Quirky Question # 196, Obligation to Indemnify Executive Accused of Criminal Conduct
I am the general counsel of a corporation in the medical device industry. Our company has its corporate headquarters in Minnesota, but we are incorporated in Delaware and have operations in 30 of the 50 states. Recently, I received a grand jury subpoena to produce documents — and learned that the Food and Drug Administration, the FBI, and the Department of Justice are each investigating whether our company violated criminal laws by shipping a medical device that the government believes had not been approved for use by the FDA.
After contacting the Assistant United States Attorney handling the case, I learned that one of our executives is a subject of the investigation. The government has contacted that executive and wants to interview her. She intends to retain counsel to represent her interests. She asked me whether the corporation will pay for her counsel. Does the company have to pay for her counsel? Even if the company does not have to pay, may the company do so anyway? If so, under what terms and conditions? If we decide not to pay for the attorney’s fees, can the executive challenge our decision? Is there anything else I should consider before we make a final decision?
Your question raises important issues which together implicate the facts, the law, and, in no small part, legal and corporate strategy. Under certain circumstances, a corporation has the ability – and sometimes the duty – to indemnify its officers, directors, employees, or agents against liability in litigation related to that person’s corporate role. A company may be empowered to (or responsible for) either advancing or subsequently reimbursing a corporate actor (hereafter called the “indemnitee” or the “executive”) for reasonable expenses, attorneys’ fees, and costs incurred in the course of legal proceedings.
The question of whether a company will pay for an indemnitee’s legal fees and costs arises nearly every day in this country. The answer depends on the facts and circumstances of the individual case, but there are some general principles that typically apply. Although your corporation is a Delaware corporation headquartered in Minnesota, much of this discussion would apply in other states as well.
First, you should consult applicable law. In this case, the company is incorporated in Delaware, and, as a result, Delaware law on indemnification will likely govern. We have summarized below the law of Delaware and a few additional states.
Second, you should consult your corporation’s bylaws. Delaware, and most other states, allow companies to limit (or expand) the scope of indemnification in their bylaws. In fact, in many states, the bylaws can trump (or supplement) the requirements and procedures as stated in the statute.
Third, you should be mindful of strategic considerations in deciding whether and how to indemnify, especially in those cases where the indemnification is permissive.
The Legal Landscape – Statutes
Although the law differs by state, there are certain principles that generally surface when reviewing the legal landscape. For example:
A company may indemnify its executive where she has acted in good faith, in a manner she reasonably believed to be in or not opposed to the best interests of the corporation, and (in a criminal action or proceeding) had no reasonable cause to believe her conduct was unlawful.
This general principle of permissive indemnification is found in virtually the same form in many state statutes – including, for example, those in Delaware, New York, and California. See Del. Code. tit. 8, § 145; N.Y. Bus. Corp. Law § 722; Cal. Corp. Code § 317. The protection typically extends to directors, officers, employees, and other agents of the corporation and would apply in civil, criminal, administrative, or investigative situations alike. So long as the indemnitee has acted with the best interests of the corporation in mind – reasonably, in good faith, and with no belief that her actions were unlawful – she may be indemnified by her employer.
The statutes in Delaware, New York, California, and also in Minnesota, provide that the protection of indemnity extends as to persons no longer in the corporate role related to the lawsuit. Importantly, each statute also provides that termination of a proceeding by judgment, order, settlement, conviction, or a plea of nolo contendere does not create a presumption that the executive did not act in good faith or otherwise meet the criteria set forth above. In other words, even a subsequent conviction does not necessarily preclude a corporation from indemnifying its executive assuming that the threshold criteria were met.
Some states also describe situations in which indemnification is not allowed. E.g., N.Y. Bus. Corp. Law § 725; Cal. Corp. Code § 317(c). These situations include: when the person is adjudged liable to the corporation; and when indemnification would be inconsistent with the law, inconsistent with a corporation’s articles or bylaws, or inconsistent with court-ordered terms of settlement.
In both New York and Minnesota, a company must report to its shareholders in writing the amount of the indemnification and to whom and on whose behalf it was paid. Minn. Stat. § 302A.521, subd. 8; N.Y. Bus. Corp. Code § 725(c).
Finally, the United States Court of Appeals for the Second Circuit has held that the government may not interfere with a corporation’s power to indemnify its executives or other employees by forcing the company to stop doing so as a condition of cooperation. United States v. Stein, 541 F.3d 130, 136 (2d Cir. 2008). Department of Justice policy has evolved to reflect this principle as well – such interference results in a Sixth Amendment (right-to-counsel) violation.
Sometimes, the “power” to indemnify a corporate agent becomes an “obligation” to do so. A company must indemnify its executive in certain circumstances.
Minnesota’s indemnification statute contains broad mandatory indemnification terms. That is, a Minnesota corporation must indemnify any person made party to a proceeding because of her former or present official capacity if the person (1) has not been otherwise indemnified, (2) has acted in good faith, (3) has received no improper personal benefit, and (4) had no reasonable cause to believe her conduct was unlawful. Minn. Stat. § 302A.521, subd. 2.
In Delaware, New York, and California, however, indemnification becomes mandatory only when a corporate actor is successful in defending herself as to a lawsuit or other investigative proceeding. Del. Code. tit. 8, § 145(c); N.Y. Bus. Corp. Law § 723; Cal. Corp. Code § 317(d). For example, if an executive is acquitted, courts do not typically reexamine the elements of indemnification (good faith, and the rest). In all likelihood, upon successful defense of a lawsuit, the company would be required to reimburse its executive for expenses incurred in connection with the proceeding. E.g., Green v. The Westcap Corp. of Del., 492 A.2d 260, 265 (Del. 1985) (referring to an “absolute right of indemnity” when a person is “successful, on the merits or otherwise”).
Without at least a threatened proceeding that involves a particular executive, a corporation’s duty to indemnify is not triggered.
As alluded to above, on the terms of the statutes, the power or the duty to indemnify an executive is only triggered when the person is a party – or threatened to be made a party – to a threatened, pending, or completed action, suit, or proceeding. See also Donahue v. Corning, 959 A.2d 574, 575 (Del. Ch. 2008).
When an executive, such as yours, is not yet being targeted for criminal prosecution or other similar involvement in a civil lawsuit, no duty to indemnify has yet arisen. However, it would appear that a situation such as being called to the grand jury, especially as a subject or target of the investigation, may be enough to trigger at least permissive indemnification. Id. at 579-80 (interpreting provision in an LLC agreement, which comported in large part with the Delaware statute on advancements, and asserting that retaining counsel for appearance before a grand jury was likely indemnifiable).
Indemnification of expenses can be “advanced”, or the executive can be reimbursed. The decision not to advance expenses can be immediately challenged by the executive.
Each of the four states’ statutes provide for advancement of expenses – that is, indemnification up-front for expenses incurred. The requirements for an advance are nearly identical in each state – “receipt of an undertaking by or on behalf of [the indemnitee] promising to repay [the amounts advanced] if it shall ultimately be determined that such person is not entitled to be indemnified” under law. Del. Code. tit. 8, § 145(e); see also, N.Y. Bus. Corp. Law § 725; Cal. Corp. Code § 317(f). Minnesota requires a similar undertaking, but in addition requires “a determination that the facts then known to those making the determination would not preclude indemnification.” Minn. Stat. § 302A.521, subd. 3.
In a situation where a corporation does not believe a person seeking indemnification acted in good faith, or in a manner she reasonably believed to be lawful, it may decide not to advance expenses. The indemnitee (in this case, perhaps better called the “non”-indemnitee) may challenge that decision by filing a lawsuit. See Del. Code tit. 8, § 145(k); Minn. Stat. § 302A.521, subd. 6(a)(5); N.Y. Bus. Corp. Law § 724; Cal. Corp. Code § 317(e)(2). The corporation’s obligation to advance expenses is different from its ultimate duty to indemnify.
A corporation’s liability for advancement of expenses can be determined immediately, i.e., while the proceedings or investigation are ongoing. But it should be noted that a corporation’s ultimate liability for indemnification may only be determined after the final disposition of the underlying proceedings. The conduct element of one’s entitlement to indemnification requires a factual inquiry into the lawsuit or investigation; therefore, such disputes cannot usually be resolved until after the underlying controversy is decided. In re RNI Wind Down Corp., 369 B.R. 174, 185-86 (Bankr. D. Del. 2007); Majkowski v. Am. Imaging Mgmt. Servs., LLC, 913 A.2d 572, 586 (Del. Ch. 2006).
The company has an obligation to pay only reasonable fees and costs.
Companies who decide or are obligated to indemnify an executive, however, do have some control over the amounts they must pay. On the statutes’ own terms, again, the company must pay only amounts “actually and reasonably incurred.” Del. Code. tit. 8, § 145(a); Minn. Stat. § 302A.521, subd. 2; N.Y. Bus. Corp. Law § 722(a); Cal. Corp. Code § 317(b); see also O’Brien v. IAC/Interactive Corp., 2010 WL 3385798, at *5 (Del. Ch. Aug. 27, 2010) (applying rule that fees are reasonable if: (1) expenses were actually paid or incurred; (2) services rendered were prudent and appropriate in the good faith judgment of competent counsel; and (3) charges were made at rates, or on a basis, comparable to those charged to others for same or similar services).
A corollary to this proposition would seem to be that the indemnitee must provide sufficient records to support the fees and costs for which she is requesting reimbursement. If the recordkeeping of fees incurred leaves something to be desired, a discount of sorts may be applied. O’Brien, 2010 WL 3385798, at *14; MCI Telecomm. Corp. v. Wanzer, 1990 WL 91100 at *12 (Del. Super. Ct. June 19, 1990).
So, what is likely to happen in your particular case? Here, the executive is the subject of investigation – not yet being targeted for criminal prosecution. However, as we have seen, being called forth for questioning in the context of an ongoing investigation may indeed be enough to trigger a power to indemnify on the part of your company. In other words, you may indemnify her if she acted in good faith, in a manner she reasonably believed to be in the best interests of the corporation, and without any belief that her actions were unlawful. It is important to note that, since you are governed by the laws of Delaware, such indemnification would not be mandatory unless and until the executive successfully defends herself on the merits or otherwise in any subsequent legal proceeding. Your company also may decide to advance the executive’s expenses, upon receiving a written undertaking from her promising to repay any amounts advanced if it she is ultimately determined to have not been eligible for indemnification. Of course, if you do not advance her expenses, and choose simply to reimburse them after the fact if necessary, you are only on the hook for reasonable expenses – and probably only those with sufficient record-keeping to back them up.
The Corporation’s Own Law – Importance of the Articles and Bylaws
Often, consulting the state statute(s) governing a company is only the first step in determining whether that company may or must indemnify one of its employees. A corporation’s articles of incorporation and/or its bylaws may also speak to the issue; and the statutes make clear that these documents may actually control.
The Minnesota statute explicitly allows a corporation to limit the scope of (or even prohibit) mandatory indemnification through contrary language in the corporation’s articles or bylaws. Minn. Stat. § 302A.521, subd. 4. In the same vein, New York and California prohibit indemnification if it would be inconsistent with a corporation’s articles or bylaws. N.Y. Bus. Corp. Law § 725(b)(2); Cal. Corp. Code § 317(h)(1). Delaware provides that the indemnification protections afforded by its statute “shall not be deemed exclusive of any other rights to which those seeking indemnification or advancement of expenses may be entitled under any bylaw [or] agreement.” Del. Code tit. 8, § 145(f).
To provide an example of a situation in which a corporation’s governing documents come into play, we may turn to the advancement of expenses (discussed above). Paying particularly close attention to the corporation’s articles or bylaws is crucial in this context. Any immediate liability on the part of the corporation likely will be determined by specific provisions therein – for example, the bylaws may set out standards of conduct required for advancement of expenses. The bylaws also may provide that indemnification (or advancement of fees and costs), which may otherwise be permissive under statute, is mandatory under the bylaws. Courts interpreting such provisions tend to construe them on their own terms. See Thompson v. The Williams Companies, Inc., 2007 WL 2215953, at *3 (Del. Ch. July 31, 2007). When the dispute is over the advancement of fees prior to a determination of liability, “[t]he scope of an advancement proceeding is usually summary in nature and limited to determining the issue of entitlement in accordance with the corporation’s own uniquely crafted advancement provisions.” Homestore, Inc. v. Tafeen, 888 A.2d 204, 213 (Del. 2005). Such proceedings are typically resolved in one direction or the other on a motion to dismiss or motion for summary judgment; however if the bylaws make reference to a particular standard of conduct, an evidentiary hearing may be required. Kaung v. Cole Nat’l Corp., 884 A.2d 500, 505 (Del. 2005).
Although a corporation could simply choose to have a provision in its bylaws stating that it will provide indemnification “to such extent and under such circumstances” as provided for in the statute, it could also provide for far more specific terms. The effect of these such bylaws or articles vary greatly, of course, by company – but in any event, you would want to refer to your own governing documents to ensure that you are adhering to all of the controlling law.
Hypothetically, let’s say that your company has concluded it has no duty to indemnify its executive, or to advance her expenses in the pending investigation and/or lawsuit. There are strategic issues you should consider before making a decision whether to indemnify your executive, or to advance her expenses. For example:
1. It is very often in the corporation’s (and the executive’s) best interests to have competent legal counsel.
2. To the extent possible, it is beneficial for the corporation who decides not to advance expenses to have an understanding with counsel for the executive as to his fee structure, especially if there is a significant risk that ultimately the company will have to pay anyway. Having this understanding with counsel, then, can lead to a much greater control of costs for the company.
3. That said, it is more likely that a counsel for an individual will spend more in fees and expenses if his or her fees and expenses are being paid upfront by a company than if the individual is paying those expenses up front. In fact, it is even more likely that if the individual retains a private attorney that an engagement agreement will provide for a flat fee (or some other arrangement that the attorney would be less likely to negotiate with the company). Because the corporation indemnifies only the individual, and – importantly – not the law firm or lawyer that represents her, the company would only ultimately be liable for the flat fee or other agreement reached, assuming it is reasonable. As a result, the corporation will likely only be required to pay the amount actually charged as opposed to what may otherwise have been a more exorbitant fee. Compare Merritt-Chapman & Scott Corp. v. Wolfson, 321 A.2d 138, 143-44 (Del. Super. Ct. 1974); O’Brien, 2010 WL3385798, at *5. In fact, if a pubic defender is retained after indictment, the company may end up with no indemnification obligation at all.
The decision whether to indemnify a corporate actor is indeed factual, legal, economic, and strategic. Any final decision should take into account all of these variables.