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Bifurcating Indemnification

by Boris Feldman[*]

You are a director of a public company. You have fired an executive for
misconduct. Her actions have embroiled the company in lawsuits, investigations,
and government enforcement actions. She has hired her own lawyers. Her lawyers
are running up huge bills and ignoring the General Counsel’s requests for budgets
and restraint. The General Counsel advises you that the ex-employee’s fees could
amount to millions of dollars, and that the company is obligated to pay them. Is
there anything you can do to stop this travesty?

Probably not.

Nearly every public company has adopted expansive indemnification policies for its
officers and directors. Most are governed by Delaware law. Those of other
jurisdictions are similar. The indemnification provisions are embodied in bylaws
and sometimes in separate indemnification agreements. At its core, the typical
indemnification provision obligates the company to pay for an executive’s lawyer
to represent her in connection with any conduct within the scope of her
employment. Indemnification continues after termination of employment for conduct
prior to the termination. Indemnification continues even if the Board fires the
executive. The executive is usually required to sign an undertaking agreeing to
repay the fees that were advanced if a court later determines that indemnification
was not permitted. The circumstances under which indemnification is barred are
rare: typically, proof that an employee engaged in unlawful conduct and did not
believe that it was in the best interests of the company. For example, an
employee who embezzled from the company bank account would probably not be
eligible for indemnification. On the other hand, an employee who falsified
revenue to improve the company’s reported results probably would be.

Regardless of whether the employee is ultimately found to have been entitled to
indemnification, the key point is this: during the course of the litigation –
including any dispute as to right to indemnification – the company continues to
pay. The approach is “pay first, litigate later.” In theory, the company can
later recoup the advanced payments from the executive after proving that
indemnification was not permitted. But, good luck finding the assets to recoup
(especially after the executive has had to deal with class actions, SEC
proceedings, and so on).

The modern approach to indemnification seems overboard, until one recalls its
historical roots: the Vandal hordes. The scenario for which indemnification
agreements are designed is this: your company has been taken over in a hostile
tender offer. The acquirer has fired everyone and is determined to deprive them
of everything to which they are entitled. The acquirer denies indemnification on
meritless grounds. But the practical effect is that the former executive cannot
pay for counsel and surrenders.

In this scenario, the modern indemnification structure makes sense. To protect
corporate officers and directors, they must know that they cannot be arbitrarily
denied the right to defend themselves. In effect, the system presumes bad faith
on the part of the board seeking to withhold indemnification, because today’s
board was yesterday’s barbarians at the gates.

The bias toward former employees, which makes much sense in the context of a
change on control, makes no sense absent a change in control. The legal system
routinely defers to a Board’s business judgment. Why should we not defer to the
Board when it decides that a fired executive’s conduct does not merit
indemnification?

In my opinion, it is time for companies to consider adopting bifurcated
indemnification provisions. Current board indemnification would apply in the
event of a change in control. Although there are various ways to define “change
in control,” corporate lawyers have great experience in doing so in connection
with employment agreements, poison pills, and other provisions.

Absent a change in control, the Board could withhold indemnification for cause.
This does not necessarily mean that the employee was terminated for cause: often,
executives are separated for doing something wrong (or not doing something right)
without labeling it a for-cause termination. Rather, the Board would make a
determination that, for particular reasons, indemnification was not appropriate or
in the best interests of the company. Those grounds could either be set forth in
the bylaws or agreements, or developed by the Board on a case-by-case basis. For
example: “Notwithstanding the foregoing, the Board may withhold indemnification
where it concludes that the employee has acted in a manner that she knew or
reasonably should have known was detrimental to the interests of the company.”

But wait, an executive might cry: how can I trust the Board to treat me fairly?
The answer is that Boards exercise broad discretion under the business judgment
rule all the time. There is no reason to deny them that discretion with respect
to decisions involving millions of dollars for the Company. If the executive
denied indemnification believes that she has been treated unfairly, she can always
seek judicial recourse – but without the company footing the bill in the interim.

Presumably, it would be the rare case in which a Board denied indemnification.
But that decision is properly made based on the facts of each situation, so long
as the extant Board remains in place and has not been ousted by a group intent on
wreaking vengeance on the prior executive team.

[*] *Copyright 2007. Boris Feldman is a member of Wilson Sonsini Goodrich &
Rosati. This article reflects his views, not his firm's. You are welcome to copy
and distribute this article, with express attribution to the author. Revised,
February 10, 2007.