Indemnification Is Good, but Advancement Is Even Better: Make Sure You Know the Difference and Level the Playing Field from the Start.

AuthorRothstein, David A.

Corporate officers and directors frequently find themselves involved in complex legal proceedings in which they face exposure merely by reason of the fact that they served as an officer or director. In such proceedings, the legal expenses incurred by the officer/director can be devastatingly massive, such that it would be unfair to require them to pay those expenses, personally, out of pocket. As such, companies regularly agree to indemnify their officers/directors for all such expenses after the fact. But the commitment to indemnify officers/directors after the fact is sometimes insufficient. In too many instances, the cash requirements of funding a legal defense can be so oppressive that it is an almost illusory benefit for the officer/director to be able to seek indemnification after the fact. So, with increasing frequency, companies commit to pay such expenses in advance. (1)

Indemnification and Advancement Together Further Important Policy Goals

Advancement provisions further important policy objectives that provide benefits to not only officers/directors, but also the companies that employ such individuals. (2) Indemnification "encourages corporate service by capable individuals by protecting their personal financial resources from depletion by the expenses they incur during...litigation that results by reason of that service." (3) But the right to indemnification is usually contingent on the outcome of the suit brought against the officer/director. Indeed, most indemnification provisions contain language similar in substance and form to the following: The officer/director shall not be entitled to indemnification with regard to any claim as to which the officer/director is found liable.

Most would agree that carve-out is logical. On the one hand, it makes sense that a corporate employer should indemnify those of its officers/directors who have been wrongly accused of something that they did not do. On the other hand, it makes little sense that a corporate employer should indemnify those of its officers/directors who are found liable for having breached duties owed to their employer in their capacity as an officer/director.

As a result, the right to indemnification cannot be established with finality until after the officer/director has prevailed on the merits. (4) But of course, that cannot be determined until the litigation has come to a close. (5) Hence, the right to (potential) indemnification cannot protect officers/directors from the potentially crushing cash-flow obligations necessary to fund a defense.

But that is where advancement comes into play. Advancement has been defined as "an especially important corollary to indemnification as an inducement for attracting capable individuals into corporate service." (6) That is so because "[advancement provides corporate officials with immediate interim relief from the personal out-of-pocket financial burden of paying the significant on-going expenses inevitably involved with investigations and legal proceedings." (7)

Indemnification and Advancement Are Distinct Legal Concepts

Indemnification and advancement work in tandem to provide benefits to corporate employers and their employees alike, but they are not the same thing. (8) Rather, "the right to indemnification and the right to advancement are distinct." (9) Indeed, the law recognizes that "[t]he advancement of legal fees does not ipso facto mean that defendant companies will have to indemnify the plaintiffs." (10)

As noted above, the right to indemnification requires success on the merits. (11) In stark contrast, advancement does not require an evaluation of the merits--because "[t]he right to advancement is not dependent on the right to indemnification." (12) Rather, "[t]he value of the right to advancement is that it is granted or denied while the underlying action is pending." (13) As such, "[t]he advancement of legal fees should be seen as a decision to advance credit and does not in any way affect the underlying action." (14)

The decision to advance legal expenses, thus, does not necessarily represent an irreversible flow of funds. Rather, by accepting payments expressly recognized merely as an "advancement," the receiving party necessarily acknowledges that the right to keep those payments depends on whether the underlying conduct is properly subject to indemnification. (15) But if it ultimately is determined that the officer/director engaged in conduct that is not properly subject to indemnification, then the recipient is obligated to repay the funds advanced by the company. (16) That, however, is to be decided only after the parties have had a full opportunity to litigate the merits--which has nothing to do with the threshold issue of whether the officer/director is entitled to advancement in the first instance. (17)

In light of the foregoing, courts are mindful not to conflate an analysis of whether advancement is proper with an analysis of whether indemnification is proper, because to do so would blur the distinct purpose of advancement provisions. (18) Indeed, courts consistently (and properly) reject the judicial-economy based argument "that it is more efficient to try claims for advancement simultaneous with the trial of the same lawsuits for which the corporate official is seeking provisional payment of his litigation expenses." (19) That type of so-called efficiency would result "in an unacceptable cost: the effective elimination of the separate right of advancement." (20)

Advancement Presents a Very Simple and Straightforward Analysis

Suits against officers/directors are often complicated and fact intensive. But that is not so with regard to the narrow, threshold issue of advancement. That analysis typically is simple and straightforward. While advancement provisions obviously can vary, and each case will turn on the language of the specific provision at issue, a typical advancement provision will set forth a few straightforward, clear, and unambiguous procedural prerequisites. Usually, the only issue vis-a-vis an officer/director's entitlement to advancement is whether those procedural prerequisites have been satisfied. But issues pertaining to the alleged misconduct forming the basis of the claims in the underlying litigation simply are not relevant. (21)

Typically, advancement provisions will contain just two simple procedural prerequisites. First, the officer/director must show that he or she has been named in a proceeding by reason of the fact that he or she is or was an officer/director of the company. Second, the officer/director must provide what is commonly referred to as an "undertaking"--i.e., a written statement promising to repay all funds advanced if it ultimately is determined that the officer/director is not entitled to indemnification. Neither prerequisite requires an in-depth analysis.

First, whether an officer/director has been sued "by reason of the fact" that he or she is or was an officer/director obviously turns on the allegations pleaded in the underlying suit. But the allegations pleaded usually leave little room for debate. If the officer/director is sued for having breached duties owed in his or her capacity as an officer/director, then it follows that the officer/director was sued "by reason of the fact" that he or she is or was an officer/director. (22) Hence, an officer/director seeking advancement usually can satisfy this prerequisite simply by referring to the allegations of the complaint. The standard is not a lofty one. (23)

Second, whether an officer/director has provided an "undertaking" is objective. The officer/director seeking advancement either provided an "undertaking" as required per the governing documents--or the officer/director did not. But again, this determination can be made without reference to any extraneous facts or law.

Advancement Is Properly Determined via Summary Proceedings

Caselaw uniformly acknowledges that advancement issues are properly to be decided via summary proceedings. In part, that is so because the issue of whether the officer/director has satisfied the contractual prerequisites presents such a simple and straightforward analysis. In part, that is so because courts endeavor to advance the policy underpinnings that advancement provisions are intended to promote, which is to provide an interim cost-shifting mechanism.

For example, in DeLucca v. KKAT Management, LLC, 2006 WL 224058 (Del. Ch. 2006), the Delaware Court of Chancery held it was proper to order the advancement of fees based on a motion for judgment on the pleadings. In pertinent part, the court explained why it was proper to decide the matter on a...

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