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Legal Intelligencer: Defending Officers and Directors From a Lawsuit by the Company

In the January 3, 2019 edition of The Legal Intelligencer, Edward Kang, Managing Member of KHF wrote “Defending Officers and Directors From a Lawsuit by the Company.

When a corporate director or officer is sued by a third party for alleged misconduct carried out in her capacity as director/officer, the company generally indemnifies the director/officer by defending her against the lawsuit. The company’s duty of indemnification arises from both the law and governing corporate documents (e.g., articles of incorporation, bylaws or employment agreement). While there are limited exceptions to the company’s duty of indemnification—e.g., the director/officer acted in her personal capacity or that she acted in bad faith against the interest of the company—the duty of indemnification is broad. The company must defend the director/officer, at least until the court determines otherwise. What protection does a corporate director/officer have, however, if the person suing her is the company itself?

A company sues its officer or director more frequently than many people think. The company could bring a direct lawsuit against an officer or director for a breach of fiduciary duty (e.g., alleged self-dealing). Sometimes, a shareholder could bring a derivative lawsuit under the company’s name against the officer or director.

Indemnification Provision Under the Law

In addition to providing an indemnification provision for an officer or director against a third-party lawsuit, the Pennsylvania Business Corporation Law also provides one for a lawsuit brought by the company, see 15 Pa.C.S.A. Section 1742. Although a corporation may restrict its duty of indemnification for an officer or director in its bylaws, the corporation must indemnify the person if the person successfully defends against the corporate action on the merits, 15 Pa.C.S.A. Section 1743. Even if the person is ultimately held liable to the company, the court could still order indemnification of the person if the court finds that “despite the adjudication of liability [against the officer or director] but in view of all the circumstances of the case, the person is fairly and reasonably entitled to indemnity for the expenses that the court of common pleas or other court deems proper.” The statute does not define under what “circumstances” the court may require indemnification even when the person is held liable to the company. But the court is likely to require indemnification only when it finds that the officer “acted in good faith and in a manner he reasonably believed to be in, or not opposed to, the best interests of the corporation,” 15 Pa.C.S.A. Section 1741 (relating to indemnification for third-party actions).

Delaware law offers similar indemnification provisions. Under the Delaware General Corporation Law, although a company’s duty to indemnify a corporate officer or director from the company’s action against the person can be limited by its bylaws and the duty applies only when “the person acted in good faith and in a manner the person reasonably believed to be in or not opposed to the best interests of the corporation,” the company must indemnify the person if the court finds that “despite the adjudication of liability but in view of all the circumstances of the case, such person is fairly and reasonably entitled to indemnity for such expenses which the Court of Chancery or such other court shall deem proper,” Del. Code Ann. tit. 8, Section 145(b).

Advancement Obligations

In addition to indemnification obligations, a company could be required to advance legal expenses to its officer or director during the lawsuit it brought against the person. That is, a company could be required to advance to its officer or director legal expenses incurred in defending against the company’s lawsuit. Courts treat the advancement obligation separate from the indemnification obligation. Under Pennsylvania law, “expenses (including attorney fees) incurred in defending any action or proceeding referred to in this subchapter may be paid by a business corporation in advance of the final disposition of the action or proceeding upon receipt of an undertaking by or on behalf of the representative to repay the amount if it is ultimately determined that he is not entitled to be indemnified by the corporation as authorized in this subchapter or otherwise,” 15 Pa.C.S.A. Section 1745. The statute goes on to state that “except as otherwise provided in the bylaws, advancement of expenses shall be authorized by the board of directors.” “Sections 1728 (relating to interested directors or officers; quorum) and 2538 (relating to approval of transactions with interested shareholders) shall not be applicable to the advancement of expenses under this section.” Accordingly, as long as the governing documents (e.g., bylaws) provide an advancement obligation for an officer or director, the corporation must provide advancement of legal expenses upon the corporation’s receipt of an undertaking by the person to repay the advancement if it is ultimately determined that the person is not entitled to indemnification. Interestingly, the decision to make advancement is solely with the board of directors (not shareholders) even if the board includes an interested board member who is being sued by the corporation.

Delaware law is more favorable to officers and directors than Pennsylvania law. Like under Pennsylvania law, a corporation, at the board’s decision, may advance legal expenses to a corporate officer or director in defending against the corporation’s action against him. Under Delaware law, however, the duty of make advancement—assuming that the governing document provides for advancement—includes not only for legal expenses incurred by the officer in “defending” against the action brought by the corporation, but also legal expenses incurred by the officer in asserting counterclaims against the corporation in the same lawsuit, see Citadel Holding v. Roven, 603 A.2d 818, 824 (Del. 1992). In ruling that the corporation must advance legal expenses incurred by the person for pursuing his counterclaims against the corporation, the Delaware Supreme Court stated “certain claims must be asserted” under the compulsory counterclaim rule (FRCP 13) and, therefore, the corporation had to advance legal expenses to the officer. The duty of advancement for legal expenses incurred for asserting counterclaims is critical since an officer would likely have a counterclaim relating to the dispute underlying the company’s lawsuit.

Delaware law is also more favorable to officers or directors regarding advancement in another way. Unlike Pennsylvania law, Delaware law allows a summary proceeding to require a corporation to comply with its advancement obligations promptly, Del. Code Ann. tit. 8, Section 145(k) (“The Court of Chancery may summarily determine a corporation’s obligation to advance expenses (including attorneys’ fees).” The entire summary proceeding takes only a few months.  Summary proceeding is invaluable as, without such procedure, it could take years before an officer or director could receive her “advancement” of legal fees, which would defeat the purpose of advancement. See VonFeldt v. Stifel Financial, 714 A.2d 79, 84 (Del. 1998) (“We have long recognized that Section 145 serves the dual policies of: allowing corporate officials to resist unjustified lawsuits, secure in the knowledge that, if vindicated, the corporation will bear the expense of litigation; and encouraging capable women and men to serve as corporate directors and officers, secure in the knowledge that the corporation will absorb the costs of defending their honesty and integrity.”).

Pennsylvania does not have a statutory summary proceeding like Delaware. Given Pennsylvania’s tendency to adopt Delaware’s leading corporate law, it would not be a surprise for Pennsylvania to adopt a similar proceeding in the future.

Conclusion

Litigation between a corporation and its officer or director is common. Unlike in a derivative lawsuit where a corporation’s interest and that of the officer/director could be aligned, in a direct corporate action against its officer/director, the corporation’s interest and the person’s interest will likely be adversarial. Litigation like that is frequently unfair to officers or directors as the company has many advantages over the persons, including the financial wherewithal and access to evidence. Officers and directors will need as much protection as possible. Practitioners who represent officers or directors should consider the following before any dispute with the company arises. Officers should seek the broadest indemnification language possible in the bylaws and employment agreement, if applicable. Such language should state that the company must indemnify the officer to the “fullest extent of the law.” They should also seek mandatory advancement language in the governing document. Ideally, officers or directors should also seek supplemental coverage, such as D&O policies. Practitioners who are defending officers or directors against the company’s lawsuit should immediately demand both indemnification and advancement from the company. Under appropriate circumstances, the company could be required to advance legal expenses incurred not only for defending against the lawsuit but also for prosecuting her counterclaims against the company.

Edward T. Kang is the managing member of Kang, Haggerty & Fetbroyt. He devotes the majority of his practice to business litigation and other litigation involving business entities. 

Reprinted with permission from the January 3, 2019 edition of “The Legal Intelligencer” © 2019 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited, contact 877-257-3382 or reprints@alm.com.