing to seek corresponding indemnification from the portfolio company, and (iii) a fund’s remedy against a portfolio is a suit for contribution.

To use the Sodano decision as guidance to avoid the outcome in Levy, consider the following:

• Include indemnification priority provisions in the fund’s organizational documents;
• Include primary indemnification obligations in written indemnification agreements entered into between any designated director and a portfolio company;
• Include indemnification priority provisions in a side-letter agreement between the fund and its portfolio companies; and
• Provide a loan from the fund to designated directors, if permitted, to pursue the indemnification claim to preserve the directors’ indemnification rights against the portfolio company.

For more information, please contact Ian B. Carter, Counsel, at 916-444-1000.

[1] Schoon v. Troy Corp., 948 A.2d 1157 (Del. Ch. 2008).
[2] Levy v. HLI Operating Co., Inc., 924 A.2d 210 (Del. Ch. 2007).
[3] Sodano v. Am. Stock Exch. LLC, 2008 Del. Ch. LEXIS 92 (Del. Ch. July 15, 2008).