Taking a Look at the Limits of Indemnification

Indemnification is the first and most important line of defense for the protection of directors and officers. But corporate officials are not always entitled to indemnification. For example, under Delaware law, they cannot claim mandatory indemnification if their defense is not successful. And they cannot seek permissive indemnification is they did not act in good faith.

A February 7, 2012 decision of the Delaware Court of Chancery takes a detailed look at the contours of these indemnification limitations, in the challenging context of a case involving a former CEO who was terminated for cause and who pled ultimately guilty to criminal charges. The court reviewed the indemnification questions in consideration both of statutory indemnification provisions as well as a separate indemnification agreement and concluded that further discovery was required in order to permit a determination whether or not the former CEO did or did not act in good faith in connection with at least some of the amounts for which he sought indemnification The decision, which can be found here, raises a number of interesting implications.

I should acknowledge at the outset Francis Pileggi's February 19, 2012 post on his Delaware Corporate and Commerical Litigation blog (here), which first brought this decision to my attention.

Background

Mark Hermelin was the CEO of K-V Pharmaceutical Company from 1975 to 2008, as well as a member of the company's board from 1975 to 2010. In 2008, the company became aware of concerns that it had manufactured oversized morphine. K-V launched an internal investigation into the cause of the manufacture and distribution of the oversized tablets. In the course of the investigation, K-V discovered it had manufactured additional oversized tablets of other pharmaceuticals. K-V notified the FDA of the oversized morphine tablets, but did not report its discovery of the other oversized tablets.

K-V's audit committee subsequently conducted an internal investigation and ultimately terminated Hermelin as CEO for cause. K-V's announcement of the termination in an 8-K triggered an investigation by the local U.S. attorney, and regulatory actions by the FDA and the Department of Health and Human Services. Hermelin sought advancement and indemnification for defense expenses he incurred in connection with these investigations and regulatory actions.

The outcome of Hermelin's involvement in each of these proceedings is relevant to the consideration of his bid for indemnification. First, the audit committee investigation resulted in his termination. Second, the AUSA's investigation ultimately resulted in Hermelin's entry of a guilty plea to two counts of criminal misdemeanor strict liability based upon an application of the Responsible Corporate Officer doctrine. Third, in connection with the HHS investigation, the agency issued a formal determination to exclude Hermelin from all federal healthcare programs for twenty years (which given Hermelin's age is tantamount to a lifetime ban); and finally, in the FDA matter, K-V and Hermelin among others entered a consent decree whereby the defendants agreed to destroy certain drugs and refrain from manufacturing or distributing any drugs until the company complied with certain quality control requirements.

In seeking indemnification, Hermelin relied not only on the statutory indemnification provisions, but he also sought to rely on a separate indemnification agreement he had entered with the company. As the Delaware court observed in the indemnification proceedings, the indemnification agreement generally make mandatory what are permissive provisions for indemnification under the relevant statutory provisions.

The February 7, 2012 Ruling

In a February 21, 2012 ruling, Vice Chancellor Sam Glasscock summarized his consideration of the indemnification issues as a determination whether Hermelin had succeeded on the merits in any of these proceedings, thus entitling him to indemnification as a matter of law, or whether additional discovery is required to determine whether Hermelin acted in good faith, in which case Hermelin would be entitled to indemnification under the indemnification agreement.

In seeking to establish that he had been successful in certain of these proceedings, Heremlin argued among other things that the outcomes had been successful in the sense that the avoided worse outcomes for himself and for the company, and in some respects that he had in effect "taking one for the team."

Vice Chancellor Glasscock concluded that Hermelin had been successful in connection with the FDA matter, and therefore was entitled to mandatory indemnification for his fees in connection with that proceeding. He concluded further that Hermelin had not been successful in the criminal matter, the HHS investigation or the audit committee investigation, and was not therefore entitled to mandatory investigation in connection with those matters.

But as for whether Hermelin was entitled to permissive indemnification (made mandatory under the indemnification agreement) in connection with the criminal matter, the HHS investigation or the audit committee investigation, Vice Chancellor Glasscock determined that further discovery is required, as Hamelin will still be entitled to indemnification for these matters under the indemnification agreement unless KV can establish that Hermelin's conduct underlying these matters for which he seeks indemnification does not meet the good faith standard required under the relevant Delaware statutes.

In reaching these conclusions, the Vice Chancellor referenced a number of the specific provisions of the indemnification agreement, including in particular the provisions specifying a presumption that Hamelin is entitled to indemnification and putting the burden of proof on the company to overcome the presumption. The Vice Chancellor also referenced the provisions of the agreement specifying that a specific outcome, order or plea will not by itself create a presumption that the indemnitee had a nonindemnifiable state of mind.

The Vice Chancellor did note the "dearth of case law addressing the scope of relevant evidence with respect to good faith" under the Delaware statutory provisions. The Vice Chancellor did note that none of the matters for which Hermelin seeks indemnification "contained a finding that Hermelin acted in bad faith or an admission of culpability by Hermelin." The Vice Chancellor noted in particular with respect to Hermelin's strict liability misdemeanor guilty pleas, that the "record is inadequate with respect to Hermelin's conduct." Similarly with respect to the HHS matter and the audit committee investigation that the record does not reflect findings that Hermelin acted in bad faith. The Vice Chancellor concluded that the parties must supplement the record before he can make the necessary determinations.

Vice Chancellor Glasscock concluded by noting that the probable explanation for the dearth of case law addressing the relevant scope of evidence with respect to good faith is that most disputes of this type likely often settle, particularly where as here the parties are subject to an indemnification agreement that at least as an initial matter compels the company to foot both parties' costs to litigate the matter. He concluded by observing that "I leave it to the parties to determine whether the elusive joys and potential benefits of such litigation outweigh the substantial costs that will result."

Discussion

This case provides a number of valuable insights. First, it provides a very useful perspective on the actual mechanics of the Delaware statutory indemnification provisions. Indeed, as Francis Pileggi points out on his blog post to which I linked above, the case presented a question of first impression under Delaware law as to the evidence relevant for the determination whether or not executive has acted in good faith for permissive indemnification purposes.

Second, and more to the point, it underscores the value to corporate executives of having a separate indemnification agreement. The Vice Chancellor's consideration of Hermelin's agreement's provisions emphasize the importance of several aspects the agreement, including in particular the presumption of indemnification; the burden of proof on the company of overcoming the presumption; and the specification that the mere fact of the entry of an order or plea will not be determinative of the issue of whether or not the indemnitee acted in good faith.

This case does underscore the breadth of a corporate official's indemnification rights under Delaware law in an expansively constructed indemnification agreement. Here, Hermelin may yet obtain indemnification for much of his attorney's fees notwithstanding (1) his termination for cause from the company; (2) his entry of a criminal guilty plea (resulting in his incarceration and the imposition of a substantial fine); and (3) an agency's entry of a lifetime exclusion order against him. Indeed, unless the company can bear its burden under the agreement of showing that Hermelin did not act in good faith, he will have a mandatory right under the agreement for the indemnification of his fees.

This outcome does underscore the fundamental tension that may underlie many indemnification provisions and agreements. That is, a corporate official seeking to negotiate an indemnification agreement will want to have the agreement drafted as broadly as possible. The company on the other hand may want the agreement constructed more narrowly. This tension highlights the fact that it is always critical in connection with the consideration of any draft indemnification to establish whose interests are being examined.

Vice Chancellor Glasscock's consideration of Hermelin's rights of indemnification for the fees he incurred in connection with the criminal proceedings is particularly interesting. It is important to note that the criminal charges against Hermelin were made pursuant to the responsible corporate officer doctrine. As I have discussed in prior posts (here and here), the word "responsible" in the doctrine's title does not mean the officer is responsible for the alleged misconduct, but only that the officer is responsible for the company. A criminal charge under this doctrine is, as the Vice Chancellor noted, a strict liability offense. As such, these nothing specific about a guilty plea that establishes that the defendant officer acted with a culpable state of mind, much less that the official acted with bad faith. Accordingly, a corporate official convicted of a strict liability criminal defense may nevertheless be entitled to corporate indemnification, in the absence of any finding of bad faith.

Moreover, given the absence of any finding of willfulness or deliberate misconduct, the guilty plea may not (depending on the actual policy exclusion wording) trigger the conduct exclusion in a D&O insurance policy. In other words, the defense fees at least could be fully insurable under the corporate reimbursement provisions of the typical D&O insurance policy. The typical presumptive indemnification provision found in many D&O insurance policies (presuming indemnification to the maximum extent permitted by law) underscores the possibility of this outcome.

I anticipate that there will be some who question whether or not Hermelin ought to have any right to indemnification under these circumstances. At this point, he may or may not be, it has not yet been determined. If the remaining indemnification disputes do not settle and the company proves he acted in bad faith, he will not be indemnified. He only receives indemnification if the company cannot prove he acted in bad faith, in which case I would say, why shouldn't he receive indemnification?

Vice Chancellor Glasscock put it this way: "Delaware law furthers important public policy goals of encouraging corporate officials to resist unmeritorious claims and allowing corporations to attract qualified officers and directors by agreeing to indemnify them against losses and expenses they incur personally as a result of their services." He added, the complete the picture that "prohibiting unsuccessful 'bad actors' also relieves stockholders of the costs of faithless behavior and provides corporate officials with an appropriate incentive to avoid such acts to begin with."

Accordingly, any argument that Hermelin should not be entitled to indemnification has to proceed on the theory that he is a "bad actor." As Vice Chancellor Glasscock concluded, however, there is not a sufficient basis on the current record to conclude that Hermelin is a bad actor. I should add that the presence of the guilty plea to the strict liability criminal charge is an distracting and confusing irrelevancy. The criminal charge is basically a status offense; Hermelin was charged because of his title, not necessarily because of his actions - or even fault, as the charges were strict liability offenses.  

I have pointed out elsewhere the fundamental problems with the imposition of liability without culpability. As I have previously argued, this deeply troublesome trend is fundamentally inconsistent with traditional notions of justice and fair play. The problems associated with these types of prosecutions should not be compounded by efforts to try to use the prosecutions as a basis to try to strip corporate officials of their indemnification rights, at least in the absence of affirmative evidence of bad faith.

I suspect others may have strong views on this subject. I invite readers to add their views to the  dialog using this blog's comment feature.

Readers with a penchant for historical references will definitely want to peruse Vice Chancellor's musings on page 7 and page 13 about the proper historical allusion for Hermelin's posture in the underlying actions, in light of his contention that his tactics of concession secured benefits and avoided worse detriments for himself and for the company. The possibilities include a Pyrrhic victory, a Hobson's choice, a Morton's Fork, or a Buridan's Ass. Vice Chancellor Glasscock is of the view that the most appropriate historical reference for Hermelin's defense is Lee's surrender at Appomattox.

M&A Plaintiffs' Attorneys as Toll Booth Operators: I have recently detailed on this blog the many problems associated with the upsurge in M&A related litigation, including among other things the problems associated with rising plaintiffs' fee awards in these cases. I have also noted that the plaintiffs' fee awards can be quite substantial even where there is no cash recovery for the benefit of the shareholders on whose behalf the plaintiffs' lawyers supposedly brought the case.

A case in point is the recent $8.8 million plaintiffs' fee award in the litigation related to the XTO Energy acquisition. As detailed in Nate Raymond's February 14, 2012 article on Am Law Litigation Daily (here), a state appellate court has affirmed the award of these fees, notwithstanding the fact that plaintiffs' attorneys recovered no cash for the plaintiff class. The appellate court's ruling is the subject of Ronald Barusch's scathing February 20, 2012 post on the Wall Street Journal's Dealpolitik blog (here).

Among other things, Barusch contends that in the settlement, the shareholders received "nothing but words." The author contends based on the appellate court's decision that the fee award was calculated on "what appears to be a totally irrational basis" The author concludes that with "outrageous" outcomes like this, these kinds of cases these class actions "have become toll booths for just about every big merger."

A Variation on the Chinese Company Litigation: As I and many others have noted, one of the most pronounced trends during 2011 was the wave of shareholder litigation involving Chinese companies. In an interesting variation on this litigation trend, a shareholder In one of the Chinese companies caught up in its own scandal has now been sued. According to a February 21, 2012 Wall Street Journal article (here), one of the investors in John Paulson's hedge funds, which had invested in the scandal-ridden Sino-Forest Corp. (about which refer here and here), has filed a purported class action lawsuit in the Southern District of Florida against Paulson's firm for failing to conduct sufficient due diligence in the firm.

According to the Journal article, Paulson's fund lost about $500 million last year on its investment in Sino-Forest, although this figure includes the loss of the fund's paper gains on the investment. The net total loss was $100 million. The lawsuit alleges gross negligence and a breach of the fund's duties to investors for "failing to expend the resources to conduct the proper initial due diligence in Sino-Forest's operations."

Though the wave of litigation involving the Chinese companies seems to have peaked last year, litigation continues to arise. This latest suit presents the latest variation of efforts by U.S. investors to try to recoup losses based upon the companies involved in the accounting scandals. The interesting thing about this latest twist is that the litigation is extending not only to the Chinese companies and their directors and officers, as well as offering underwriters and auditors, but now it is even extending to shareholders.

Photography and the Physics of Canine Balance: All I can say is -- take a look at the oddly compelling photos in this collection captioned "Maddie the Coonhound Standing on Things" (here)

Read other items of interest from the world of directors & officers liability, with occasional commentary, at the D&O Diary, a blog by Kevin LaCroix.

For more information about LexisNexis products and solutions connect with us through our corporate site.