The Case for Non-Discretionary Advancement Policies

You have recently been appointed General Counsel of a publicly traded Delaware corporation. A few months into your tenure, the Board asks whether the company should establish a policy for the automatic advancement of defense costs to officers or directors involved in company-related litigation. Your answer is that incorporating a non-discretionary advancement policy into the bylaws would be in the long-term best interests of the company.

A non-discretionary advancement provision would require the company to advance all legal expenses for any officer or director involved in any civil, criminal, administrative or investigative proceeding arising because the person is or was an officer or director of the company. Any advancement of defense costs would be conditioned upon their signing an undertaking to repay, as required by state law, and upon such other terms the company may choose to include in its advancement provision (see below). You know that advancing legal costs can be very expensive ' you have witnessed the dramatic increase in Department of Justice (DOJ) and SEC investigations into the conduct of officers and directors of public companies, not to mention the ever present reality of shareholder and derivative suits. Nevertheless, you think the risk of large legal bills is outweighed by significant potential benefits to the company.

The first benefit of a non-discretionary advancement policy is well-understood: In order to attract and retain highly-qualified officers and directors, a company needs to be willing to defend them should they come under investigation for actions taken in service of the company. Second, company support for the defense of a person who is being investigated or prosecuted for conduct while at the company allows that person to mount a full defense against any allegations of wrongdoing, with such defense possibly inuring to the company's benefit. Third, having a non-discretionary advancement policy prevents the DOJ or SEC from suggesting, subtly or not, that the company should not advance legal fees to the subjects of a particular investigation and from drawing an adverse inference about the company's cooperation with the investigation because the company is paying the legal fees of possible targets.

Why Should a Company Advance Defense Costs?

As any company would no doubt remind an outsider inquiring about investigations or prosecutions of any officer or director, it is important to remember that accusations of wrongdoing are far different from actual findings of misconduct. The mere fact that an officer or director is accused should not lead a company to turn its back on the person without first giving him or her a chance at vindication. What if the government is wrong? What if the person can demonstrate that he or she always acted in good faith? Companies need to encourage the kind of risk taking that allows growth in new directions. This goal is undercut if risk-takers are placed in unfair peril because they must fund their own defense if something goes wrong. How will the company explain itself to prospective officers and directors who might fear that any risks they take could result in their being cut loose by the very company that they serve? Although it is easy to understand why a company might balk at paying to defend an allegedly 'faithless fiduciary,' Reddy v. Electronic Data Systems Corp., 2002 WL 1358761 (Del. Ch. Jun. 18, 2002), 'to give effect to this natural human reaction as public policy would be unwise.' Id.

Non-discretionary advancement policies provide officers and directors with the necessary resources to resist unjustified lawsuits. At the same time, they encourage highly qualified people to serve as officers and directors, 'secure in the knowledge that the corporation will absorb the costs of defending their honesty and integrity.' VonFeldt v. Stifel Fin. Corp., 714 A.2d 79, 84 (Del. 1998).

Officers found guilty of wrongdoing are liable to the company for all the money that was advanced. 'The right to advancement is not dependent on the right to indemnification. The right to indemnification requires 'success on the merits or otherwise,” whereas Delaware law 'expressly contemplates that corporations may confer a right to advancement that is greater than the right to indemnification.' Homestore, Inc. v. Tafeen, 888 A.2d 204, 212-13 (Del. 2005).

Showing Foresight in Establishing Advancement Procedures

After your Board decides to incorporate a non-discretionary advancement policy into the bylaws, you should assist the Board in establishing a procedural framework for the advancement provision that is most beneficial to the company's needs. According to Delaware law, the company must condition any advancement to a current officer or director 'upon receipt of an undertaking by or on behalf of such director or officer to repay [the advancement]' if he or she is found to be ineligible for indemnification. DEL. GEN. CORP. L. ' 145(e). In addition to the requisite undertaking, 'corporations may specify by bylaw or contract the terms and conditions upon which present and former corporate officials may receive advancement ' ' Homestore, 888 A.2d at 212. For example, the company could condition advancement upon the receipt of a sworn representation that the person seeking advancement believes he or she acted in good faith. See, e.g., Thompson v. Williams Companies, Inc., 2007 WL 2215953 (Del. Ch. July 31, 2007). And you should consider whether employees below the officer level will also be offered advancement; Delaware law allows companies to advance legal fees for 'other employees and agents ' upon such terms, if any, as the corporation deems appropriate.' DEL. GEN. CORP. LAW ' 145(e).

The key task in establishing an advancement policy is to foresee what kinds of protections should be in place if and when officers and directors find themselves accused of wrongdoing. The policy should then be made non-discretionary so that any qualifying individual knows that he or she will receive advancement when it's needed. If an officer or director comes to the Board hat in hand seeking advancement of legal expenses from the very company he is alleged to have wronged, a company with discretion may be 'reluctant to advance funds for his defense, fearing that the funds will never be paid back and resisting the idea of seeing further depletion of corporate resources at the instance of someone perceived to be a faithless fiduciary.' Reddy, 2002 WL 1358761. By having a non-discretionary policy, the company can allow officers and directors to avoid being placed in this horrible situation.

Litigation costs have increased as the DOJ, the SEC, state criminal and regulatory authorities, and of course private plaintiffs, put officers and directors of public companies under increasing scrutiny for any perceived management misstep or alleged breach of their fiduciary duties. As companies increasingly conduct their own prophylactic internal investigations or attempt to show their full cooperation with the investigative body, it is critical that the company do its best to assist the officers and directors in defending themselves. Insuring that individuals accused of wrongdoing have the necessary resources to mount a full defense gives them the opportunity to seek to vindicate themselves and prevent any vicarious liability to the company.

Another key reason why companies should have non-discretionary advancement provisions is the possibility that the DOJ could consider the advancement of legal fees as evidence that the company is not cooperating with, or even impeding, a DOJ investigation. Although the DOJ acknowledges that it's 'the rare case' where advancement of legal fees may be viewed as 'impeding an investigation,' the McNulty Memorandum (Dec. 12, 2006) went on to explain that 'fee advancement is considered with many other telling facts to make a determination that the corporation is acting improperly to shield itself and its culpable employees from government scrutiny.' But if a company's bylaws require the advancement of legal fees whenever specified conditions are met, it will be inappropriate for a prosecutor to infer that the company is trying to cover up a problem by paying legal fees in a particular case. In July 2008, as this article went to press, the DOJ indicated that it might change its standards for evaluating a company's cooperation, so that a company's advancement of legal fees would no longer be a factor to consider for evaluating cooperation. Because of the possibility that the DOJ's views on fee advancement will fluctuate over time, it is all the more important that companies establish policies today that will protect the company should it come under government scrutiny sometime in the future.

Conclusion

The idea of advancing legal fees to an officer or director who may well be ineligible for indemnification can be a bitter pill for a company's board to swallow. Although the company can later seek reimbursement from the party who is adjudicated to have acted in bad faith toward the company, see, e.g., Bergonzi v. Riteaid Corp., 2003 WL 22407303 (Del. Ch. Oct. 20, 2003), the prospects of repayment are at best uncertain. Nevertheless, as the General Counsel, you should remind your Board that by giving accused officers and directors a full chance to defend themselves, your Board may wind up defending the company too.

Marjorie J. Peerce ([email protected]), a member of this newsletter's Board of Editors, is a partner at Stillman, Friedman & Shechtman, P.C., New York. Nathaniel I. Kolodny is an associate at the firm.

You have recently been appointed General Counsel of a publicly traded Delaware corporation. A few months into your tenure, the Board asks whether the company should establish a policy for the automatic advancement of defense costs to officers or directors involved in company-related litigation. Your answer is that incorporating a non-discretionary advancement policy into the bylaws would be in the long-term best interests of the company.

A non-discretionary advancement provision would require the company to advance all legal expenses for any officer or director involved in any civil, criminal, administrative or investigative proceeding arising because the person is or was an officer or director of the company. Any advancement of defense costs would be conditioned upon their signing an undertaking to repay, as required by state law, and upon such other terms the company may choose to include in its advancement provision (see below). You know that advancing legal costs can be very expensive ' you have witnessed the dramatic increase in Department of Justice (DOJ) and SEC investigations into the conduct of officers and directors of public companies, not to mention the ever present reality of shareholder and derivative suits. Nevertheless, you think the risk of large legal bills is outweighed by significant potential benefits to the company.

The first benefit of a non-discretionary advancement policy is well-understood: In order to attract and retain highly-qualified officers and directors, a company needs to be willing to defend them should they come under investigation for actions taken in service of the company. Second, company support for the defense of a person who is being investigated or prosecuted for conduct while at the company allows that person to mount a full defense against any allegations of wrongdoing, with such defense possibly inuring to the company's benefit. Third, having a non-discretionary advancement policy prevents the DOJ or SEC from suggesting, subtly or not, that the company should not advance legal fees to the subjects of a particular investigation and from drawing an adverse inference about the company's cooperation with the investigation because the company is paying the legal fees of possible targets.

Why Should a Company Advance Defense Costs?

As any company would no doubt remind an outsider inquiring about investigations or prosecutions of any officer or director, it is important to remember that accusations of wrongdoing are far different from actual findings of misconduct. The mere fact that an officer or director is accused should not lead a company to turn its back on the person without first giving him or her a chance at vindication. What if the government is wrong? What if the person can demonstrate that he or she always acted in good faith? Companies need to encourage the kind of risk taking that allows growth in new directions. This goal is undercut if risk-takers are placed in unfair peril because they must fund their own defense if something goes wrong. How will the company explain itself to prospective officers and directors who might fear that any risks they take could result in their being cut loose by the very company that they serve? Although it is easy to understand why a company might balk at paying to defend an allegedly 'faithless fiduciary,' Reddy v. Electronic Data Systems Corp., 2002 WL 1358761 (Del. Ch. Jun. 18, 2002), 'to give effect to this natural human reaction as public policy would be unwise.' Id.

Non-discretionary advancement policies provide officers and directors with the necessary resources to resist unjustified lawsuits. At the same time, they encourage highly qualified people to serve as officers and directors, 'secure in the knowledge that the corporation will absorb the costs of defending their honesty and integrity.' VonFeldt v. Stifel Fin. Corp. , 714 A.2d 79, 84 (Del. 1998).

Officers found guilty of wrongdoing are liable to the company for all the money that was advanced. 'The right to advancement is not dependent on the right to indemnification. The right to indemnification requires 'success on the merits or otherwise,” whereas Delaware law 'expressly contemplates that corporations may confer a right to advancement that is greater than the right to indemnification.' Homestore, Inc. v. Tafeen , 888 A.2d 204, 212-13 (Del. 2005).

Showing Foresight in Establishing Advancement Procedures

After your Board decides to incorporate a non-discretionary advancement policy into the bylaws, you should assist the Board in establishing a procedural framework for the advancement provision that is most beneficial to the company's needs. According to Delaware law, the company must condition any advancement to a current officer or director 'upon receipt of an undertaking by or on behalf of such director or officer to repay [the advancement]' if he or she is found to be ineligible for indemnification. DEL. GEN. CORP. L. ' 145(e). In addition to the requisite undertaking, 'corporations may specify by bylaw or contract the terms and conditions upon which present and former corporate officials may receive advancement ' ' Homestore, 888 A.2d at 212. For example, the company could condition advancement upon the receipt of a sworn representation that the person seeking advancement believes he or she acted in good faith. See, e.g., Thompson v. Williams Companies, Inc., 2007 WL 2215953 (Del. Ch. July 31, 2007). And you should consider whether employees below the officer level will also be offered advancement; Delaware law allows companies to advance legal fees for 'other employees and agents ' upon such terms, if any, as the corporation deems appropriate.' DEL. GEN. CORP. LAW ' 145(e).

The key task in establishing an advancement policy is to foresee what kinds of protections should be in place if and when officers and directors find themselves accused of wrongdoing. The policy should then be made non-discretionary so that any qualifying individual knows that he or she will receive advancement when it's needed. If an officer or director comes to the Board hat in hand seeking advancement of legal expenses from the very company he is alleged to have wronged, a company with discretion may be 'reluctant to advance funds for his defense, fearing that the funds will never be paid back and resisting the idea of seeing further depletion of corporate resources at the instance of someone perceived to be a faithless fiduciary.' Reddy, 2002 WL 1358761. By having a non-discretionary policy, the company can allow officers and directors to avoid being placed in this horrible situation.

Litigation costs have increased as the DOJ, the SEC, state criminal and regulatory authorities, and of course private plaintiffs, put officers and directors of public companies under increasing scrutiny for any perceived management misstep or alleged breach of their fiduciary duties. As companies increasingly conduct their own prophylactic internal investigations or attempt to show their full cooperation with the investigative body, it is critical that the company do its best to assist the officers and directors in defending themselves. Insuring that individuals accused of wrongdoing have the necessary resources to mount a full defense gives them the opportunity to seek to vindicate themselves and prevent any vicarious liability to the company.

Another key reason why companies should have non-discretionary advancement provisions is the possibility that the DOJ could consider the advancement of legal fees as evidence that the company is not cooperating with, or even impeding, a DOJ investigation. Although the DOJ acknowledges that it's 'the rare case' where advancement of legal fees may be viewed as 'impeding an investigation,' the McNulty Memorandum (Dec. 12, 2006) went on to explain that 'fee advancement is considered with many other telling facts to make a determination that the corporation is acting improperly to shield itself and its culpable employees from government scrutiny.' But if a company's bylaws require the advancement of legal fees whenever specified conditions are met, it will be inappropriate for a prosecutor to infer that the company is trying to cover up a problem by paying legal fees in a particular case. In July 2008, as this article went to press, the DOJ indicated that it might change its standards for evaluating a company's cooperation, so that a company's advancement of legal fees would no longer be a factor to consider for evaluating cooperation. Because of the possibility that the DOJ's views on fee advancement will fluctuate over time, it is all the more important that companies establish policies today that will protect the company should it come under government scrutiny sometime in the future.

Conclusion

The idea of advancing legal fees to an officer or director who may well be ineligible for indemnification can be a bitter pill for a company's board to swallow. Although the company can later seek reimbursement from the party who is adjudicated to have acted in bad faith toward the company, see, e.g., Bergonzi v. Riteaid Corp., 2003 WL 22407303 (Del. Ch. Oct. 20, 2003), the prospects of repayment are at best uncertain. Nevertheless, as the General Counsel, you should remind your Board that by giving accused officers and directors a full chance to defend themselves, your Board may wind up defending the company too.

Marjorie J. Peerce ([email protected]), a member of this newsletter's Board of Editors, is a partner at Stillman, Friedman & Shechtman, P.C., New York. Nathaniel I. Kolodny is an associate at the firm.