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Do You Want Protection? Better Get it in Writing

Kevin Kinross

It is generally understood that under most state’s laws corporate directors enjoy various forms of protection that provide a shield from liability for their actions as a corporate director. Such protections include the business judgment rule, statutory indemnification, D&O insurance policies, and even indemnification agreements, which may include rights beyond those provided by statute and advancement of legal fees.

While these principles are generally understood, it may nevertheless come as a surprise to many that an organization’s ability to adjust the provisions may even include the ability to eliminate former directors’ advancement rights, at least according to Delaware Chancery Court’s recent opinion in Schoon v. Troy. In Schoon v. Troy, the court was faced with a claim for indemnification by a former director of Troy Corporation, William Bohnen. Mr. Bohnen resigned in February 2005. Later that year, Troy amended its bylaws to eliminate the right of former directors to advancement of expenses incurred to defend claims. A few months after amending the bylaws, Troy sued Mr. Bohnen and another Troy director for breach of fiduciary duty. Mr. Bohnen asked Troy to advance his defense costs. Troy declined, Mr. Bohnen sued and lost. The corporation’s bylaw had originally provided that “the Corporation shall pay the expenses incurred by any present or former director.”

The Chancery Court held that while a bylaw amendment cannot rescind a vested contract right, Mr. Bohnen’s right to advancement was not vested at the time of Troy’s bylaw amendment because no claim had been made against him at that time even though the incident, or the act or omission, giving rise to the claim arose while the right to advancement existed. In doing so, the Court rejected Mr. Bohnen’s argument, holding that the language of the original bylaws did not preserve his right to advancement because his right vested only after the amendments took place, at the commencement of litigation.

With Schoon, until an actual claim is asserted against a director in a proceeding for which the director would ordinarily be entitled to advancement of legal fees, the director has no vested legal right to advancement, and yes, the director’s rights can be lawfully terminated. Prior to this decision, it was well accepted and understood that the purpose of indemnification and advancement is to encourage board service and assure directors that their expenses relating to their official actions will be repaid – even if litigation arises after they resign from the board. Now this can no longer be accepted as true.

If you are a director reading this article, then yes, shock is the appropriate word to describe what you are feeling. Especially since the purpose of indemnification and advancement is to encourage board service and assure directors that their expenses relating to their official actions will be repaid.

In light of this ruling, the only certain way for directors to avoid Mr. Bohnen’s fate in Schoon is to insist that the corporation provide indemnification rights via a separate agreement, which as a formal, written contract cannot be amended without the director’s consent. Corporations may also consider including in their bylaws a provision intended to override the Schoon principle—such as a clause to the effect that “any repeal, modification, or amendment to these indemnification or advancement provisions shall not adversely affect any right in respect of acts or omissions of any indemnified person occurring prior to such repeal, modification, or amendment.” There is no apparent downside to such a provision, but there can be no assurance that it cannot be amended away just as in Schoon.

At the same time, however, directors must remember that most D&O liability insurance policies include former directors within their definition of insured persons, and that under most circumstances a former director for whom advancement and indemnification has been withheld should still have a right to seek defense expenses and indemnification under such policies. Thus, an organization’s D&O policy should provide adequate protection even for former directors – assuming that the limits available under the policy were not exhausted by other insured persons. Further, former directors who are concerned that they may be exposed with no protection can now also consider a “retired director and officer liability insurance policy.” This kind of coverage, which is popular in England and Australia, which is currently only being offered by a few carriers, are noncancellable and nonrescindable, and provides coverage for up to 6 years after the director resigns, retires or is fired.

The point being, that the director in Schoon lost his expected right of advancement after he left the board. Directors concerned about their rights following board service will want to fully consider any available protection.

At a minimum, this holding stresses that for a director to be guaranteed protection, without any personal out-of-pocket expense, the director needs to have his or her own separate indemnification agreement with the organization. Such agreements will reduce the possibility that a later board could eliminate advancement rights after the director has left board service. Without a separate agreement, directors now have no reasonable assurance that after they leave the board their rights to advancement and indemnification will be preserved. If you want to ensure that your rights to advancement and indemnification will be preserved, its simple - you better get it in writing.

If your organization has not reviewed its articles or code of regulations in several years and either or both may be outdated, good corporate governance suggests you contact your corporate attorney to begin a review. In doing so, your organization’s governing documents may be updated to provide the greatest protection to your board.