As discussed in an earlier article (see “Increasing Criminal Exposures: Will Your Insurance Respond?” and elsewhere in the Appendix of The D&O Book), federal law enforcement authorities are investigating with greater frequency potential criminal charges against directors and officers in a variety of contexts. In the so-called Yates Memorandum, the Department of Justice recognized that “One of the most effective ways to combat corporate misconduct is by seeking accountability from the individuals who perpetrated the wrongdoing” and that it is “important that the Department fully leverage its resources to identify culpable individuals at all levels in corporate cases.”

The practical impact of this new and aggressive Department of Justice (DOJ) initiative is still largely unknown. Any criminal investigation or proceeding against directors and officers raise several important issues with respect to the company's legal ability and obligation to indemnify the director or officer for defense costs, fines, penalties, or other loss incurred because of the criminal investigation or proceeding. Corporate directors and officers, and their advisors, should therefore be aware of issues concerning the adequacy of their company's indemnification protection for directors and officers. The following discussion summarizes some of those issues and is generally based upon Section 145 of the Delaware General Corporation Law, which describes indemnification of directors and officers for a company incorporate in Delaware.

1. Permissive/Mandatory Indemnification. State indemnification statutes generally permit but do not require a company to indemnify its directors and officers. The one exception is where the defendant director and officer is successful in defending the claim. In that case, indemnification statutes usually require the company to indemnify the person's costs incurred in that successful defense. A company can, and almost always does, create an obligation to indemnify its directors and officers by adopting an indemnification provision in the company's bylaws or certificate of incorporation. Therefore, to evaluate a company's right and obligation to indemnify its directors and officers regarding criminal matters, the company's internal indemnification provision as well as the applicable state indemnification statute should be carefully examined.

2. Standard of Conduct. Indemnification statutes generally apply to both civil and criminal proceedings that are commenced or threatened against current or former directors and officers. Such indemnification is subject to the person satisfying a standard of conduct set forth in the statute. For example, to qualify for indemnification under the Delaware statute, a director or officer must have acted in good faith and in a manner reasonably believed to be in the best interests of the company. With respect to any criminal proceeding, the person must also have had no reasonable cause to believe his conduct was unlawful.

State indemnification statutes also typically require most disinterested directors or independent legal counsel to decide whether the conduct of the director or officer satisfies the statutory standard of conduct and thus whether indemnification for the director or officer is authorized. Like D&O insurance policies, indemnification statutes permit, and bylaw indemnification provisions should require, the company to advance defense costs until such a determination can be made at the end of the claim. However, if it is ultimately determined that indemnification is not permitted, then the director and officer must repay to the company the amount of defense costs advanced by the company.

3. Fine/Penalty Indemnification. State indemnification statutes usually describe the type of loss incurred by a director and officer which may be indemnified by the company. The Delaware statute, like most state indemnification statutes, expressly authorizes indemnification of a wide variety of losses, including not only defense costs in a criminal proceeding but also fines incurred by the director or officer. The indemnification is permitted as long as the fine is assessed with respect to conduct which is indemnifiable.

4. Conflict with the Company. Directors and officers who are targets of or defendants in a criminal proceeding will usually be entitled to advancement of defense costs and potentially to indemnification if their actions are found to satisfy the statutory standard of conduct. However, that standard of conduct may be difficult to satisfy in many criminal matters where the director or officer is convicted or pleads guilty. Because the right to indemnification is far from certain in such context, companies may be reluctant to grant indemnification for targeted directors and officers out of concern that the DOJ may view that indemnification as evidence of both the company's lack of cooperation and the company's failure to support the DOJ's efforts to deter future illegal activity.

5. Indemnification Planning. Because mandatory indemnification of directors and officers generally exists only pursuant to a bylaw indemnification provision, it is important that the bylaw provision affords the broadest indemnification protection for directors and officers that is desired by the company. Most such provisions mandate indemnification and defense costs advancement “to the fullest extent permitted by law.” Many other protective provisions could be (but frequently are not) included to maximize the protections afforded to directors and officers. Some of those additional provisions are:

Discourage Wrongful Refusal. Even under a mandatory indemnification provision, there is some subjectivity to the indemnification process since the incumbent board of directors must determine that the defendant director or officer qualifies for indemnification. If the defendant and the incumbent directors are antagonistic, the indemnification protection may be wrongly withheld. The bylaw indemnification provision can contain several features that reduce the incentive for a company to wrongfully refuse to indemnify a director or officer. For example, the provision can state that a director or officer who is denied indemnification and who is successful in whole or in part in a lawsuit against the company to enforce his or her indemnification rights, is entitled to reimbursement from the company of costs incurred in enforcing his or her indemnification rights. Such a provision can also state that in any such suit to enforce indemnification rights, the company bears the burden of proof to establish that the claimant is not entitled to indemnification. In addition, the provision can state that any determination by the board of directors with respect to the claimant's right to indemnification is not a defense for the company in such a suit, and does not create a presumption against the claimant. All these provisions minimize the chance the company will wrongly withhold indemnification, and maximize the chance the director or officer can retain his or her indemnification rights.

Contractual Rights. The provision can expressly create a contractual right in favor of the directors and officers to the broad indemnification protection described in the provision. Because of such a provision, the company should not be permitted to unilaterally and retroactively amend or eliminate those indemnification rights. This provision affords protection equivalent to that available under a separate indemnification contract between the company and its directors and officers.

Subsidiaries. By statute, a company is authorized to indemnify its directors, officers, employees, and agents, as well as any person serving at the request of the company as a director or officer of another organization. As a result, a parent company may not be permitted or required to indemnify the directors and officers of its direct and indirect subsidiaries unless those subsidiary directors and officers are serving in that capacity at the request of the parent company. The parent company's bylaw indemnification provision can state that a director or officer of a direct or indirect subsidiary of the company or any employee benefit plan of the company or such subsidiary, is deemed to be serving in that capacity at the request of the company. This provision would require a parent company to indemnify the directors and officers of all its subsidiaries as well as fiduciaries of their employee benefit plans. Although ultra-protective for the directors and officers of the subsidiaries, this provision obviously creates new liability exposures for the parent company that should be considered before adopting such a provision. An alternative approach would be to afford this indemnification protection only to directors and officers of the parent company who serve a subsidiary in any capacity.

When it comes to corporate indemnification of directors and officers, the law of the state in which the company is incorporated typically applies. Although generally consistent, those state indemnification laws vary. Therefore, the applicable state law should be reviewed when evaluating indemnification protection under insurance policies.