Sophisticated, experienced, and effective directors and officers rarely join a public company unless that company has a platform of protection that they deem adequate. The platform in this case relates to personal and financial risk that may befall these directors and officers. The three factors we typically think of at Woodruff Sawyer as the pillars of that platform are good corporate governance, indemnification agreements, and directors and officers (D&O) insurance.
In a recent poll, some of our readers wanted to know more about D&O indemnification agreements. To help me tackle this important topic, I sat down with James Hu, M&A partner at White and Case, and Chauncey Lane, transactional partner at Holland and Knight.
Here are the highlights of our conversation. You can also watch the full discussion below.
What Are Indemnification Agreements?
James Hu: Serving on a public company board as a director or senior officer carries with it a number of liability exposures, including alleged violation of state fiduciary duty issues or federal securities law, or government investigations.
Some states, such as Delaware, require companies to provide certain minimum mandatory indemnification obligations toward their directors and officers. But that obligation typically covers a very narrow circumstance: If the director or officer is successful in winning the underlying matter, then the company is mandatorily obligated to indemnify the director or officer for the expenses (e.g., attorney fees incurred). It doesn’t say anything about a settlement amount, which is the most likely outcome in the United States, and it doesn’t cover expenses incurred in connection with a lawsuit that is lost. It also doesn’t solve a cash flow issue because indemnity is retroactive. It is only after the director or officer incurs those expenses that they can seek indemnity, which means they will need to cover legal fees out of pocket as the lawsuit progresses. For these reasons, the mandatory minimum indemnity is often insufficient to attract high-caliber candidates to serve in such a high-stakes position.
This is where an indemnification agreement comes into play, and it sits nicely under the framework of state law. For example, the Delaware General Cooperation Law (DGCL) has expansive permissions for a company to indemnify its Ds and Os as long as they meet certain minimum conduct requirements. And, of course, any well-drafted indemnification agreement has the advancement of expenses concept, which requires the company to fund litigation expenses as the litigation progresses through its multi-year court journey.
Yelena Dunaevsky: The DGCL section 145(g) also allows corporations to purchase insurance coverage for their directors and officers. Most corporations do have this kind of coverage, but they have a choice of how to structure that coverage and how much of that coverage to purchase.
Negotiations Around SPAC-Related Indemnification Agreements for Directors and Officers
Chauncey Lane: Negotiating an indemnification agreement, particularly in a SPAC context, is a complex process, with lots of different moving parts and parties involved. One of the biggest issues is the scope of the indemnification. If there is a legal proceeding related to someone’s role as an officer or director of the company, the individual is generally entitled to indemnification. But for special purpose acquisition companies (SPACs), that scope can and probably should be broadened.
For example, when a SPAC goes through a de-SPAC/merger and a claim comes in at the time of the de-SPAC or after, the SPAC directors and officers may not necessarily be the directors and officers of the surviving entity. Will the surviving entity’s indemnification agreement cover the SPAC’s directors and officers or vice versa, the SPAC’s indemnification agreement cover the post-merger entity’s Ds and Os? It’s essential to make sure that indemnification obligations of the entities within the SPAC’s life cycle are clearly laid out in various indemnification agreements.
Other issues that may come up include:
- Multiple affiliations. You could have an individual who is a director or officer of the SPAC and the managing member of the sponsor entity. Is that individual entitled to indemnification in their role as a manager of the sponsor entity? If the indemnification agreement does not address this directly, this individual could suffer some exposure.
- Affiliated entities. The target may have a primary operating entity, but its CEO might also be affiliated with several related entities. If those related entities are involved in a claim, does identification cover each of those different types of relationships?
- Successor language. Your indemnification agreement should have a successor and assignment provision making it clear that any successors to the SPAC take on the obligations that are in the SPAC’s indemnification agreement. This will ensure the surviving entity will be obligated to indemnify the SPAC’s directors and officers after the merger.
|Yelena Dunaevsky: The insurance policy is keyed off the indemnification agreements that are in place at the company. If the indemnification is not there or it is not clearly worded, the insurance product may not function the way the parties intend it to function.
Yelena Dunaevsky: You have several sides of coverage in a typical D&O policy—for example, Side A and Side B. Side B is the coverage that kicks in to reimburse the company for its costs of indemnification, typically after a self-insured retention (SIR, like a deductible) is met. Side A kicks in when the entity is unable or unwilling to indemnify, but it is not subject to an SIR.
So, if the indemnification parameters in the indemnification agreement are not clearly set out (e.g., it is not clear which individuals the company is obligated to cover and under which circumstances), it is difficult to ensure a correct response from the D&O policy.
What Costs Can Be Advanced?
Yelena Dunaevsky: Let’s say you have a situation where the attorneys’ fees and the defense costs are piling up. The policies typically have a carefully negotiated provision that allows the insurer to advance the costs almost immediately to cover the directors and officers. Having a clear idea of how the advancement mechanism will work and negotiating that mechanism when the policy is put in place with the help of your insurance broker and attorney is incredibly important.
|Chauncey Lane: Most indemnification agreements will cover losses and expenses. Typically, it’s only expenses that are advanced, not losses. Make sure that that definition of expenses is thorough and broad enough to cover the different areas that might be applicable.
Chauncey Lane: The advancement of expenses concept highlights an important interplay between the company’s bylaws and articles of incorporation and the indemnification agreement itself. The bylaws and articles don’t typically outline the exact mechanism of how the advancement is supposed to take place, but the indemnification agreement does.
The factors to keep in mind are:
- The details of the mechanism for the advancement of expenses. Typically, it is five to 30 days. As a director or officer, you would obviously want those expenses to be advanced as quickly as possible.
- What the bylaws and articles of the entity say about the nature of the advancement of expenses—is it permissive or mandatory? Ideally, as a director or officer, you’d want the company to have an affirmative obligation to advance expenses.
- State law provisions relating to the application of indemnity expenses and, for example, the directors’ and officers’ repayment obligations.
- State law on the standard of conduct required of directors and officers (e.g., indemnification entitlement hinging on good faith).
What Happens If a Company Refuses to Indemnify Ds and Os?
James Hu: If a company refuses to indemnify the director or officer, the D or O may follow dispute resolution provisions set out in the agreement to compel the company to do so. One should also look for a provision in the agreement that may require the company to be responsible for the director’s or officer’s expenses when enforcing their indemnification rights.
Yelena Dunaevsky: From the insurance perspective, when the company refuses or is unable to indemnify the Ds and Os, Side A of the policy will step in. Side A of the policy is where there is no self-insured retention, and the coverage applies from dollar one.
It’s important to keep in mind that the insurance policy generally will not cover punitive damages or criminal activity.
James Hu: It is interesting to think about indemnification for Ds and Os in three concentric circles. The core mandatory indemnification obligation of the company stemming from state law is a very small circle (e.g., only expenses and attorney fees on cases the Ds or Os win). The next larger circle is the coverage for the Ds and Os under the indemnification agreement, which covers a broader range of losses. And the third, even larger circle is insurance coverage, which is permitted to have an even greater standard of coverage than the company’s indemnification agreement. An interesting case to illustrate this third concentric circle is RSUI Indemnity Company v. Murdock.
Tips From the Mergers and Acquisitions (M&A) Perspective
Chauncey Lane: The indemnification agreement is only as good as the assets and the resources behind it. So, as an officer and a director, you have to understand the nature of the transaction and where the assets will be located because that’s the best place for your identification obligation to rest.
The other important element to consider is the interplay between the articles of incorporation and bylaws on the one hand and the indemnification agreement on the other. The articles and the bylaws provide only a baseline foundation for indemnification. Your indemnification agreement provides the details necessary for you to achieve the indemnification you need.
Also, it’s super important to make sure the indemnification obligation is a part of any change of control.
James Hu: I always ask: When was the last time the team reviewed the indemnity agreement? If it was 10 years ago, it’s time to take another look.
There is also a timing element to making an announcement of any amendments. You don’t want people scratching their heads and wondering, “Why are you amending these agreements now, out of the blue?”
The D&O indemnity provision should not use boilerplate language but should be looked at as a substantive provision. In the pre-closing checklist process, make sure the tail policy is indeed obtained and will be bound around the time the deal closes.
Yelena Dunaevsky: The tail policies come up on my radar all the time in the M&A context, and a lot of the time, people don’t really pay attention to them. Lack of tail coverage could become problematic not only in that it could limit other insurance coverages (e.g., representations and warranties insurance coverage) in an M&A deal, but in that by forgoing tail coverage, the company would essentially be cheating the directors and officers out of the protection they bargained for and were expecting.
Woodruff Whiteboard Breakdowns: Indemnification Agreements
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