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Hermelin v. K-V Pharmaceutical Co., C.A. No. 6936-VCG (Del. Ch. Feb. 7, 2012) (Glasscock, V.C.)

February 7, 2012

In this memorandum opinion, the Court of Chancery considered cross-motions for partial summary judgment as to whether a former CEO of a Delaware corporation succeeded on the merits or otherwise in certain regulatory and criminal proceedings and thus would be entitled to mandatory indemnification under Section 145 of the DGCL and an indemnification agreement.  The Court found that the former CEO, who had pled guilty to certain criminal charges and been subjected to other regulatory penalties, was successful in only one of the three underlying proceedings at issue.  The Court noted, however, that the former CEO could be entitled to indemnification under the indemnification agreement if further, limited discovery revealed that he acted in good faith.  The Court also found that the former CEO was not entitled to an advancement of expenses in connection with a civil action in which he sought injunctive relief, because he did not obtain the corporation’s consent to initiate that proceeding as required by the indemnification agreement.

In May 2008, two pharmacies notified K-V Pharmaceutical Company (“KV” or the “Company”) that KV had manufactured and distributed oversized morphine sulfate tablets.  KV conducted an internal investigation and discovered that it had indeed manufactured oversized tablets of morphine sulfate, as well as oversized tablets of other drugs.  After KV notified the Food and Drug Administration, several proceedings were initiated involving KV and Marc S. Hermelin, a former director and CEO of KV.  First, KV’s Audit Committee conducted its own investigation, which resulted in a decision to terminate Hermelin’s employment as CEO.  News of the termination precipitated a criminal investigation by the U.S. Attorney’s Office for the Eastern District of Missouri and two Federal strict liability misdemeanor charges against Hermelin (the “Criminal Matter”).  The FDA and the Office of the Inspector General of the Department of Health and Human Services (“OIG”) also brought two separate regulatory actions involving Hermelin (the “FDA Matter” and the “HHS Matter”).   

Hermelin filed suit in the Court of Chancery against KV and sought a declaration from the Court that he was entitled to mandatory indemnification for each of underlying proceedings under Delaware law and an indemnification agreement between KV and Hermelin (the “Indemnification Agreement”).  The Court explained that Hermelin would be entitled to mandatory indemnification as a matter of law if the outcomes of the proceedings could be deemed a success for Hermelin.  If the Court did not find that Hermelin was successful on the merits or otherwise, the Court would then need to consider, on a more complete record, whether Hermelin acted in bad faith, thus disqualifying him from the permissive indemnification made mandatory by the terms of the Indemnification Agreement. 

In addressing whether Hermelin was successful on the merits or otherwise, the Court noted that the Indemnification Agreement provided an additional clarification of the phrase “success on the merits or otherwise” stating, in part, that “a settlement or other disposition short of final judgment may be successful if it permits a party to avoid expense, delay, distraction, disruption and uncertainty.”  The Court noted that the parties had disagreed on how closely a court must scrutinize the outcome of a proceeding to determine whether a party was successful. In particular, KV suggested that the Court should look behind the outcome of the proceeding and determine “whether the relevant governmental entity believed or intended Mr. Hermelin to be successful….”  The Court rejected KV’s argument and stated that it need only look at the outcome of the proceeding and determine whether the indemnitee has avoided an adverse result.  The Court therefore concluded that the only relevant consideration was “what the result was, not why it was.”

The Court then assessed each of the proceedings.  With respect to the Criminal Matter, the Court found that Hermelin was not successful and not entitled to mandatory indemnification.  Hermelin pleaded guilty to both charges of federal strict liability misdemeanors and was ordered to pay $1.9 million in fines and forfeitures and sentenced to a maximum of thirty days in jail.  Hermelin argued that a guilty plea is not necessarily an adverse judgment and by choosing to plead guilty, he was able to avoid expense, delay, distraction, disruption, and uncertainty and was therefore “successful.”  The Court contrasted the case to one in which the charges were reduced as a result of a plea bargain, and held that Hermelin’s guilty plea to every charge against him cannot constitute a successful outcome, despite any advantages associated with his plea.

The Court found that Hermelin was likewise not entitled to mandatory indemnification for the HHS Matter.  The OIG, after considering information submitted by Hermelin in his defense, excluded Hermelin for twenty years from healthcare programs—a decision the parties acknowledged was essentially a lifetime ban in light of Hermelin’s age.  The Court found this result to “clearly” not constitute a success for Hermelin.  The Court rejected Hermelin’s assertion that despite the effective life-time ban, the outcome was still a success because he was not required to make a payment. 

The only proceeding for which the Court deemed Hermelin successful on the merits was the FDA Matter.  In that proceeding, the FDA sought to prohibit Hermelin, and other defendants, from manufacturing, holding, or distributing any drug until the defendants brought their operations up to standard.  The restrictions ultimately imposed, however, were not applied to Hermelin.  Because Hermelin was able to avoid a personally negative result in connection with this proceeding, the Court found that he succeeded in the matter, and therefore was entitled to indemnification.

The Court acknowledged that because the Indemnification Agreement generally granted indemnification rights to the fullest extent permitted by the DGCL, Hermelin could be entitled to indemnification, even for the proceedings in which he was unsuccessful, as long as he did not act in bad faith.  However, the Court postponed making a determination on Hermelin’s conduct until it could consider further evidence at a plenary trial.  The Court defined the scope of evidence relevant to bad faith in this context.  It stated that typically a finding of bad faith in an underlying proceeding is conclusive evidence that the indemnitee is not entitled to indemnification.  However, when an underlying proceeding involves a settlement or some sort of regulatory investigation, as in this case, there may not be an underlying judicial record on which to base a finding of bad faith.  The Court ultimately held that the relevant evidence is limited to Hermelin’s conduct underlying the proceedings for which Hermelin sought indemnification. 

In addition to his indemnification claims, Hermelin also sought advancement for legal fees and expenses in prosecuting an action for injunctive relief against the St. Louis County Jail, where he was incarcerated following his conviction in the Criminal Matter.  The Court found that Hermelin was not entitled to advancement because the Indemnification Agreement restricts advancement for actions or portions thereof initiated by the indemnitee, unless the proceeding was authorized by the KV Board of Directors.  Hermelin argued that he did not initiate the action but rather employed the only defense available to him when he was faced with the potential disclosure of sensitive private information.  The Court rejected this argument, finding that Hermelin’s situation was no different than that of any person whose rights are infringed in such a way that warrants injunctive relief.  Hermelin alternatively argued that his claim for injunctive relief is more akin to a compulsory counterclaim.  The Court rejected this argument as well, explaining that Hermelin’s “abstract construction” of “compulsory counterclaim” expanded the definition in a manner unsupported by the language of the Indemnification Agreement or the case law.

The full opinion is available here