RISKVUE ARCHIVE | FEATURE STORIES

Director and Officer Indemnification and Insurance: Part 1

By James W. Reuter and Raymond W. Faricy III, Lindquist & Vennum P.L.L.P.

Perhaps the most obvious hazard of serving as a director or officer of a public company is that corporate managers, with growing frequency, are named as parties to litigation as a consequence of their position. Legal proceedings against corporate managers are brought for a variety of alleged misconduct, including breaches of fiduciary duty to the corporation or its shareholders, and liabilities under state and federal securities laws.

Litigation is an expensive proposition. Regardless of the particular merits of a claim, the corporate manager will incur litigation expenses, and might be required to make substantial expenditures of time and other resources defending the allegations.

Companies commonly provide indemnification of directors and officers against liabilities. Within the corporate context, the purpose of indemnification is to encourage capable individuals to accept positions in corporate management by assuring them that any expenses incurred in the course of upholding their duties will be borne by the corporation. These liabilities might include judgments, witness fees, litigation expenses, settlement payments and attorney fees.

Sources of Indemnification

States commonly regulate and provide for indemnification of directors and officers in their corporation laws. Indemnification of corporate managers is also frequently provided for in a corporation’s charter or bylaws, or through an indemnity, employment or other type of contract between the corporate manager and the corporation.

The source of the indemnification will frequently describe the process a corporate manager must follow to obtain indemnification. Generally, the corporate manager must provide the corporation with notice of a claim or threatened claim at the time (or soon after) such claim is instituted or threatened. There may be situations where indemnification is not sought until after the claim has been fully resolved. In either event, the corporate manager must submit appropriate documentation to the corporation for any liabilities for which indemnification is sought.

State indemnification statutes (and most every other source of corporate indemnification) can also prescribe the situations in which the corporate managers can receive reimbursement of their litigation expenses prior to the final disposition of the matter. Without recourse to these “advances,” it is not hard to imagine situations where the personal assets of the corporate manager would be wiped out by the on-going costs of defending against the claim prior to its final resolution.

Mandatory and Permissive Indemnification

Indemnification statutes contain general provisions for mandatory and permissive indemnification. Under mandatory statutory provisions, a corporation must indemnify those corporate managers who satisfy certain statutory prerequisites. Mandatory indemnification generally is required where the corporate manager has been successful in defense of the action for which indemnification is sought. A successful defense includes situations where the corporate manager prevails based on the merits or “otherwise”; for example, where the corporate manager has a valid procedural defense against the claim.

The permissive statutory provisions commonly grant corporate boards some discretion in determining whom to indemnify. In the permissive indemnification context, corporate managers who seek reimbursement must meet a specified standard of conduct before they may be indemnified. This usually requires that the corporate manager acted in good faith and in a manner he or she reasonably believed to be in the best interests of the corporation, and did not receive an improper personal benefit from the conduct or action in question.

Limitations on Indemnification

Although indemnification statutes may give a corporation broad right to determine the situations in which the corporation is permitted to provide indemnification to its corporate managers, these statutes often prohibit a corporation from providing indemnification in certain circumstances. Delaware law, for example, prohibits a corporation from limiting the liability of a corporate manager:

• For any breach of the corporate manager’s duty of loyalty to the corporation or its stockholders;
• For acts or omissions not in good faith, or which involve intentional misconduct or a knowing violation of law;
• For transactions where the corporate manager received an improper personal benefit;
• For the unlawful payment of dividends or unlawful stock purchase or redemption.

Although corporate indemnification is largely a creature of state law, there are situations where corporate indemnification of corporate managers may interfere with the federal government’s ability to regulate corporations. Accordingly, there are a variety of public policy limitations that are intended to restrict corporate indemnification. For example, the Securities and Exchange Commission has a long-standing position that indemnification of corporate managers for federal securities laws violations is against public policy. Underlying the SEC’s position is the assumption that the federal securities laws are intended to stimulate diligence and deter violations by corporate managers, and that indemnification would undermine these objectives.

The SEC’s position on indemnification of corporate managers raises the issue of whether state indemnity laws, which focus primarily on the protection of corporate managers, may be preempted based on the purported conflict with the underlying purposes of the federal securities laws. Accordingly, the corporate manager has to understand that corporate indemnification invokes the competing concerns of federal and state governments, and that the broad protections provided in a state’s corporate indemnification statute (or in any other source of indemnification) may be restricted by federally imposed limitations. 

ABOUT THE AUTHORS

Jim Reuter is a partner in the Minneapolis law firm of Lindquist & Vennum and chair of the firm’s Insurance Coverage Group. He can be contacted at 612-371-3519; jreuter@lindquist.com. Ray Faricy practices in the firm’s Corporate and Business Department. He can be reached at 612-371-3507; rfaricy@lindquist.com.

Read Director and Officer Indemnification and Insurance (Part 2)

riskVue | The webzine for risk management professionals
February 2003