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Officers or directors of companies, or people who are thinking of taking a position as an officer or director of a company, need to consider the risk of liability they may face from being named in a lawsuit.

The personal risk of litigation for officers and directors is even more acute in the case of public companies and the potential for securities class action lawsuits or governmental investigations. In such situations, much has been written and people often focus on whether the company provides indemnification or has directors and officers (D&O) insurance. Indeed, a company’s ability to indemnify and the extent of D&O coverage may be important factors in a company’s ability to attract and retain capable officers and directors.

But, in the case of D&O insurance, such coverage may not kick in until the end of the proceeding, and oftentimes only when the company is unable to cover certain legal expenses. And in the case of indemnification, while most states have corporate indemnification provisions that require a corporation to indemnify an officer or director if they have been successful in defending an action, again, that requires waiting until the end of the action to obtain reimbursement. Many officers and directors, however, forget to consider what could potentially have the most significant impact on an individual’s defense in a litigation – whether and to what extent the company provides advancement of legal costs and fees.

Some corporations have mandatory advancement provisions, while others have permissive advancement provisions. In either case, a corporation may impose certain conditions or prerequisites (such as an undertaking to repay any fees advanced if not entitled to indemnification) on an officer or director’s right to advancement.

Indemnification and advancement of fees are different things governed by separate statutory provisions and usually separate provisions in a company’s bylaws. Indemnification governs the means by which a company will reimburse a party’s expenses, including legal expenses under particular circumstances (usually if the person has acted in good faith and not against the interest of the company).

Indemnification comes at the end of a litigation or proceeding, when there has been a final determination of whether such expenses are indeed indemnifiable. Advancement, on the other hand, allows a company to cover a party’s legal expenses in advance of a final determination of whether such expenses are indemnifiable, usually during the pending proceeding as those expenses are actually being incurred.

Litigation is expensive, especially securities litigation. Due to the nature of the timing, advancement can determine whether an officer or director who is a party to an action or target of an investigation can successfully mount an adequate defense to a securities action or governmental investigation.

There are generally three sources of indemnification and advancement for officers and directors: state statutory provisions, corporate bylaws, and private employment or other contracts. Most states have corporate indemnification statutory provisions that provide the parameters of who is indemnified and under what circumstances. Additionally, states frequently have a separate, but related, statutory provision regarding advancement of legal expenses.

A number of states’ indemnification provisions permit corporations to advance legal expenses to officers and directors. Some such provisions require the receipt of an undertaking that the person will repay any amounts advanced if the party is found not entitled to indemnity under the applicable statutory standard. An officer or director should make sure that he or she is familiar with the relevant state of incorporation’s statute on indemnification and advancement. A second source for indemnification and advancement of corporate officers and directors is a corporation’s bylaws. The corporation’s bylaws sometimes track the state statutory language or provide general guidelines, such as indemnification and advancement will be provided to the fullest extent permitted by law.

It is important to understand if advancement is provided for in the corporation’s bylaws and if it is mandatory or permissive. And, if so provided, what are the conditions imposed. If advancement is mandatory, then the company has a binding obligation to advance all reasonable fees. If permissive, the company could choose to not advance, especially if there is a concern that the officer or director engaged in wrongdoing. Finally, officers of a corporation may have indemnification and advancement provisions in a private employment contract. If the bylaws do not provide for mandatory advancement, one might try to get it through a contract.

To highlight just how important advancement parameters can be to party’s defense, a recent Delaware case rejected a party’s attempt to challenge the stringent prerequisite conditions imposed by his corporate employer on his right to advancement of legal expenses. In Thompson v. The Williams Companies Inc., the court held that where a corporate bylaw allows the board to impose conditions on a party’s right to advancement, the conditions subsequently imposed by the board were not arbitrary. These conditions, however, were fairly onerous, especially for the plaintiff who was not a high level officer or director with significant personal wealth.

The conditions imposed by the board before Thompson, who had already incurred $500,000 in legal fees associated with a governmental investigation, was entitled to advancement were the following: a representation by Thompson that he believed he met the standard for indemnification; a limitation on advancement for legal expenses only after indictment, not for expenses incurred during any government investigation; and a security deposit provided by Thompson to adequately secure fully his obligation.

It was this last requirement that was most burdensome to Thompson. Thompson argued that the dollar-for-dollar security demanded was impossible to meet and effectively eviscerated his right to advancement. The court, however, upheld the requirements as fully consistent with the corporate bylaws. While the bylaws in Thompson were discretionary, rather than mandatory, it would not be uncommon for a corporation to have such provisions. Therefore, officers, directors and employees of public companies should take note of such provisions in their corporations’ bylaws.

Courts will analyze advancement and indemnification claims based on corporate bylaws from a pure contract-interpretation standpoint. For example, in Happ v. Corning Inc., a former director sued by the SEC for insider trading sought additional indemnification from Corning. When Happ initially sought advancement of his legal expenses, Corning made him sign a negotiated undertaking in which he agreed to repay defense costs if it were finally determined that he wrongfully used nonpublic information. After a jury found that Happ was liable for insider trading, Corning sought repayment of the advances. Happ, in turn, alleged that the undertaking was obtained under duress (particularly his economic duress in needing to defend the SEC action) and should be vitiated.

The court analyzed the duress defense as it would in any other contract situation and held that “[w]hether or not pressure existed, Corning’s insistence on the undertaking was not unlawful or wrongful within the meaning of the duress doctrine.” Because the corporation’s bylaws (and Happ’s contract with Corning) did not specify how the undertaking must be worded, the parties were free to negotiate (and the corporation free to insist on) its own specific wording of the undertaking.

When there is litigation regarding whether or not a corporation should be required to advance a party’s legal expenses, it also necessarily raises the question of who should pay the costs associated with a lawsuit brought by an officer, director, or employee against its current or former corporation for advancement in the first place? Courts generally have held that, assuming the party is successful in getting advancement, the party is also entitled to “fees on fees” – in other words, the corporation should reimburse the officer or director its costs for prosecuting the advancement claim. Courts also have said that a corporation’s bylaws could provide that there are no fees on fees in an advancement dispute.

Corporations – both public and private – should scrutinize the language used in the indemnification and advancement provisions in their corporate bylaws or contracts, so as to prevent a situation in which the corporation is required to advance legal expenses to an officer, director or employee that it is suing for wrongdoing. Several cases decided last year involve just this situation.

For example, In DeLucca v. KKAT Management LLC, a former principal and fund manager of Katonah Capital was sued in New York by her employer and its affiliates for breaching her fiduciary duty and contractual obligations to the companies. DeLucca brought an action in Delaware against the affiliated LLCs seeking advancement to defend the New York action. DeLucca argued that she was entitled to advancement and indemnification because the LLCs’ operating agreement allowed for indemnification “for any loss ‘in connection with or arising out of or related to’ the operating agreement, the operations or affairs of a [the KKAT companies].

While the LLCs argued that it was ridiculous that this provision would mean that she could be advanced or indemnified for her legal expenses in connection with a lawsuit brought against her by the companies itself, the court – analyzing the issue from a pure contract perspective – rejected that argument. Instead, the court found that the “capacious and generous standard” of the provision allowed for automatic advancement and indemnification “in connection with, arising out of, or related to the operating agreement or operations or affairs of either the KKAT Companies or the Katonah funds.”

Directors, officers and those considering such positions should educate themselves about their current or prospective corporations’ indemnification and advancement policies, in addition the corporations’ D&O insurance. In the absence of a bylaw provision requiring mandatory advancement of legal expenses one may want to consider a separate agreement that includes such a term.

JAY A. DUBOW is a partner resident in the Philadelphia office of Pepper Hamilton. He focuses his practice on complex business litigation, with a special emphasis on defending against securities class action litigation and representing clients involved in investigations by the U.S. Securities and Exchange Commission, the Pennsylvania Securities Commission and various self-regulatory organizations, including stock exchanges and the National Association of Securities Dealers. He also conducts internal investigations on behalf of clients.

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