Directors' and Officers' Indemnification Agreements: Precision Pays
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Published in the Spring 1999 edition of COMMITTEE NEWS, a publication
of the Professionals', Officers' and Directors' Liability Committee of the
Tort and Insurance Practice Section of the American Bar Association
The financial protection afforded to directors and officers under state indemnification statutes, such as Section 145 of Delaware's General Corporation Law, depends to a great extent on the provisions in corporate charters, by-laws, or other agreements that the corporation adopts in order to give effect to those indemnification provisions that are merely permissive and require express corporate implementation. In both of the cases that are discussed in this article, the Delaware Court of Chancery, one of the nation's leading business courts, ruled in favor of the complaining officer and director with respect to their claims under the respective indemnification provisions at issue in those cases. While both cases turn on their unique facts, they may certainly be construed as placing a greater burden on the corporation in "getting it right" when indemnification provisions are drafted.
DISCLOSURE AND GOOD FAITH
The most recent of the two cases discussed in this article highlights what duties, if any, an officer of a Delaware corporation has to disclose information to his company when negotiating an indemnification agreement, and conversely, what questions as a practical matter, the corporation should be asking in that negotiation context. See Greco v. Columbia/HCA Healthcare Corp., C.A. No. 16801, 1999 Del. Ch. LEXIS 24 (Del. Ch. Feb. 11, 1999). In that action, the plaintiff, Samuel A. Greco, was a Senior Vice President of Financial Operations of the defendant, Columbia/HCA Healthcare Corp. ("Columbia") until Columbia, which was faced with mounting pressure from a criminal investigation, decided to terminate through voluntary severance agreements, several high-level officers, including Greco. As part of the termination process for Greco, he and Columbia negotiated a severance agreement, which provided, inter alia, for indemnification, the advancement of litigation expenses, and insurance coverage in accordance with the applicable corporate charter provisions that addressed those subjects. 1999 Del. Ch. LEXIS 24 at *3-6.
The crux of the defense by Columbia to the advancement of Greco's litigation expenses was that Greco had consulted certain lawyers in connection with the negotiation of his severance agreement with Columbia and should have disclosed the identities of those lawyers to Columbia. The key lawyer whose identity had not been disclosed, at least in Columbia's theory of the case, was a New York attorney who represented Florida Software Systems, Inc. ("FSS"), a Columbia vendor. FSS was owned and controlled by a personal friend of Greco and, significantly, FSS sued Columbia after Greco had departed from Columbia. Before the FSS action against Columbia had been filed, Columbia had advanced litigation expenses to Greco in accordance with his severance agreement and the company's charter provisions on indemnification. Indeed, at the request of Columbia, Greco had attempted to resolve the differences between FSS and Columbia before FSS filed suit. Id. at *12-13.
On the same day that Columbia filed a third-party complaint against Greco in the FSS litigation, it notified Greco that it would not honor the terms of the severance agreement with Greco by advancing litigation expenses in either the criminal investigation (for which Columbia had been previously advancing litigation expenses to Greco), or the litigation expenses that Greco would be incurring in the third-party complaint brought against him that same day by Columbia. Id. at *13-14.
In analyzing Columbia's refusal to comply with its indemnification obligations to Greco, the court focused on the three legal defenses advanced by Columbia based on Greco's failure to identify the counsel on which he had relied in the severance agreement negotiations:
(1) Greco's non-disclosure was fraudulent concealment;
(2) Greco's non-disclosure violated the implied covenant of good faith and fair dealing; and
(3) Greco's non-disclosure constituted "reprehensible conduct" which barred recovery under the unclean hands doctrine.
First, as to the argument of fraudulent concealment, Columbia's theory was predicated on the assertion that as an officer of Columbia when he was negotiating the severance agreement, Greco had an obligation as a corporate fiduciary to disclose all material facts related to the negotiations. Id. at *24-25. The Vice Chancellor responded to that argument by pointing out that Greco was in the process of being terminated. Accordingly, his interests in the negotiation of the severance agreement were from the beginning of that process adverse to those of Columbia and, thus, did not implicate his fiduciary duties to the company:
I am at a loss as to why Greco had a duty to disclose the identity of those to whom he looked for legal advice. Columbia was on notice that any attorney for Greco would be duty bound to seek as much protection and benefit for Greco as possible in the context of the [severance agreement] negotiations. [The officer negotiating with Greco on behalf of Columbia] in fact believed Greco was consulting with an attorney and [that officer] had legal and employee relations resources at his disposal to address any proposals Greco brought to the table.
Id. at *26. Furthermore, with respect to the fraudulent concealment argument, the court observed that there was nothing in the record, other than speculation, to establish that had the fact of the attorney involvement been made known to Columbia, there would have been any different outcome with respect to the terms for indemnification and advancement of litigation expenses that were ultimately agreed to by the parties. Id. at *28-29.
Second, the essence of Columbia's argument based upon the violation of the implied covenant of good faith and fair dealing was that Greco "may" have disclosed confidential information to his attorney that "may" have assisted FSS in its litigation against Columbia. The court found the record devoid of any evidence to support that argument and summarily rejected it. Id. at *31-32.
Third, the court also rejected the unclean hands argument. The court found nothing "reprehensible" in Greco's reliance upon an attorney that had a relationship with FSS. The court did not believe it unusual for a lay person such as Greco not to recognize any adverse or improper implications arising from his retention of counsel that had a relationship with an adversary of Columbia, especially before FSS had filed suit against Columbia.
In short, the Court of Chancery rejected all of Columbia's defenses to Greco's claims for the advancement of his litigation expenses.
INDEMNIFICATION AND THE RIGHT TO SELECT COUNSEL
The second recent decision by the Delaware Court of Chancery addressed the always important issue as to the ability of an officer or director of a Delaware corporation to use counsel of his selection to represent him in litigation and to obtain advancement of litigation expenses for that selected counsel. See Chamison v. HealthTrust, Inc, C.A. No. 15904, 1999 Del. Ch. LEXIS 14 (Del. Ch. Jan. 12, 1999). The plaintiff in that action, Alan Chamison, served as director of an entity called EPIC Holdings, Inc. ("EPIC"). The defendant in the case, HealthTrust, Inc., The Hospital Company ("HealthTrust") acquired EPIC and agreed as part of the acquisition to provide the full indemnification rights, including advancement of litigation expenses, available to officers and directors under Delaware law. Id. at *3-7. The right to the advancement of litigation expenses was an issue because a derivative action had been brought against EPIC in which it was alleged that the EPIC Board, including Chamison, had violated their fiduciary duties in approving the sale to HealthTrust. It was contended by the plaintiff in the underlying derivative action that the allegedly inadequate price paid for EPIC was the product of the agreement by HealthTrust to repurchase certain stock appreciation rights awarded to key EPIC officers as incentive bonuses for their efforts on behalf of EPIC. Significantly, before the HealthTrust acquisition of EPIC, Chamison as a director of EPIC had filed an action against EPIC and the other members of the EPIC board and obtained an order that enjoined the proposed buyback of the stock appreciation rights. Id. at *3-6.
Shortly after the filing of the derivative action, HealthTrust agreed to comply with its indemnification obligations to the EPIC directors, including Chamison. Additionally, Chamison had indemnification rights from another source, American Medical Holdings, Inc. ("AMH"), a holding company for American Medical International, Inc., ("AMI"), of which Chamison was also an officer. It was AMI's substantial interest in EPIC that resulted in Chamison being selected to the EPIC Board as AMI's designated representative. Id. at *3. After a series of subsequent corporate acquisitions, the successor to AMH, Tenet Healthcare Corporation ("Tenet"), also agreed to honor its indemnification obligations to Chamison. Id. at *9-10.
The nub of the dispute between Chamison and HealthTrust related to HealthTrust's initial insistence that Chamison be represented by the law firm that was representing the other EPIC directors in the derivative action. Chamison contended that he had two unique defenses in the underlying derivative action that distinguished him from the other EPIC directors who were defendants: (1) his lack of pecuniary interests in the stock appreciation rights buyback, and (2) his assertion that the value of the stock appreciation right buyback had been misrepresented to him by EPIC's CEO. Id. at *8. Accordingly, Chamison used his own separate counsel to represent him in the underlying derivative action and HealthTrust declined to advance the expenses for those attorneys. Not insignificantly, Chamison's separate counsel succeeded in having the derivative plaintiff dismiss all claims against Chamison with prejudice. Id. at *11.
The substance of Chamison's claim in the Court of Chancery was that he was entitled to at least contribution, if not complete indemnification from HealthTrust for the costs incurred and paid by Tenet in defense of the underlying derivative action. While a portion of the court's decision dealt with the issue of the right of contribution from HealthTrust in view of Tenet's payment of Chamison's litigation expenses, the more interesting issue concerned whether Chamison had the right to select his own counsel to represent him in view of his alleged unique defenses that distinguished him from other EPIC directors.
The court began its analysis of the obligation of HealthTrust to Chamison with the recognition that the issue was one purely of contract, namely HealthTrust's indemnification agreement, and that that contract contained a valid provision giving HealthTrust the right to select counsel who would represent those directors with a right to indemnification. Id. at *20. However, at the same time the court held that under Delaware law there is an implied covenant of good faith and fair dealing in every contract, and each party to such a contract has made an implied covenant "to interpret and act reasonably upon contractual language that is on its face reasonable." Id. at *22. The Chancellor recognized that the Delaware courts apply the implied covenant concept only in narrow circumstances but, as discussed below, considered its application appropriate in the case of Chamison's indemnification rights and the right to separate counsel. The court explained the operation of the implied covenant concept as follows:
This implied covenant is a judicial convention designed to protect the spirit of an agreement when, without violating an express term of the agreement, one side uses oppressive or underhanded tactics to deny the other side the fruits of the parties' bargain. It requires the Court to extrapolate the spirit of the agreement from its expressed terms, and based on that "spirit," determine the terms that the parties would have bargained for to govern the dispute, had they foreseen the circumstances under which their dispute arose. The Court then implies the extrapolated term into the express agreement as an implied covenant and treats its breach as a breach of the contract. The implied covenant cannot contravene the parties' express agreement and cannot be used to forge a new agreement beyond the scope of the written contract.
Id. at *22 (footnotes admitted).
In applying the implied covenant concept to HealthTrust's argument that Chamison had waived his right to indemnification by refusing to use the law firm selected to represent all of the EPIC directors, the court analyzed the admittedly unique defenses of Chamison in the underlying derivative action within the context of the contract language permitting HealthTrust to select counsel for which litigation expenses were sought. The court recognized that the indemnification agreement contained no language that limited HealthTrust's ability to select Chamison's defense counsel. Accordingly, the court held that without limiting language, HealthTrust had broad discretion in applying the indemnification contract provisions at issue. However, in the court's view HealthTrust abused that discretion by "trying to force Chamison to accept a defense that was markedly inferior to an existing and known alternative." Id. at *26. Further, the court observed, that there is no language in 8 Del. C. § 145 which suggests that a corporation's counsel selection clause "trumps" a director's right to utilize his best legal defenses.
Indeed, § 145's purpose is to enable Delaware companies to attract competent directors by offering them indemnification for suits arising from their service to the companyBruns counter to the notion that an indemnitor could, through a counsel selection clause, foist a less-than-the-best defense upon an indemnitee. HealthTrust's contractual indemnification of Chamison invoked the same obligations and served the same purpose as § 145. Therefore, I conclude that their agreement did not contemplate sacrificing a director's defensive options to HealthTrust's counsel selection prerogative.
Id. at *27 (footnote admitted).
The court also discussed the fact that HealthTrust eventually offered to pay for separate counsel for Chamison at a point much closer to trial, which Chamison also declined. The court rejected HealthTrust's argument that Chamison's refusal to accept those lawyers constituted a breach of the indemnification agreement. That argument failed because the new counsel selection was proposed when HealthTrust knew that the trial date in the derivative action was fast approaching and that Chamison's own firm had spent considerable time and effort in his defense. By insisting initially that Chamison use the same counsel as the other EPIC directors, the court viewed that "oppressive behavior" as the basis for estopping HealthTrust to assert that Chamison breached the indemnification agreement by rejecting the later proffered counsel. Id. at *30.
Thus, as in Greco, above, the Court of Chancery denied the corporate defendant's effort to avoid its indemnification obligations.
Both of these decisions underscore the importance of detailed consideration by all interested parties of the terms and conditions of agreements between officers, directors and corporations that implement Section 145 indemnification rights. The negotiation of such agreements is often undertaken in an environment that requires prompt action and in an atmosphere where the relationship between the officer or director and the company may be in some state of deterioration if not completely adversarial. Both of these circumstances operate against careful consideration of the full implications of such agreements.
In the Greco case, the corporation could easily have required the requisite disclosure to avoid what it later considered a conflict of interest on the part of Greco. The Chamison case underscores the premium that an officer or director should place on including language in an indemnification agreement that will provide him with the option for counsel selection rather than leaving the corporation with the choice, at least in situations like Chamison, where the defenses of directors may be different or adverse. It is clear from the Chamison decision that the Court of Chancery will apply the indemnification statute, 8 Del. C. § 145, in a fashion that will enable an officer or director to pursue a course of action that will provide him with the best defenses available. In the Chamisoncase, Chamison was fortunate in being able to demonstrate that his position was clearly distinct from the other EPIC directors and that he, therefore, should have been able to select his own counsel. In other cases, the factors supporting the need for separate counsel may be more subtle. In those cases, a clearly worded indemnification agreement permitting the officer or director to select his own counsel in situations where a good faith basis exists to support the selection of separate counsel, would obviously avoid unnecessary litigation.
- Mr. James is a partner with Potter Anderson & Corroon LLP in Wilmington, Delaware. The views expressed in this article are those of the author alone and not of his firm or its clients.
- See, e.g., VonFeldt v. Stifel Financial Corp., 714 A.2d 79, 81 n.5 (Del. 1998); Citadel Holding Corp. v. Roven, 603 A.2d 818, 823 (Del. 1992); Advanced Mining Systems, Inc. v. Fricke, 623 A.2d 82, 83 (Del. Ch. 1992).
- The Delaware General Corporation Law provides in 8 Del. C. § 145(k) for a summary non-jury proceeding with respect to claims brought for indemnification or for advancement of litigation expenses related to indemnification claims.
- In support of its application of the implied covenant rule, the court referred to several authorities including, Gilbert v. El Paso Co., 490 A2d. 1050, 1055 (Del. Ch. 1984), aff'd, 575 A.2d. 1131 (Del. 1990); Katz v. Oak Industries Inc., 508 A2d. 873, 880 (Del. Ch. 1986); Restatement (Second) of Contracts § 205 (1981).