WESFACCA Indemnification Issues (2011)

A Practical Look at Everyday Issues

General Reinsurance Corporation120 Long Ridge Road | Stamford, Connecticut

April 1, 20118:45 a.m. to 12:30 p.m.

Indemnification Clauses

Your Presenters

H. Kennedy [email protected]

Richard S. Smith, [email protected]

Elizabeth J. [email protected]

Edward B. [email protected]

Program Agenda

• Indemnifications in Sale of Goods Contracts H. Kennedy Hudner

• Drafting Indemnifications with an Eye to Insurance Coverage

Elizabeth J. Stewart

• Indemnifications in Corporate Mergers and Acquisitions

Richard S. Smith, Jr.

• Recent Developments in D&O Indemnification Issues Edward B. Whittemore

Where Obtuse Meets Terrifying

Indemnification Clauses:

H. Kennedy Hudner

5

• “Education is what you get when you read the contract.

Experience is what you get when you don’t.”

- Pete Seeger

“If you think words don’t have power, read an indemnification clause.”

• Your in-house client reads the indemnification.

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In the Beginning, There was Darkness…

• You give an inspiring explanation to the

business people…

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You Take Charge

Your Client Wants the Sale

• Client looks to you.

• You need to understand the

transaction in order to give

good advice.

• You need to understand the

contract.

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• One size does not fit all.

• Context of your transaction Are you buyer or seller? Or both? Giving an indemnification or receiving one? Sale of goods? Services? Intellectual Property? Sale to end user? Distributor? OEM? What happens to your product downstream? Off the shelf? Or custom product? Your design? Made to Buyer’s specifications?

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The Big Picture

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The Big Picture

• Does indemnification cover only 3rd-party claims, or the Buyer’s claims as well?

• Cover Buyer’s customers?

• Does it cover Buyer’s negligence?

• Cover cost of recalls? Replacement goods only, or cost of labor in the field as well?

• Interplay with disclaimer of consequential damages and limitation of liability???

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Pretty Standard

• Indemnification for infringement of patent, copyright, trademark and trade secret.

• Any IP, or United States IP only?

• Also, indemnification for breach of confidentiality. Pay close attention to what is described as

confidential.

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Hypothetical #1Sale of Bottling/Packing Equipment

• $1.5 Million bottling/packing equipment

• Sell to Coca Cola.

• If machine fails: Loss of Coke’s product

Inability to package and ship

Loss of revenues ($250k/day). Damages for late delivery.

• Coke offers its indemnification clause

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Buyer’s Indemnification Clause

• Seller will indemnify and hold harmless Buyer, its

employees, agents, directors, shareholders,

distributors, and customers (“Indemnified Parties”)

from any and all claims, judgments, damages,

losses, costs and expenses (including Buyer’s

attorney’s fees) incurred by Indemnified Parties and

arising directly or indirectly from this transaction

and/or the use of the Goods.

Break it Down – The 7 Questions

1. Who?

2. What?

3. Trigger?

4. Control of defense?

5. Dollar caps?

6. Interplay with other clauses.

7. Covered by insurance?

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Who?

1. Who are you indemnifying?

Coke, its distributors and customers. Each may have separate damages.

• First negotiation point – narrow the indemnified party to just Coca Cola.

• Don’t indemnify non-parties. No contractual control. Too many variables.

• Multiple levels of independent damages.

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What?

2. Indemnifying from what? “Any and all damages, losses, etc.”

• Includes (i) Coke’s internal losses and (ii) 3rd-party claims.

• Also includes damages suffered by distributors and end users. Many layers of damages.

• Includes Coke’s attorney’s fees. Note this is more significant because you are not allowed to control the defense. Coke defends and sends you a bill for their lawyers.

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What is the Trigger???

• You are obligated to defend if Coke incurs losses or

damages “arising directly or indirectly from this

transaction and/or the use of the Goods.”

• Seems reasonable, no?

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Watch the Trigger Clause

• Under this trigger clause:

Seller does not have to be in breach of contract.

Does not have to be negligent.

• In fact, Seller does not have to be at fault!

• As long as Coke incurs losses related to transaction or use of Goods, Seller is liable.

• This is how the parties have contractually assigned the risk.

• Congratulations, you are

an insurance company!

• Is this enforceable? How

much do you want to

spend to find out?

• Will your boss be happy?

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Trigger Clause

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Control of Defense

• Absent extraordinary reasons, indemnifying

party should control the defense.

• Need the good faith cooperation of

indemnified party.

Spell out witness costs

Access

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Control of Settlement

• Indemnifying party should be able to make

any monetary settlement without consent of

indemnified party.

• Non-monetary settlement with consent, which

shall not be unreasonably withheld, delayed

or conditioned.

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Unlimited Liability?

• Standard to have unlimited liability for:

IP infringement

Breach of confidentiality

• Can you accept risk of unlimited liability for breach

of contract? Breach of warranty?

• Coca Cola example: $1.5 M machine.

• Coke’s damages will run @ $1.6 Million per week.

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Know Your Risk Tolerance

• Companies are like people, some are more

risk tolerant, some less.

• Which is your company???

• And who decides? Sales? Division chief?

CFO? CEO?

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Liability $$$$

• If can’t limit the trigger, try an aggregate dollar cap over life of contract.

• No magic bullet, just straight horse trading.

• Beware of indemnification “up to the limits of Seller’s liability insurance.” You are stuck paying this amount even if your

insurance doesn’t cover.

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Layered Approach to Limiting Indemnification Liability

• Indemnify only the buyer.

• Narrow the trigger:

Indemnify for personal injury or property damage caused solely and directly by you while on Buyer’s premises.

Indemnify only for Epidemic Failure. (And pray it never happens.)

For product recalls (Labor only? Parts only? Aggregate cap? Per year or total contract?)

Dollar cap? Revenues from past 3/6/12 months?

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Never Forget

• If unlimited liability, this is a bet-your-

company clause.

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So, Will Your Insurance Cover?

• Need to check your policy and perhaps your

broker.

• (And listen carefully to Elizabeth Stewart…)

• But if you cannot track language of your

policy, assume that you are NOT covered.

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Indemnify up to Policy Limits

• Two variations:

Dollar cap at policy limits

Dollar cap at amounts actually paid by insurance company

• #1 “Seller shall indemnify and hold Buyer harmless…up to the coverage limits specified in Seller’s liability insurance policy, including its umbrella policy.”

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But What If…?

• This is dangerous for the Seller

Insurance company might not pay.

Seller still obligated up to insurance limits.

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Tying Indemnification to Insurance

• #2 “Seller’s obligation to indemnify Buyer shall be limited to the amount of money actually paid by Seller’s liability insurance policy.”

• Dangerous for Buyer Payment too uncertain.

Amount of payment also uncertain.

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Interplay with Other Clauses

• How does it affect Limitation of Liability and Disclaimer of Consequential Damages???

• As Seller, you want to make sure that your limitation of liability and disclaimer take priority over your indemnification obligations.

• Need clear language.

• “Notwithstanding Section 5 (Indemnification), in no event shall Seller be liable for consequential damages…”

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• Or: “This provision shall take precedence

over Section 5 (Indemnification).”

• Or: “The provisions of this indemnification

clause shall be limited by the limitations on

liability set forth in Sections 3 (Limitation of

Liabilities) and 4 (Disclaimer of

Consequential Damages).”

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Alternatives – Personal Injury Only

• There are alternatives you can try for:

• “Seller will indemnify Buyer for any claims,

judgments, damages, settlements, costs and

expenses (including but not limited to Buyer’s

attorney’s fees) arising out of personal injury

or property damage caused solely and

directly by Seller while on Buyer’s premises.”

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Case Study #1: Loss of Product with $$ Cap

• Seller sells growth medium to drug company for $1,000. Buyer uses medium with $100,000 worth of its product. Bad growth medium results in loss of $100,000 product and schedule delays.

• Starting positions: Buyer wanted full indemnification; Seller wanted replacement of medium only.

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The Resolution

• Buyer has obligation to test 100% of

purchased medium batches.

• If Buyer finds bad batch before use in

manufacture, sole remedy is replacement of

medium.

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The Resolution

• In event bad medium spoils the

manufacturing batch:

Seller will pay $20,000 for first bad batch

$30,000 for second

$50,000 for third

$100,000 for any other

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Case Study #2:

• Seller sells component part to an OEM.

#1 Electronic board in printer assembly

#2 Small motor in windmill

• OEM wants indemnification for field failures:

Cost of part

Cost of lost profit on OEM’s printer (or windmill) units

Cost of labor

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Two Sellers, Two Outcomes

• Printer component

Seller accepted the indemnification as is.

“This part won’t fail.”

• Windmill component

Seller tried to negotiate caps.

Buyer refused.

Seller walked away from deal. Risk too high for returns.

Contractual Indemnity Provisions and Insurance

Elizabeth J. Stewart

Off-The-Rack Rules

Contribution

• The right of a tortfeasor to recover from other

tortfeasors shares of the amount paid to the

injured party.

• Often governed by statutes.

• Can apply to judgment, settlement and/or

defense costs.

New York Statutes

• Tortfeasor who is jointly and severally liable

may seek contribution for excess over its

equitable share of liability (NY CPLR 1401).

• Tortfeasor who is 50% or less liable shall

only be liable for its equitable share of non-

economic loss (NY CPLR 1601).

Connecticut Statutes

• In negligence cases, each tortfeasor is liable only for its proportionate share of damages.

• But the uncollectible amounts may be reallocated among the remaining tortfeasors on the basis of their proportionate fault (C.G.S. 52-572h).

• A tortfeasor may seek contribution for the amount it paid in excess of its proportionate share (C.G.S. 52-572h).

Settlements and Contribution in New York and Connecticut

• A release, settlement or similar agreement between a claimant and a tortfeasor discharges the tortfeasor from all liability for contribution to other joint tortfeasors.

• Settlement reduces amount plaintiff can recover from nonsettling parties.

Indemnity

• A shift of liability between parties, either through

tort law or contract, for the entire judgment,

settlement and/or defense or defense costs.

• Typically applies where contribution statutes do

not apply.

• Typically shifts whole loss.

• Shifts the entire liability to one who is negligent.

• If party is partially negligent, it can only seek

contribution, not indemnification.

• Indemnification includes attorneys’ fees and costs

of defense of underlying action, but does not

include costs of prosecuting an action to be

indemnified.

New York and Connecticut Common Law

Contracting Around Off-The-Rack Rules

Indemnitee’s Own Negligence

• Unless prohibited by statute, a party may

contract for indemnification of its sole

negligence.

• That indemnification provision must explicitly

state the intent to contract for indemnification

of sole negligence.

• New York Prohibits this for: Construction (N.Y. Gen. Oblig. Law § 5-322.1) Leases (N.Y. Gen. Oblig. Law § 5-321) Caterers (N.Y. Gen. Oblig. Law § 5-322) Building service and maintenance

(N.Y. Gen. Oblig. Law § 5-323) Architectural and engineering services

(N.Y.Gen. Oblig. Law § 5-324) Places of public recreation

(N.Y. Gen. Oblig. Law § 5-326)

Indemnification for Sole Negligence

Indemnification for Sole Negligence

• Connecticut Prohibits this for:

Construction (C.G.S. § 52-572k)

Residential Leases (C.G.S. § 47a-4)

Effect of Insurance on Contracts with Indemnification Clauses

Issues to Consider

• Duty to Defend

• Duty to Indemnify

• Whose insurance policy should pay?

• Under what circumstances?

• Read the policies when draftingindemnification clauses

• Make sure to get the necessary endorsements andmake sure indemnitees are covered as additionalinsureds

• For long tail claims, hold onto policies

Duty to Defend

• Broader than duty to indemnify because duty to defend is based on allegations of complaint, not ultimate judgment or settlement.

• Duty to defend vs. right to receive reimbursement for defense costs.

• Is there a right to independent counsel? What if there is a conflict of interest?

Areas Where Indemnification and Insurance Can Collide

• Other insurance clause.

• Exclusion for liability assumed by contract.

• Additional insured coverage.

Other Insurance Clause

• Typical Language of a Pro Rata Clause:

If a loss covered by this policy is also covered

by other insurance, we will pay only the

proportions of the loss that the limit of liability

that applies under this policy bears to the total

amount of insurance covering the loss.


• Typical Language of an Excess Clause:

Unless otherwise endorsed, this policy shall be excess over any other insurance whether prior or subsequent hereto, and by whomsoever effected, directly or indirectly covering loss or damage insured hereunder, and this Company shall be liable only for the excess of such loss or damage beyond the amount due from such other insurance, whether collectible or not, however, not exceeding the limits as set forth in the Declarations.


• Majority rule: if 2 insurance companies with the same insured have identical other insurance clauses, there is a pro rata sharing by the 2 insurance companies.

• Majority rule: if 2 insurance companies have different other insurance clauses, courts will try to interpret each of them together.

• Exception: indemnity agreement betweennamed insured (indemnitor) and additional insured (indemnitee) and additional insured has its own insurance coverage. The entire loss is shifted to the insurance carrier for the named insured (indemnitor).

New York and Other Insurance Clause

• New York does not follow this exception.

• The terms of insurance policies govern

coverage and cannot be overridden by

contracts between the parties.

Connecticut and Other Insurance Clause

• CT follows the majority rule for more than one

insurance policy.

• No CT law as to whether the exception for

indemnification applies.

Exclusion for Liability Assumed by Contract

• Typical Language:

This insurance does not apply to:

“Bodily injury” or “property damage” for which the insured is obligated to pay damages by reason of the assumption of liability in a contract or agreement. This exclusion does not apply to liability for damages:

(1) That the insured would have in the absence of the contract or agreement; or

(2) Assumed in a contract or agreement that is an “insured contract,” provided the “bodily injury” or “property damage” occurs subsequent to the execution of the contract or agreement . . . .

• If the policyholder-indemnitor’s conduct contributed

to the liability, the policyholder would be liable

anyway even if it did not have an indemnification

contract, so the first exception would apply.

• If the indemnitor would not be liable but for the

indemnification agreement, the exclusion would bar

coverage because the first exception would not

apply

Exception If Insured Would Have Been Liable Without Contract:

Exception for Insured Contract

• Insured contract – a contract entered into by the

policyholder that assumes the liability of another,

which contract (and corresponding liability) the

insurance company specifically agrees to insure.

• NOTE: If an indemnification agreement is

important to you, you may be able to purchase a

Contractual Liability Coverage Endorsement to

cover it.

Additional Insureds

• Need to be specifically identified as additional insureds in the policy.

• Contractual Liability Coverage Endorsement does not make an indemnitee a party to a policy.

• Even if an indemnitee is listed as an Additional Insured, a carrier’s duties are what the carrier promised to do in the policy, not what the indemnitor-insured promised to do in an indemnification agreement.

Vendor Endorsements

• Protect retailers and distributors of products.

• Issue: What if named insured manufactures

a component of a vendor’s product?

Additional Insureds

• Issue: What if both the named insured and the additional insured are negligent?

• Watch coverage – typically coverage is only for vicarious liability of the additional insured for something the named insured did.

• But there are cases in Connecticut and New York where carriers had to cover additional insureds regardless of whether the additional insured or the named insured was negligent.

Issues Relating to Indemnification in M&A Transactions

Richard S. Smith, Jr.

Valuable Resources

• ABA Model Asset Purchase Agreement.

• ABA Model Stock Purchase Agreement.

• ABA 2009 Private Target Mergers & Acquisitions Deal Points Study (for Transactions Announced in 2008) (the “2009 Deal Points Study”).

• ABA 2010 Strategic Buyer/Public Target Mergers & Acquisitions Deal Points Study (for Transactions Announced in 2009).

Interplay Between Various Provisions of the Agreement

• Indemnification Provisions.

• Definitions.

• Representations and Warranties.

• Covenants.

• Purchase Price Adjustment Provisions.

• Other Miscellaneous Provisions.

Survival

• In order to ensure that representations and warranties may serve as the basis for post-closing liability, acquisition agreements typically include an express survival clause to avoid the potential application of the doctrine of merger and specify the extent to which the representations and warranties survive the closing.

• Certain representations, particularly those covering fundamental corporate matters (such as organization and authority), title to the purchased assets, sufficiency of the purchased assets, taxes, environmental matters and ERISA, typically have longer survival periods.

• Covenants and agreements typically survive indefinitely or for the shorter period specified within the particular covenant or agreement.

Survival —Time to Assert Claims

• Survival provisions, without more, may not be the same as the time to assert claims.

• A bare survival clause may be interpreted to specify the time during which a breach may occur, not when an action must be filed. See, e.g., Western Filter Corp. v. Argan, Inc., 2008 U.S. App. LEXIS 18147 (9th Cir. Aug. 25, 2008).

• To avoid ambiguity, the survival provision should be carefully drafted to specify whether it is intended to specify the time during by which an action must be filed.

Survival —Sample Provision

Section 8.01 Survival. Subject to the limitations and other provisions of this

Agreement, the representations and warranties contained herein shall survive

the Closing and shall remain in full force and effect until the date that is [___]

[years/months] from the Closing Date; provided, however, that the

representations and warranties in Sections [__] shall survive indefinitely and the

representations and warranties in Sections [__] shall survive for the full period of all

applicable statutes of limitations (giving effect to any waiver, mitigation or extension

thereof) plus 60 days. All covenants and agreements of the parties contained

herein shall survive the Closing indefinitely or for the period explicitly specified

therein. Notwithstanding the foregoing, any claims asserted in good faith with

reasonable specificity (to the extent known at such time) and in writing by notice

from the non-breaching party to the breaching party prior to the expiration date of

the applicable period shall not thereafter be barred by the expiration of the relevant

representation or warranty and such claims shall survive until finally resolved.

Survival —What’s Market?

• According to the 2009 Deal Points Study, 70% of the transactions surveyed had a general survival period of 18 months or less.

• The most common carve outs were for taxes (74%), due authority (64%), capitalization (62%), due organization (44%), ownership of shares (39%), fraud (37%), breach of covenants (36%, intentional breach (34%), broker’s/finder’s fees (34%), environmental (33%), and employee benefits (31%).

Sample Provision—Asset Purchase Agreement

“Subject to the other terms and conditions of this Article VIII, Seller

and each Shareholder, jointly and severally, shall indemnify and

defend each of Buyer and its Affiliates and their respective

Representatives (collectively, the “Buyer Indemnitees”) against,

and shall hold each of them harmless from and against, and shall

pay and reimburse each of them for, any and all Losses incurred or

sustained by, or imposed upon, the Buyer Indemnitees, whether or

not involving a Third-Party Claim, based upon, arising out of, with

respect to or by reason of….”

Who are the Indemnitors?

• Seller.

• Each shareholder.

• Joint and several liability.

• Consider need for other indemnitors (i.e.,

parent companies, sister companies and

other affiliates).

Who are the Indemnitees?

• Buyer.

• Buyer’s Affiliates. An “affiliate” of a person is generally defined to mean “any other Person

that directly or indirectly, through one or more intermediaries, controls, is controlled by, or is under common control with, such Person.”

The term “control” (including the terms “controlled by” and “under common control with”) generally means the possession, directly or indirectly, of the power to direct or cause the direction of the management and policies of a Person, whether through the ownership of voting securities, by contract or otherwise.

• Buyer’s Representatives. The term “representative" is generally defined to mean, with respect to

any Person, any and all directors, officers, employees, consultants, financial advisors, counsel, accountants and other agents of such Person.

How are Damages/Losses Calculated?

• Typical provision:

“Losses” means losses, damages, liabilities, deficiencies, Actions, judgments, interest, awards, penalties, fines, costs or expenses of whatever kind, including reasonable attorneys’ fees and the cost of enforcing any right to indemnification hereunder and the cost of pursuing any insurance providers; provided, however, that “Losses” shall not include punitive damages, except in the case of fraud or to the extent actually awarded to a Governmental Authority or other third party.

• Diminution in value.

• Incidental, consequential, special and punitive damages.

Breach of Reps & Warranties

• Knowledge and materiality are frequently utilized to qualify specific representations and warranties and, if utilized, significantly effect the Seller’s obligation to indemnify the Buyer from and against alleged breaches.

• The Seller generally prefers to use a knowledge qualifier, as opposed to a materiality qualifier, because its availability depends on what the Seller knew, or should have known, rather than the magnitude of the problem.

Breach of Reps & Warranties continued

• Buyer’s frequently take the position that the representations and warranties should not be qualified in any respect because they simply serve to allocate the risk of liability and the purchase price was determined based on the assumption that there are no unknown liabilities.

• Furthermore, Buyer’s argue that the “basket” provides the appropriate level of protection for “immaterial” claims.

Knowledge —Sample Provision

• Knowledge — an individual will be deemed to have Knowledge of a particular fact or other matter if:

(a) such individual is actually aware of such fact or other matter; or

(b) a prudent individual could be expected to discover or otherwise become aware of such fact or other matter in the course of conducting a reasonably comprehensive investigation regarding the accuracy of any representation or warranty contained in this Agreement.

Knowledge —Sample Provision continued

A Person (other than an individual) will be deemed to have “Knowledge” of a particular fact or other matter if any individual who is serving, or who has at any time served, as a director, officer, partner, executor, or trustee of such Person (or in any similar capacity) has, or at any time had, Knowledge of such fact or other matter (as set forth in (a) and (b) above), any such individual (and any individual Party to this Agreement) will be deemed to have conducted a reasonably comprehensive investigation regarding the accuracy of the representations and warranties made herein by that Person or individual.

ABA Model Asset Purchase Agreement.

Material Adverse Effect—Sample Provisions

• “Material Adverse Effect” means any result, occurrence, fact, change, event or effect that has a materially adverse effect on the business, assets, liabilities, capitalization, condition (financial or other), results of operations of Target.

• “Material Adverse Effect” means any result, occurrence, fact, change, event or effect that has, or [could/would] reasonably be expected to have, a materially adverse effect on the business, assets, liabilities, capitalization, condition (financial or other), results of operations or prospects of Target.

• “Material Adverse Effect” means any result, occurrence, fact, change, event or effect that is or could reasonably be expected to have a materially adverse effect on (i) the business, assets, liabilities, capitalization, condition (financial or other), or results of operations of Target, (ii) Seller’s ability to consummate the transactions contemplated hereby, or (iii) Buyer’s ability to operate the business of Target immediately after Closing in the manner operated by Seller before Closing.

Material Adverse Effect—Sample Provisions continued

• “Material Adverse Effect” means…, except to the extent resulting from (A) changes in general local, domestic, foreign, or international economic conditions, (B) changes affecting generally the industries or markets in which Company operates, (C) acts of war, sabotage or terrorism, military actions or the escalation thereof, (D) any changes in applicable laws or accounting rules or principles, including changes in GAAP, (E) any other action required by this Agreement, or (F) the announcement of the Transactions.

• “Material Adverse Effect” means…, except to the extent resulting from (A) changes in general local, domestic, foreign, or international economic conditions, (B) changes affecting generally the industries or markets in which Company operates, (C) acts of war, sabotage or terrorism, military actions or the escalation thereof, (D) any changes in applicable laws or accounting rules or principles, including changes in GAAP, (E) any other action required by this Agreement, or (F) the announcement of the Transactions (provided that such event, change, or action does not affect Company in a substantially disproportionate manner).

Baskets and Caps

• Baskets.

Thresholds.

Deductibles.

• Caps.

• Carve Outs.

Baskets —Typical Provision

Seller shall not be liable to the Buyer Indemnitees for indemnification

under Section 8.02(a) (other than with respect to a claim for

indemnification based upon, arising out of, with respect to or by reason

of any inaccuracy in or breach of any representation or warranty in

Sections __, __, __, and __ (the “Buyer Basket Exclusions”)), until

the aggregate amount of all Losses in respect of indemnification under

Section 8.02(a) (other than those based upon, arising out of, with

respect to or by reason of the Buyer Basket Exclusions) exceeds

$____, in which event [Seller shall be required to pay or be liable for all

such Losses from the first dollar OR Seller shall be required to pay or

be liable for the Losses that exceed $_____].

Baskets —What’s Market?

• According to the 2009 Deal Points Survey, 95% of the transactions surveyed included some sort of basket.

• Within the subset of transactions that included a basket:

50% were drafted as deductibles;

37% were drafted as first dollar thresholds; and

13% were drafted as combination thresholds.

• Baskets as a percentage of transaction value:

44% had baskets equal to .5% or less;

45% had baskets that were .5% to 1% of transaction value; and

11% had baskets that exceeded 1% of transaction value.

Caps —Typical Provision

• Seller’s aggregate liability to the Buyer

Indemnified Parties for indemnification under

this Article VIII for any and all Losses

incurred by the Buyer Indemnified Parties

shall not exceed $_____.

Caps —What’s Market?

• Similarly, 92% of the transactions surveyed included some sort of indemnification cap.

• Within the subset of transactions that included a determinable cap:

The minimum cap was 1.23% of transaction value;

The maximum cap was 100% of the transaction value;

The mean cap was 21.72% of the transaction value; and

The median cap was 11.19% of the transaction value.

Baskets/Caps —Carve Outs

The most frequent carve outs were for fraud (59%/66%), capitalization (57%/49%); taxes (57%/48%); due authority (55%/49%); intentional breach (41%/38%); broker’s/finder’s fees (40%/33%); due organization (37%/29%); ownership of shares (35%/33%); title to/sufficiency of assets (24%/21%); employee benefits/ERISA (23%/15%); no conflicts (22%/22%); and environmental (15%/10%).

Third Party Claims

• Most acquisition agreements contain a separate provision governing third party claims.

• These provisions generally specify the extent to which the indemnifying parties may participate in, or assume, the defense of proceedings for which indemnification is sought.

• Because acquisition agreements are generally drafted by the Buyer, and the Buyer is more likely to be the indemnified party, these provisions typically impose significant limitations substantive and procedural limitations.

Third Party Claims —Typical Provisions

• Notice requirement: Applicable to formal proceedings only.

Failure to give notice does not affect the indemnifying party’s obligations, unless such failure prejudices the defense.

• Right to Assume Defense generally subject to: No conflict of interest.

Financial capacity.

Use of counsel satisfactory to Indemnified parties.

Third Party Claims —Typical Provisions continued

• The indemnifying party is bound by the indemnified

party’s defense if it does not assume defense.

• Assuming the defense conclusively establishes that

the claims are within the scope of the indemnifying

party’s indemnification obligations.

Sandbagging

• The Buyer’s first draft typically provides that the Buyer’s right to indemnification will not be affected by any investigation conducted, or any knowledge acquired, with respect to the accuracy or inaccuracy of any representation or warranty of the Seller.

• This leads to the possibility that the Buyer may assert a claim for a breach of representations and warranties even if the Buyer knew they were untrue when the transaction was consummated.

• This provision is frequently subject to considerable negotiation between the parties.

Sandbagging—Typical Provisions

• Pro-Sandbagging:

Section 8.08 Effect of Investigation. The representations, warranties and covenants of the Indemnifying Party, and the Indemnified Party's right to indemnification with respect thereto, shall not be affected or deemed waived by reason of any investigation made by or on behalf of the Indemnified Party (including by any of its Representatives) or by reason of the fact that the Indemnified Party or any of its Representatives knew or should have known that any such representation or warranty is, was or might be inaccurate or by reason of the Indemnified Party's waiver of any condition set forth in Section 7.02 or Section 7.03, as the case may be.

• Anti-Sandbagging:

Seller shall not be liable under this Article VIII with respect to any Losses arising out of matters within the knowledge of Buyer at the Closing Date.

Sandbagging —What’s Market?

• According to the 2009 Deal Points Survey:

53% of the transactions surveyed were silent

on the issue;

39% included a “pro-sandbagging” provision;

and

8% included an “anti-sandbagging” provision.

Sandbagging —What’s Market?

• Within the transactions that contained an anti-sandbagging provision:

74% of the transactions limited the requisite knowledge to actual knowledge;

13% included constructive knowledge; and

13% did not differentiate between the two.

• With respect to timing:

50% of the transactions limited the requisite knowledge to knowledge acquired pre-signing; and

50% did not differentiate between pre-signing and post-signing.

Materiality Scrapes

• After a typical negotiation, many of the representations and warranties are qualified by materiality.

• A typical negotiated acquisition agreement also contains some sort of basket, whether it be a deductible or a threshold, which must be reached before the Buyer can asset a claim against the Seller.

• Under this scenario, the Buyer cannot assert a claim unless the particular problem is severe enough to rise to the level of a breach of a particular representation or warranty and the damages suffered by the Buyer are in excess of the relevant basket amount.

Materiality Scrapes

• A “materiality scrape” is a contractual provision that eliminates all materiality qualifiers for purposes of determining whether a breach of a particular representation or warranty has occurred and/or the amount damages that have resulted from such breach.

• Under this approach, the materiality qualifiers continue to be relevant for purposes of determining whether the Seller has fulfilled its disclosure obligations and whether all relevant closing conditions have been satisfied but they effectively disappear at closing.

• After the closing, the Seller’s representations are either right or wrong in their unqualified form and the relevant basket serves as the Seller’s single line of defense against claims asserted by the Buyer.

Materiality Scrapes—Typical Provision

Notwithstanding anything in this Agreement to the contrary, for

purposes of the parties’ indemnification obligations under this

Article VIII, all of the representations and warranties set forth in

this Agreement or any certificate or schedule that are qualified by

the words “material,” “materiality,” “material respects,”

“Material Adverse Effect” or words or similar import or effect shall

be deemed to have been made without any such qualification

for purposes of determining (i) whether a breach of any such

representation or warranty has occurred, and (ii) the amount of

losses resulting from, arising out of or relating to any such

breach of representation or warranty.

Materiality Scrapes —What’s Market?

•According to the 2009 Deal Points Survey:

76% of the transactions surveyed did not contain a materiality scrape; and

24% did.

•Within the subset of those that did:

68% did not limit the scrape to the calculation of damages; and

32% did.

Escrows, Holdbacks and Other Deferred Payments

• Many acquisition agreements include some sort of escrow, holdback or other deferred payment mechanism, pursuant to which some portion of the purchase price is not paid until well after the closing.

• These techniques favor the Buyer by helping to ensure that the Seller Indemnitors will have the financial resources to fulfill their indemnification obligations in the event that problems are discovered post-closing.

• Sellers, in turn, often turn the presence of an escrow or holdback to a positive by negotiating for corresponding provisions that limit its aggregate indemnification obligation to the amount of the escrow or holdback amount.

Escrows & Holdbacks —What’s Market?


19% of the transactions surveyed did not contain any sort of escrow or holdback; and

81% did.

• Within the subset of those that did:

41% provided that the escrow/holdback was the exclusive remedy; and

59% provided that it was not the exclusive remedy.

Escrows & Holdbacks —What’s Market?


16% of determinable escrows or holdbacks had a value that was less than or equal to 5% of the aggregate transaction value;

26% had a value that was less than or equal to 7% of the aggregate transaction value; and

69% had a value that was less than or equal to 10% of the aggregate transaction value.

• Only 15% of the escrows or holdbacks had a value in excess of 15% of the aggregate transaction value.

Exclusivity

• Given the extensive indemnification provisions that typically are

heavily negotiated between the parties and included in most

acquisition agreements, the Seller frequently argues that those

provisions should serve as the Buyer’s exclusive remedy in the

event of a breach of the representations, warranties, covenants

or other obligations set forth in the agreement.

• Although Buyers often agree to include an exclusive remedy

provision, it generally excludes claims based on fraud, criminal

activity or willful misconduct and claims for equitable relief (such

as specific performance).

Exclusivity —Typical Provision

Section 8.09 Exclusive Remedies. Subject to Section 10.11 [Specific Performance], the parties acknowledge and agree that their sole and exclusive remedy with respect to any and all claims (other than claims arising from fraud, criminal activity or willful misconduct on the part of a party hereto in connection with the transactions contemplated by this Agreement) for any breach of any representation, warranty, covenant, agreement or obligation set forth herein or otherwise relating to the subject matter of this Agreement, shall be pursuant to the indemnification provisions set forth in this Article VIII. In furtherance of the foregoing, each party hereby waives, to the fullest extent permitted under Law, any and all rights, claims and causes of action for any breach of any representation, warranty, covenant, agreement or obligation set forth herein or otherwise relating to the subject matter of this Agreement it may have against the other parties hereto and their Affiliates and each of their respective Representatives arising under or based upon any Law, except pursuant to the indemnification provisions set forth in this Article VIII. Nothing in this Section 8.09 shall limit any Person's right to seek and obtain any equitable relief to which any Person shall be entitled or to seek any remedy on account of any Person's fraudulent, criminal or intentional misconduct.

Exclusivity —What’s Market?

•According to the 2009 Deal Points Survey:

85% of the transactions surveyed included an exclusive remedy provision;

9% expressly provided that indemnification did not represent the exclusive remedy; and

6% were silent on the issue.

•Within the subset of that included an exclusivity provision:

69% included a carve out for fraud;

35% included a carve out for equitable remedies; and

27% included a carve out for intentional misrepresentation.

Recent Developments in D&O Indemnification Issues –April 1, 2011

Edward B. Whittemore

Recent Developments in D&O Indemnification Issues

• Topic 1 – Recent statutory changes in Delaware

• Topic 2 – Can a company indemnify its officers for SOX Section 304 clawback liability?

• Topic 3 – Determining Indemnifiable Conduct (“official capacity” claims vs. “personal obligation” claims)

• Topic 4 –Can Bylaws contain conditions to advancement rights?

• Topic 5 –What are reasonable fees and costs in an advancement case?

• Conclusion: Board should make the Business Judgment

• Overview of DGCL Statutory Indemnification

and Advancement Rights

• Retroactive Elimination of Indemnification

Rights / The Schoon case and the 2009

amendment to Section 145(f) of the DGCL

• 2010 Delaware amendments

Recent Statutory Changes in Delaware

Overview of Indemnification and Advancement under the DGCL

• The statutory authority for indemnification rights for directors, officers, employees, and agents of Delaware corporations is Section 145 of the Delaware General Corporation Law (the “DGCL”) (see handout).

• This section provides for mandatory indemnification in one limited context, while permitting (but not requiring) such indemnification in others.

• Under 145(a), a Delaware corporation may indemnify any person who was or is a party or is threatened to be made a party to a proceeding…. by reason of the fact that such person is or was a director, officer, employee or agent of the corporation or is or was serving at its request in such capacity in another corporation or business association, against expenses (including attorneys’ fees), judgments, fines and amounts paid in settlement actually and reasonably incurred by such person in connection with such action, suit or proceeding

• Good Faith/Conduct requirement: indemnification only possible “if such person acted in good faith and in a manner such person reasonably believed to be in or not opposed to the best interests of the corporation and, with respect to any criminal action or proceeding, had no reasonable cause to believe such person’s conduct was unlawful.”

• Section 145(b) – derivative actions (actions brought by or in the right of the corporation), similar in scope and language to Section 145(a)

• Section 145(c) – “success on the merits” indemnification:

Overview of Indemnification and Advancement under the DGCL continued

• (c) To the extent that a present or former director or officer of a corporation has been successful on the merits or otherwise in defense of any action, suit or proceeding referred to in subsections (a) and (b) of this section, or in defense of any claim, issue or matter therein, such person shall be indemnified against expenses (including attorneys' fees) actually and reasonably incurred by such person in connection therewith.

• Most Delaware public companies, in their charters and/or bylaws, agree to provide broad indemnification rights that encompass these statutory requirements.

• Meaning of “to the fullest extent permitted by law” – held to encompass § 145(a), (b) and (c) claims. See Paolino case.



• Advancement, while similar to indemnification, differs in that a director or officer who is entitled to receive advancement has the right to have his or her legal expenses paid on an as-incurred basis, rather than at the conclusion of the litigation or proceeding. See DGCL Section 145(e).

• However, if a director or officer receives advancement and a court later determines that the director or officer was not entitled to indemnification, then the advanced amounts must be repaid.

• Most Delaware corporations provide broad and mandatory advancement rights to any covered person who must defend a proceeding for which indemnification could be available at the conclusion of the proceeding.


• Why are broad indemnification and advancement rights so common? According to the Delaware Supreme Court (2005):

Indemnification: encourages corporate service by the most capable individuals by protecting their personal financing resources from depletion by the expenses they incur during an investigation or litigation that results by reason of that service.

Advancement: Although advancement provides an individual benefit to corporate officials (immediate relief from a financial burden), it is also “a desirable underwriting of risk by the corporation in anticipation of greater corporate-wide rewards” for its shareholders.

• General belief prior to Schoon – a director’s right to require a company to provide advancement of expenses vested upon the commencement of the director’s service and could not be unilaterally terminated or changed by the company after the director’s tenure ended.

• In Schoon v. Troy Corp., 948 A.2d 1157 (Del. Ch. 2008), the Chancery Court allowed the Schoon Board to amend the Bylaws to revoke a former director’s right to receive advancement of legal expenses even though the bylaws that were in place during his board service expressly stated that the director’s right to receive advancement would continue even after his tenure on the board ended.

• Former director argued, under Salaman v. National Media Corp., a 1992 Delaware decision, that a bylaw advancement right is a vested contract right that “commences” when the director takes office and thereafter cannot be unilaterally terminated.

Retroactive Elimination of Indemnification Rights

• Reactions: The decision was broadly criticized.

• M&A bar also was concerned that indemnification and advancement rights of target company directors and officers could be adversely impacted after a transaction.

• Result: Greater use of bilateral indemnification agreements.

• Result: Practitioners and other affected constituents asked the Delaware legislature to amend the statute to resolve the uncertainty created by the Schoon decision.

Retroactive Elimination of Indemnification Rights continued


• Section 145(f) amended (effective 8/1/09) by adding the following sentence at the end:

A right to indemnification or to advancement of expenses arising under a provision of the certificate of incorporation or a bylaw shall not be eliminated or impaired by an amendment to such provision after the occurrence of the act or omission that is the subject of the civil, criminal, administrative or investigative action, suit or proceeding for which indemnification or advancement of expenses is sought, unless the provision in effect at the time of such act or omission explicitly authorizes such elimination or impairment after such action or omission has occurred.


• Note: similar amendments to Section 8.58 of the MBCA were

recently proposed, see 65 Bus. Lawyer 1149 (Aug. 2010).

• Post-Schoon, indemnification agreements remain an increasingly

attractive option for directors and officers.

• The 2010 amendments to § 145 were intended to distinguish between the indemnification rights of a corporation’s current directors and officers and the indemnification rights of a former officer or director or persons serving at the request of the corporation as directors, officers, employees, or agents of other entities.

• Section 145(d) was revised to make clear that the provision in that Section requiring a specific determination that indemnification is proper in certain circumstances applies only when the person requesting indemnification is a director or officer of the corporation at the time the determination is made (as opposed to when the person so requesting is a director, officer, agent, or employee of another entity or a former director or officer).

Recent Statutory Changes –2010 Amendments to § 145

Recent Statutory Changes –2010 Amendments to § 145 continued

• Section 145(e) was amended to make clear that persons serving at the request of the corporation as directors, officers, employees or agents of another entity may receive advancement of expenses from the corporation on such terms and conditions, if any, as the corporation deems appropriate.

• Section 145(e) previously had expressly authorized advancement only to persons serving as directors, officers, employees, and agents of the corporation itself, leading to some ambiguity as to the source of the authority to provide advancement to persons serving “at the request” of the corporation.

• SOX Provision: Section 304 requires that a CEO or CFO of a public company reimburse the company for any incentive compensation received or stock sale profits recognized during the 12-month period following the filing of a financial statement that is subsequently required to be restated as a result of misconduct (see handout).

In 8+ years since SOX’s passage, Section 304 cases have been relatively rare. Courts have determined that only the SEC may bring Section 304 actions and the SEC brought cases under Section 304 alleging that the CEO and CFO were personally engaged in the misconduct alleged.

Can a Company Indemnify its Officers for SOX Section 304 Clawback Liability

Can a Company Indemnify its Officers for SOX Section 304 Clawback Liability continued

• Whose misconduct is required? The issuer only, or must the CEO/CFO be personally involved in the misconduct?

• SEC’s Position: No-fault clawbacks are authorized by the statute, and the only required misconduct that must be shown is that of the issuer, acting through any of its directors, officers, employees or agents. (See SEC v. Jenkins.)

• Post-SOX, a common scenario – company restates its financials, and misconduct of the CEO/CFO or other senior management is or may be present.

• What should a company do? Seek reimbursement directly from the officer or wait for the SEC to bring the action against the officer(s) to compel the officer(s) to reimburse the company? Tough decision.

• But can public companies indemnify an officer for the amounts that must actually be repaid to the company as disgorgement?

• NO – U.S. Court of Appeals for the 2nd Circuit recently ruled, in a case of first impression, that a company may not agree to indemnify its CEO or CFO for any compensation or stock sale profits that the officers are required to disgorge under Section 304. See Cohen v. Viray, 622 F. 2d 188 (2d Cir., Sept. 30, 2010).


• DHB Industries, a body armor manufacturer, collapsed in late 2005 following revelations that it had used an inferior material to manufacture its products.

• August 2006 – civil and criminal cases were filed against DHB’s former CFO and COO, alleging widespread accounting fraud at the company in the years leading up to the collapse in its share value.

• 2007 – DHB restated its annual financials for 2003, 2004 and 2005, and soon afterward civil and criminal cases were filed against DHB’s former CEO David H. Brooks.



• 2007 Civil suit – the SEC alleged that the former CEO had violated various securities laws and demanded disgorgement from Brooks of more than $186 million in stock sale proceeds and bonuses under Section 304.

• July 2008 – Fed. Dist. Ct. overseeing the consolidated derivative and class action suits against DHB, approved a settlement under which DHB agreed to release and indemnify Brooks and DHB’s former CFO from any liabilities they might incur under Section 304 (see handout).

• United States (DOJ and SEC) objected to the settlement on several grounds, including that it undermined the SEC’s ability to hold Brooks and the former CFO accountable under Section 304.

• The 2nd Circuit rejected the settlement, ruling in the government’s favor that a company may not conduct an “end-run” around the statute, by agreeing to indemnify a former CEO or CFO from potential Section 304 liability.

• Second Circuit found that: private parties may not sue to enforce Section 304 (consistent with

other courts)

since only the SEC can enforce Section 304, only the SEC should be permitted to “exempt” a CEO or CFO from the section – and the indemnification agreement was effectively an attempt to settle Brooks’ Section 304 liability (at $0).

Court noted that its holding is similar to case law interpreting Section 29(a) of the Exchange Act to void contractual attempts to indemnify persons for Rule 10b-5 liability under the Exchange Act.



• Any impact on the Dodd Frank Clawback provision? Unclear – may depend on whether the courts will imply a private right of action under new Dodd Frank section.

• Dodd Frank Provision: Effective July 22, 2010, Section 954 of Dodd Frank added a new Section 10D to the Exchange Act requires that the national securities exchange prohibit the listing of any company’s securities where the company has not developed and implemented a policy providing that :

in the event that the issuer is required to prepare an accounting restatement due to the material noncompliance of the issuer with any financial reporting requirement under the securities laws, the issuer will recover from any current or former executive officer of the issuer who received incentive-based compensation (including stock options awarded as compensation) during the 3-year period preceding the date on which the issuer is required to prepare an accounting restatement, based on the erroneous data, in excess of what would have been paid to the executive officer under the accounting restatement.”

• Comparison of SOX and Dodd Frank provisions (see handout).

Determining Indemnifiable Conduct

• What is the conduct that triggers indemnification/advancement rights?

• Common problem for companies – management determines that the corporate official seeking corporate funds for legal expenses has acted, or may have acted, disloyally or even deliberately harmed the company.

• Must an official always be advanced expenses? Very frequently, the answer is YES, because contractual advancement typically is provided under Delaware law granting corporations the power to indemnify and advance litigation expenses to any person made a party to a proceeding “by reason of the fact that the person is or was a director, officer, employee or agent of the corporation.

• What does this phrase mean? – A claim is “by reason of” corporate service when the allegations challenge conduct by the proposed indemnitee in his or her official corporate capacity.

• Official Capacity Doctrine – Delaware courts have interpreted the § 145 “by reason of” language broadly, requiring only a nexus or causal connection between the official’s corporate capacity and the matter for which advancement or indemnification is sought.

• The key question in determining whether a causal nexus linked the underlying claims and corporate service is what capacity the official was acting in when he or she engaged in what is alleged to have been wrongful.

• This determination is dispositive of an advancement request too because officials, to be eligible for advancement, must establish that they were acting in their capacity as an “indemnification-eligible position” when undertaking the conduct underlying the allegations against them.

Determining Indemnifiable Conduct continued


• As long as the official’s corporate powers were used or necessary for the commission of the alleged misconduct, capacity-based challenges to advancement and indemnification have typically been rejected even when the underlying proceeding involves serious misconduct actuated by personal greed.

• Examples/Litigated Cases (a/k/a “officers behaving badly”)

• Perconti v. Thornton Oil Corp. (C.A. No. 18630-NC, Del. Ch. May 3, 2002) the Court of Chancery held that a former CEO was entitled to mandatory indemnification after criminal charges arising from his embezzlement of corporate funds were dropped after a mistrial.


• Tafeen v. Homestore Inc., 888 A.2d 204 (Del. 2005) – the Delaware Supreme Court held that a broad advancement bylaw provision required advanced payment of $3.9 million in legal expenses to a former officer (VP – business development and sales) whose alleged conduct had drawn a mountain of litigation, including a criminal indictment, arising from the officer’s fraudulent scheme to inflate the company’s revenues, which generated $15 million in sales of inflated stock.

• Supreme Court stated: The broader salient benefits that the “public policy behind Section 145 seeks to accomplish for Delaware corporations will only be achieved if the promissory terms of advancement contracts are enforced by courts even when corporate officials, such as Tafeen, are accused of serious misconduct.”

• Corollary to the Official Capacity Doctrine is the Personal Obligation Doctrine – No advancement if the alleged wrongdoing did not implicate the official’s use of corporate powers entrusted to him or her.


• See Cochran case (809 A.2d 555, Del. 2002).

“When a corporate officer signs an employment contract committing to fill an office, he is acting in a personal capacity in an adversarial, arms-length transaction. To the extent that he binds himself to certain obligations under that contract, he owes a personal obligation to the corporation. When the corporation brings a claim and proves its entitlement to relief because the officer has breached his individual obligations, it is problematic to conclude that the suit has been rendered an "official capacity" suit subject to indemnification under DGCL § 145 and implementing bylaws. Such a conclusion would render the officer's duty to perform his side of the contract in many respects illusory.”


• Weaver v. ZeniMax Media, Inc. (Del. Ch. 2004) – Count I – breach of fiduciary duty for officer’s failure to properly manage R&D expenses (advancement available) but in Count II the court rejected claims by former officer for advancement of expenses related to claims by the company that officer breached his employment agreement with the company by taking excessive paid vacation time and his wrongful receipt of corporate reimbursement for personal travel expenses.

• But, the personal obligation doctrine has limits. See Paolino v. Mace Security International, 985 A.2d 392 (Del. Ch. 2009).

• Paolino, former Chairman/CEO was found to be entitled to advancement for contractual, statutory and fiduciary counterclaims by the corporation alleging that the CEO failed to discharge his oversight and supervisory duties.

• Paolino served from 1999-2008 as Chair/CEO and had a 2006 employment agreement with severance protections. In May 2008, CEO was terminated for cause. Mace’s Bylaws provided broad right to mandatory advancement for expenses incurred in defending any action, suit, or proceeding for which indemnification might potentially be available.

• Mace argued that the counterclaims did not arise “by reason of the fact” that Paolino was serving as Chairman and CEO, but rather out of breaches of his employment agreement.

• Court found that when an employment agreement is at issue, Section 145 does not “go out the window.”

• “A claim for which the corporation seeks to avoid advancement must clearly involve a specific and limited contractual obligation without any nexus or causal connection to official duties.”


• Does Delaware law require that all of the terms regarding advancement rights to which a person is entitled must be located in one document?

• In Xu Hong Bin v. Heckmann Corporation, 2010 Del. Ch. LEXIS 3 (Jan. 8, 2010), the Chancery Court assessed competing claims of whether and when a corporation’s bylaws authorize the Board to impose reasonable conditions prior to advancing legal fees were consistent with or contrary to the right to advancement contained in the Certificate of Incorporation.

• Xu founded China Water, which was acquired by Heckmann Corp. in 2008. Xu became a Heckmann director and received cash and stock proceeds from the 2008 sale of China Water.

Can Bylaws Contain Conditions to Advancement Rights Provided in the Certificate

Can Bylaws Contain Conditions to Advancement Rights Provided in the Certificate continued

• The parties soon got into a dispute about the China Water business, its poor performance and related escrow payments. In early 2009, they negotiated and signed an agreement to resolve the dispute, which also called for Xu to resign as a Heckmann director, for 13.03 million shares of Heckmann being held in escrow to be sold back to Heckmann for $14 million, for the release of restrictions on the remaining 3.5 million Heckmann shares to Xu and for Heckmann to pay Xu an additional $6 million in cash.

• Heckmann paid the cash amounts but decided to cancel the remaining 3.5 million shares owed to Xu. Xu later filed suit, and Heckmann counterclaimed, asserting (Count I) breaches of Xu’s fiduciary duties as a Heckmann director, (Count II) breached of the settlement agreement and (Count III) a conversion claim on the $ 6 million payment which was allegedly fraudulently obtained.

• Xu filed a separate suit in Delaware to enforce his advancement rights with respect to the breach of fiduciary duty claims and the conversion claim, under the provisions of Heckmann’s Certificate. Xu sought summary judgment that advancement of his expenses incurred in defending Counts I and III of the Heckmann counterclaims. The Chancery Court in a late 2009 opinion dismissed Count III with prejudice.

• Heckmann’s Certificate and Bylaws each contained provisions related to indemnification and advancement (see handout).

• The Chancery Court found that Xu had succeeded on the merits of Count III (“success on the merits” indemnification under §145(c)) and was thus entitled to advancement of those expenses. As to Count I, however, the Court denied Xu’s motion.



• Xu argued that the Bylaw provision regarding “terms and conditions” for advancement violated DGCL §109(b) (see handout).

• Xu also made the “same document” argument.

• Held: no violation of DGCL § 109(b) in connection with the provisions in the bylaws that allowed the board to impose reasonable conditions on advancement, for two reasons.


• First, because the Court determined that the bylaw provisions were drafted and made effective contemporaneous with the provisions in the charter regarding advancement rights and thus must be reconciled as “simultaneously enacted founding documents”, if at all possible.

• Second, both documents were in effect when Xu began his service as a director and he should have been aware of the advancement provisions when he began his service as a director.

• advance only those expenses that are “actually and reasonably incurred . . . “

• Scenario: – former officer is entitled to advancement under corporate Bylaws, and company agrees to advance expenses. Former officer hires top firm to defend him in an SEC investigation, and defense team begins to work. Legal fees mount quickly, and sure enough, STICKER SHOCK. If the company refuses to pay invoiced amounts of counsel to the former officer, or holds back a % of the billed fees and expenses, what happens?

• Answer: A lawsuit by the officer to enforce his advancement rights, and if the parties cannot agree on the reasonableness of the fees/expenses, often the appointment of a Special Master by the Chancery Court.

• Example: Fuhlendorf v. Isilon Systems, Inc., C.A. No. 5772-VCN (Aug. 30, 2010).

What are Reasonable Fees and Costs in an Advancement Case

• Facts: Isilon Systems, Inc., a Seattle based data storage computer company acquired by EMC in late 2010.

• Former CFO sought advancement in 4 separate civil actions and related investigations. Isilon had signed an indemnification agreement with the former CFO, providing him with advancement rights.

• SEC action involved 5 transactions recognized in the first three quarters after Isilon’s Dec. 2006 IPO, which resulted in a restatement by Isilon because of allegedly misstated revenues of $4.8 million because of “side agreements” providing a “right of return” or by so-called “round trip” arrangements.

What are Reasonable Fees and Costs in an Advancement Case continued


• All fees and expenses were advanced for actions other than the SEC investigation, except when Isilon’s “enthusiasm waned” according to the Court. See 2010 Del. Ch. LEXIS 222 (Nov. 9, 2010).

• Isilon held back a portion of the billed amounts (Jan. to Nov. 2010) by Dorsey & Whitney, LLP, the CFO’s counsel, in relation to the SEC investigation, because the company and its counsel found that the fees and expenses to be unreasonable and that D&W statements vague and overly redacted.

• By late 2010, the fees and expenses totaled $7 million, with a jury trial scheduled for April 2011.

• Bills for 2010 totaled $6.096 million. Isilon agreed to pay 66%, or $4.027 million, but held back 34%, or $2.068 million, because of its own effort to impose cost controls on the CFO’s counsel and disallowance of vague or redacted time entries set forth is the D&W invoices.

• Parties could not agree on the reasonableness of the fees and expenses.

• Chancery Court confirmed advancement in November 2010 and later appointed a Special Master to resolve the dispute.

• Feb. 8, 2011 – Special Master, Lawrence Ashby of Ashby & Geddes LLP, issues his final report to the Court.



• The Special Master explained:

Recognizing that delays inherent in any interim effort to resolve reasonableness issues could readily defeat the advancement right altogether, this Court in this and other cases has tried to articulate a flexible right to advancement that still affords a measure of interim protection against “clearly unreasonable advancement requests.”

• Master rejected Isilon’s request for discovery/depositions of the tasks performed by D&W, but noted that D&W was engaged in “a very expansive litigation approach that reflects little concern for costs or explanations.”

• Master recommended that a 10% discount be applied to the $2.068 million amount in dispute, and applied the Duthie v. CorSolutions Medical, Inc. (2008 Del. Ch. LEXIS 128) standard, as follows:

Advancement is not the proper stage for a detailed analytical review of the fees, whether in terms of the strategy followed or the staffing and time committed. Typically, a good faith certification form counsel should suffice. In the absence of clear abuse, the fees should be advanced.



• The Report offers a range of practical advice for Delaware advancement cases/fee disputes, as follows:

the number of lawyers who can attend a deposition (generally, two if actively defending or taking).

whether "working lunches" in one's office should be included as part of the costs advanced (typically no, if you would not charge the client otherwise)

paid travel time billing of online research to the client allocation of tasks (e.g., document reviews) to senior/junior attorneys

and/or paralegals

• A number of Delaware decisions (2002+) have rejected efforts by corporations that have promised mandatory advancement to disavow those promises due to the alleged – and in some cases admitted or proven – wrongful nature of the conduct for which advancement is sought.

• In his 2006 law review article “Sinners Who Find Religion”, 25 Texas. Rev. Litig. 251, Stephen Fraidin of Weil, Gotshal & Manges LLP, the author cautioned Delaware companies – their directors, and legal advisers – that they need to understand that the often reflexive decision to grant broad advancement rights to directors, officers, and employees can have unintended consequences to the corporation (and its shareholders) and to the directors who grant these rights.

e.g., Bergonzi v. Rite Aid Corp. (former CFO who pled guilty to criminal fraud, but entitled to advancement after convictions and through criminal appeals).

Conclusion – Have Your Board Make (and then revisit) the Business Judgment

Conclusion – Have Your Board Make (and then revisit) the Business Judgment continued

• How Does the Board perceive mandatory advancement “after the fact”? Answer: “Maddening”

• Like other business decisions, the decision to provide broad and mandatory advancement rights should be made by the Board in the deliberate exercise of its business judgment, BEFORE adopting broad/mandatory charter, bylaw or agreement provisions mandating advancement in all cases, and should strike a proper balance.

• Considerations to weigh (Pros and Cons) and Alternatives:

Conclusion – Have Your Board Make (and then revisit) the Business Judgment continued

• Requiring a secured undertaking (and permitting Board waivers in appropriate cases)

• Distinguishing between direct suits by the corporation and derivative suits by shareholders

• Watch your Bylaw definition of officers (lots of “vice presidents”?)

• No mandatory advancement at all, use a “case by case basis” approach and weigh all relevant factors at the time of a potential advancement

Indemnification Clauses

THANK YOU

• Questions?

• Follow-Up H. Kennedy Hudner, 860.240.6029, [email protected]

Elizabeth J. Stewart, 203.772.7710, [email protected]

Richard S. Smith, Jr., 860.240.6053, [email protected]

Edward B. Whittemore, 860.240.6075, [email protected]

Documents

WESFACCA Indemnification Issues (2011)