Davis Polk & Wardwell Newsflash

Delaware Court Ruling Puts a Spotlight on Indemnification/Expense Advancement Bylaws

June 5, 2008

The recent Delaware Chancery Court decision upholding a company’s retroactive repeal of a former director’s right to advancement of expenses in defending against fiduciary duty-based claims has, not surprisingly, generated concern that the indemnification provided to directors and officers by corporate bylaws may not be sufficient to protect them fully - particularly once they leave the office. As a strictly legal matter, the court’s holding is best analyzed in the context of the specific bylaw at issue in that case, which lacked certain essential protective features designed to ensure against adverse retroactive amendment. The decision highlights the need to review existing indemnification and advancement provisions, but we believe that wholesale changes to bylaws that have been properly drafted are not called for. The ruling does present an additional consideration for those companies that are weighing the merits of entering into separate indemnification contracts with directors and officers (as discussed below).

In Schoon v. Troy, a former director of Troy Corporation sought advancement of legal fees and expenses incurred in defending against allegations that he had breached his fiduciary duties in connection with his service on Troy’s Board of Directors.  During the period that William Bohnen served as a director at Troy, the company’s bylaws provided for advancement of expenses for current and former directors.  Shortly after Bohnen’s resignation, in response to an action brought by a current director, Troy approved several amendments to its bylaws, including the removal of former directors from the class of directors entitled to advancement of expenses.  In a surprise ruling, the Chancery Court rejected Bohnen’s claim that his right to advancement had vested when he took office and could not be unilaterally rescinded by the company.  The court reasoned that, Bohnen’s right to advancement would have vested only if a claim had been asserted against him prior to the amendment of the bylaws.  Since there was no evidence that Troy was contemplating the claims against Bohnen at the time of the amendments, the court concluded that Bohnen’s rights under the pre-amendment bylaws had not vested and were effectively repealed by the amendments.

While the decision in Schoon upsets the general expectation that indemnification rights provided by corporate charters and bylaws cannot be unilaterally and retroactively rescinded, the holding should not be of broad applicability to indemnification and advancement bylaws of other companies and does not change the long line of Delaware cases that have upheld indemnification protections in favor of directors and officers. Carefully crafted indemnification bylaws (or charter provisions, which cannot be amended by the board without shareholder approval) typically have in place provisions designed to protect against exactly the kind of adverse, retroactive amendment that occurred in Schoon, by providing that the right to indemnification is a "contract right" and that "neither the amendment nor repeal of [the indemnification rights], nor the adoption of any provision of [the] Certificate of Incorporation or the bylaws of the Corporation, nor, to the fullest extent permitted by Delaware Law, any modification of law, shall eliminate or reduce the effect of [the indemnification rights] in respect of any acts or omissions occurring prior to such amendment, repeal, adoption or modification."

Notwithstanding our conclusion that this ruling should not jeopardize the integrity of well-drafted indemnification bylaws, this case may lend further impetus to the trend towards adoption of standalone separate indemnification contracts with directors.  In the past four years, the number of Fortune 500 companies with separate indemnification agreements with directors has increased significantly, from 50 in May 2004 to approximately 120 in May 2008.  This reflects a recognition that the general protections extended by indemnification bylaws or charter provisions may be supplemented with greater detail in a bilateral contract.  Some of the specificity that can be achieved through a standalone indemnity agreement includes:

  • creating a presumption (the enforceability of which has not yet been ruled on) that the director will be entitled to indemnification and placing the burden on the company of proving otherwise
  • establishing a timetable for the determination of entitlement to indemnification and stipulating that the director shall be entitled to indemnification if such a determination is not made within the prescribed period
  • providing that the determination as to entitlement be made in certain cases (e.g., after a change of control) by independent counsel rather than by the Board, if so requested by the director
  • providing for a right to adjudication in court against an adverse determination by the company as to entitlement to indemnification
  • providing mechanics for advancement of expenses
  • clarifying that advancement of expenses is not dependent on the director’s ability to repay or his/her entitlement to indemnity

If you have any questions regarding this newsflash, please call your Davis Polk contact.

See a copy of Schoon v. Troy, C.A. No. 2362-VCL (March 28, 2008).

Davis Polk & Wardwell