Director and Officer Indemnification and Liability Protection

Discussion

Indemnification literally means "to make whole." When a company indemnifies its directors and officers, it means the company promises to reimburse them for certain legal expenses, damages, and judgments incurred as a result of lawsuits relating to their corporate actions. In effect, the company becomes the insurer for its officers and directors. (The company usually purchases insurance to cover its own risk.)

Limited liability means a director's or officer's personal financial assets are not at risk if the individual loses a lawsuit that results in a financial reward and/or damages to the plaintiffs. Most companies that indemnify their officers and directors also limit or eliminate the personal liability of these individuals.

State law determines the limits for director and officer indemnification and liability protection; companies within each state generally have a choice on whether or not to take full advantage of this protection.

The extent to which corporate directors and officers should be indemnified and their personal liability limited against judgments resulting from their acts as corporate agents is a difficult question for shareholders. On one hand, shareholders want directors and officers to be responsible for their actions, and accountable for their failures. Most professionals are exposed to some risk of personal liability for negligence or other breach of duty; malpractice suits against doctors and lawyers are just two examples.

On the other hand, shareholders recognize that directors and officers are asked to make extraordinarily difficult choices, and that it is not in the interest of shareholders for them to be too risk averse. If the risk of personal liability is too great, companies will not be able to find liability insurance; even with insurance, they may not be able to find directors willing to serve. Shareholders cannot ask directors to be right all of the time, only to oversee the company's activities with care and with strict observance of their duty to protect the interests of the shareholders.

Traditionally, corporate officers and directors have had two duties: a duty of care and a duty of loyalty.

The duty of care is generally interpreted as a "reasonable director standard." In other words, we expect more from a director than what we expect from a simple "reasonable man"; we expect the director to behave reasonably according to the experience and expertise a director should have. We might not expect a reasonable person to be familiar with generally accepted accounting principles or earnings per share, but we do expect that of a director. Corporate officers who are also directors are sometimes held to an even stricter standard, because they know more about the day-to- day operations of the company. Similarly, directors of large companies are sometimes held to a stricter standard than directors of small companies, because directors of large companies are expected to be more familiar with complex corporate finance and governance issues. One observer has said that the duty of care contains two elements: alertness to potentially significant corporate problems and deliberative decision making on issues of fundamental corporate concern. In general, there is no way to establish a clear standard for the duty of care, and courts must examine the facts of each case.

Application of the duty of care has been made more unpredictable by the so-called "business judgment rule." This court-applied doctrine provides that directors normally will not be held liable for honest mistakes in business judgment. Obviously, lax application of the business judgment rule can undermine the duty of care. Courts have had considerable difficulty in applying both in a consistent manner.

The duty of loyalty dates back to at least 1742, and it is still reasonably intact. Courts examining violation of this duty have occasionally held that a conflict of interest transaction is void, even if the company and shareholders are not harmed (for example, if the CEO buys equipment the company was planning to sell, and he pays a fair market price). More often, the court will let these transactions stand, if there is no harm. The burden is on the party claiming a breach of the duty of loyalty to prove that there was a conflict of interest (in the example above, that the shareholders had an interest in getting the highest price for the equipment, and the CEO had an interest in buying it for the lowest price). Then the burden is on the director or officer to show that the transaction was fair (that he bought the equipment for the same price that it would have realized on the open market).

In recent years, many state legislatures have enacted measures to limit liability of directors. Delaware's limited liability statute [Title 8, Section 102, Subsection (b)(7)] is similar in scope and implementation to at least 25 state statutes. They all permit companies to adopt a charter amendment to either limit or eliminate altogether a director's personal liability for monetary damages stemming from a breach of the fiduciary duty of care.

Most state liability legislation, including Delaware's, does not limit or eliminate monetary liability for: (i) any breach of the director's duty of loyalty to the company or its shareholders, (ii) acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law, (iii) willful or negligent conduct in connection with the payment of an unlawful dividend, or (iv) any transaction from which the director derived an improper personal benefit.

While few states dictate shareholder ratification of expanded indemnification proposals, boards usually seek shareholder approval in order to avoid conflict of interest charges and to have a stronger case should they later have to defend their indemnification in court.

In states where indemnification provisions are overly broad -i.e., companies are allowed to cover a director's legal expenses, plus damages, in derivative cases when the director is unsuccessful in his defense-a significant problem arises since shareholders are in effect picking their own pockets. In such cases, an unsuccessful defense by an indemnified director means the company loses more through recovery and reimbursement than it had originally suffered in damages.

Any attempt to limit the board's monetary liability or expand indemnification for a breach of its fiduciary obligations, including the duty of care, runs counter to the right of shareholders, as owners of the company, to hold their agents personally accountable for misdeeds committed in the name of the company and to seek appropriate compensation.

However, there is a need for management to remain free of the risk of financial ruin as a result of a misstep that was unintentional. Therefore, rational limits on the breadth of indemnification are the best way to strike a balance between the shareholders' interest in accountability and their interest in attracting and retaining quality agents to work on their behalf. By covering legal expenses in cases when good faith was exhibited, the appropriate signal is sent to the board.