Indemnification and Advancement Issue of First Impression Decided by Chancery
The Court of Chancery addressed an issue of first impression in Delaware regarding: “what evidence is relevant to an inquiry into whether an indemnitee acted in good faith for the purposes of permissive indemnification” under DGCL §§145(a) and (b). The Court also addressed: (1) Whether the former CEO is entitled to mandatory indemnification as a matter of law; (2) Whether additional discovery is required to determine whether the former CEO acted in good faith (in which case he would be entitled to statutorily permissive indemnification pursuant to his rights under an indemnification agreement.)
The plaintiff in this case was the former CEO of the defendant corporation for approximately twenty three (23) years. As a result of certain problems associated with some of the morphine tablets that the company supplied to pharmacies, and after an internal investigation, the company decided to terminate the former CEO for cause. After the disclosure of the determination was made on the Form 8-K filing, investigations followed by the U.S. Attorney’s Office for the Eastern District of Missouri and regulatory investigations by the FDA and the U.S. Department of Health and Human Services. This 50-page opinion provides copious background facts.
The former CEO, Hermelin, sought advancement and indemnification regarding the investigations and related proceedings. The Court described in great detail, the circumstances surrounding the proceedings for which advancement and indemnification were sought. The Court recounted the principal facts in order to evaluate whether Hermelin succeeded on the merits of those proceedings. This analysis was necessary so that it could be determined whether Hermelin was entitled to “statutorily permissive” indemnification pursuant to the terms of his indemnification agreement.
The Vice Chancellor who authored this opinion was a historian before ascending to the bench and invokes an iconic writer who lived during the heyday of the Roman Empire. His Honor also references a famous battle from the U.S. Civil War. In footnotes 6 and 7 as well as in the accompanying text, the Court discusses an argument by the company that none of the proceedings at issue involved mandatory indemnification.
Referring to Pyrrhus and the Battle of Asculum in 279 B.C., as recorded by the Greek historian Plutarch (who was also cited in a previous decision by former Chancellor Chandler), the Court observed that even Pyrrhic victories, where success comes at great sacrifice, are entitled to mandatory indemnification under Delaware Law (even though a Pyrrhic victor may only be entitled to reasonable fees and costs under § 145(c) of Title 8 of the Delaware Code (“DGCL”)).
The Court also observed that most of the “successes” alleged by Hermelin, the former CEO, were not Pyrrhic wins at great cost, but the rather, the Court explained that they were “instead losses akin to that of Lee at Appomattox, of which it may be said that the surrender on generous terms avoided an inevitable loss requiring supreme sacrifice, and was not in that sense successful.”
The facts of one of the background proceedings examined in the opinion involves the “responsible corporate officer doctrine” (“RCO”), which originates from a U.S. Supreme Court decision in which the Supreme Court found certain corporate officers in positions of authority to be criminally liable on misdemeanor charges under the Food, Drug, and Cosmetic Act (FDCA). That decision was reinforced in U.S. v. Park, 421 U.S. 1615 (1975), and, in effect, imposed strict liability for some statutory violations on responsible corporate officials who are subject to the Food, Drug and Cosmetic Act. See footnote 11. For a helpful commentary on the RCO doctrine generally, refer to Kevin LaCroix’s discussion on his blog, The D & O Diary.
Hermelin had argued that one of choices he was confronted with in one of the proceedings at issue, required him to either divest himself of his ownership in the company or agree not to contest the penalties, which also would have cost the company to suffer penalties. The Court in footnote 19 described this not as a Hobson’s Choice, but rather a Morton’s Fork, the latter being a choice between two equally undesirable alternatives, instead of no choice at all.
The Court also observed in footnote 19 that neither a Hobson’s Choice nor a Morton’s Fork should be confused with either a “Catch-22” or a “Buridan’s Ass.” (The latter term was also explained in the footnote).
The Court provided an overview of the statutory framework under the DGCL with respect to the indemnification rights of corporate officers and directors, which is largely enabling in approach and:
“sets two boundaries for indemnification: the statute requires the corporation to indemnify a person who is made a party to proceeding by reason of his service to the corporation and has achieved success on the merits or otherwise in that proceeding. On the other end of the spectrum, the statue prohibits a corporation from indemnifying a corporate official who is not successful in the underlying proceeding and has acted, essentially, in bad faith.” Slip Op. at 2.
The Court explained that in those circumstances between the two extremes of “success” and “bad faith,” the DGCL leaves the corporation with the discretion to determine whether to indemnify its officers or directors. Thus, corporations routinely define their indemnification obligations by charter, bylaw or contract. When indemnification is permissive, the terms of the agreement the corporation provides will control unless it conflicts with a mandatory statutory provision.
The Court clarified that the record necessary to determine the entitlement to mandatory indemnification can be a record substantially more limited than that required to determine the right to permissive indemnification, which inquires into the good faith of the indemnitee.
The Court had requested briefing from the parties on the issue of whether the former CEO was “successful” in any of the proceedings for which he seeks indemnification, thus triggering the mandatory indemnification under DGCL §145(c), as compared to the proceedings for which permissive indemnification was available under DGCL §145(a), in which case the proper scope of relevant evidence would need to be addressed.
The Court determined that the indemnification agreement expressly excluded advancement for the matter in which the former CEO had initiated the lawsuit involving his incarceration in Missouri, and that he was not entitled to mandatory indemnification for that criminal matter, but that he is entitled to mandatory indemnification for the separate matter involving the FDA. The Court also described the scope of evidence relevant to permissive indemnification in other matters that were at issue.
Standard of Review
The Court determined that the standard of review would be similar to cross motions for summary judgment as described in Court of Chancery Rule 56(h).
The bylaws of the Company required mandatory advancement of the former CEO’s expenses for certain matters. That language was controlling except to the extent that it contravened the provisions of the DGCL.
The Court observed that even if Hermelin were not “successful on the merits or otherwise”, he “would still be entitled to indemnification unless [the company] can show that his conduct underlying the matters for which he seeks indemnification does not satisfy the good faith standard required by DGCL §145(a)”. See footnote 47 (quoting §145(a) as permitting indemnification “so long as the person acted in good faith and in a manner the person reasonably believed to be in or not opposed to the best interest of the corporation, and, with respect to any criminal action or proceeding, had no reasonable cause to believe the person’s conduct was unlawful”).
Regarding mandatory indemnification under DGCL §145(c), when determining success on the merits, the Court explained that: “it does not look behind the result”. Rather, where the outcome of the proceeding signals that the indemnitee has avoided an adverse result, the indemnitee has succeeded “on the merits or otherwise.” See footnotes 49 and 50 (citing a case providing that “success under §145(c) does not mean moral exoneration.”) See also footnote 55 (quoting case providing that “an indemnitee in a criminal proceeding is successful anytime she avoids a conviction”).
The Court addressed the issue of what scope of evidence would be relevant to a good faith analysis under §145(a). The Court observed that “where a corporate officer or director is not “successful on the merits or otherwise,” §145(a) of the DGCL permits a corporation to indemnify a person so long as “the person acted in good faith and in a manner the person reasonably believed to be in or not opposed to the best interest of the corporation, and, with respect to any criminal action or proceeding, had no reasonable cause to believe the person’s conduct was unlawful.” See footnotes 64 and 65.
The Court further observed that statutorily mandated indemnification based on the standard of “success on the merit or otherwise”, can usually be determined from the relevant court documents in the underlying action.
By contrast, however, statutorily permissive indemnification requires a determination as to whether an officer or director acted in good faith with respect to the conduct that led to the underlying action. This latter determination requires additional discovery to supplement the record.
The Court emphasized that this was an issue of first impression in Delaware regarding “what evidence is relevant to an inquiry into whether an indemnitee acted in good faith for the purposes of permissive indemnification under DGCL §§145(a) and (b)”. See text accompanying footnote 66.
The Court determined that a plenary trial was required on the issue of whether the former CEO “acted in good faith and in a manner he reasonable believed to be in or not opposed to the best interest of KV, with respect to any criminal action or proceeding, and had no reasonable cause to believe his conduct was unlawful.” The Court reasoned that:
Unlike Section 145(c), Section 145(a) requires a finding that the indemnitee did not act in bad faith, a fact-intensive inquiry that will most likely require a trial and credibility determinations. The disparity between the relevant evidence, respectively, under Sections 145(a) and (c) is, of course, the reason I decided to resolve issues of mandatory indemnification in a summary fashion.
The Court described the limitations imposed on relevance issues and also rejected the argument of the former CEO that the issue of good faith should be limited to records established in the matters for which he seeks indemnification. The Court emphasized and reasoned that permissive indemnification requires a finding that the indemnitee did not act in bad faith–a fact intensive inquiry that cannot be determined without a live hearing and testimony.
UPDATE: Kevin LaCroix, on his blog: The D & O Diary, provides a characteristically insightful analysis of this case here.