An oddball legal dispute bouncing around the Delaware Chancery court system has yet again produced another legal precedent that should give pause to corporate directors facing lawsuits.

The court recently decided that, yes, a company can retroactively sever legal protections to directors after they leave the board. In Schoon v. Troy Corp., the court ruled that a company can amend its by-laws and eliminate its obligations to advance legal fees to a director who is sued, as well as eliminate the director’s indemnification—even if the director seeking the advancement had served on the board under the prior by-laws and left the board before the by-laws were amended.

This is the second time a Troy-related case has cropped up in Delaware decisions this year. In February, the Delaware Supreme Court ruled that the plaintiff, ex-director Richard Schoon, could not file a derivative shareholder lawsuit against other directors of Troy Corp. because he owned no shares in the company.

The latest decision, however, is likely to gain much more attention. “This is scary for people in this area,” says Howard Steinberg of the law firm McDermott Will & Emery.

Gartner

Steven Gartner of the law firm Willkie Farr & Gallagher says, “People are paying careful attention to what the by-laws say and are asking for separate indemnity agreements.”

Like most companies, Troy’s by-laws traditionally required the company to advance legal fees to current and former officers and directors for company-related investigations and litigations and indemnify them if they are found liable for any infraction. In November 2005, however, Troy amended its by-laws so the company was no longer obligated to advance fees to former directors—including to William Bohnen, a director who had retired earlier that year.

When ex-director Schoon filed his derivative lawsuit, Troy countered with another lawsuit against Schoon and Bohnen, alleging breach of fiduciary duties. As a result, Schoon and Bohnen asked Troy to advance their litigation costs. The company refused. Bohnen then sued, figuring he was entitled to advancement of fees under the by-laws in place when he had served as a director. The Chancery Court has now ruled against him.

The Chancery Court specifically held that since there was no claim against Bohnen at the time Troy changed its by-laws, the company was in its rights to deny the former director any money.

That could be an ominous precedent for directors, since their legal bills can routinely run into six or even seven figures when they are hauled into court. “If you don’t have your expenses covered, you can really be in trouble,” Gartner says.

Law firms have churned out a small flock of legal bulletins on the decision, warning that the Chancery Court has now changed its mind about what event triggers a director’s right to claim advancement of legal fees. A bulletin from the firm O’Melveny & Myers says Bohnen’s expectation of legal fees traces back to a 1992 Delaware Superior Court decision, which found that advancement of legal fees depends on when the underlying wrongdoing occurred. In Schoon v. Troy, however, the Chancery Court has held that advancement rights are triggered by the later lawsuit or discovery of the wrongdoing.

A client memo from Wachtell, Lipton, Rosen & Katz warns that: “The Schoon case highlights the need for corporations to review, and in some cases revise, their indemnification and expense advancement provisions to make sure they protect the rights of directors and officers as intended.”

WHO PICKS UP THE TAB?

Below is an excerpt of a recent legal bulletin from the firm Wachtell, Lipton alerting clients to possible consequences of the Schoon decision.

The Schoon case highlights the need for corporations to review, and in some cases revise, their indemnification and expense advancement provisions to make sure they protect the rights of directors and officers as intended. While it is uncertain whether Schoon will be followed at the Delaware Supreme Court level, or applied outside its fact pattern, prudence suggests that corporations seeking to offer strong indemnification protection and to deal with the threat potentially posed by the Schoon ruling should make sure that

(i) indemnification and advancement provisions are clearly stated to constitute a “contract” between the corporation and each director or officer who serves in such a capacity at any time while the provisions are in effect, whether or not such person continues to serve in such capacity at the time advancement or indemnification is sought, (ii) indemnification and advancement provisions cannot be retroactively amended to adversely affect the rights of indemnified persons arising in connection with any acts, omissions, facts or circumstances occurring prior to such amendment, and (iii) the bylaws make it clear that the advancement rights being provided pertain to expenses incurred in connection with the same set of proceedings for which indemnification is provided. Where practical to do so, additional protection could be achieved by including the

indemnification provisions into a corporation’s charter, which cannot be amended by the board without

shareholder approval.

Source

Wachtell, Lipton (May 28, 2008).

Many say indemnification rights and advancement of legal fees are vital to attract quality candidates to a board of directors, who want protection for exercising judgment and taking business risks on behalf of the company. Critics, however, argue that offering too much protection entices directors to make reckless decisions; as a result, not all companies do offer advancement rights.

In its legal bulletin, Wachtell Lipton recommends that companies assure their indemnification and advancement provisions are clearly stated to constitute a “contract” between the corporation and each director or officer who serves in that capacity at any time while the provisions are in effect, whether or not the individual continues to serve in that capacity at the time advancement or indemnification is sought.

Goodman

It’s unclear exactly how broad the repercussions of the Schoon decision will be. Amy Goodman, of the Gibson, Dunn & Crutcher law firm, describes the dispute as “an unusual case” that might not arise at other companies. “Most by-laws have provisions that cover directors after they leave,” she says.

The law firm Debevoise & Plimpton has published a bulletin recommending that companies include a provision in their by-laws to override the Schoon principle—a clause that effectively says, “No amendment to these indemnification provisions shall affect any right in respect of acts or omissions of any indemnified person occurring prior to such amendment.”

Still, the Debevoise bulletin goes on to warn: “There is no downside to including such a provision, but there can be no assurance it cannot be amended away, just like Bohnen’s right to advancement.”

Wachtell goes a step further, recommending the more drastic step of including indemnification provisions in a company’s charter, which cannot be amended by the board without shareholder approval.

A Separate Peace

Legal experts also encourage directors to seek indemnification and advancement rights via a separate agreement with the company, beyond whatever the by-laws or charter specify. Goodman, who chairs an American Bar Association committee on director and officer liability, says companies are increasingly moving in that direction. She says 120 of the Fortune 500 companies offer separate indemnification agreements, up from only 50 in 2004.

Steinberg

“From a company’s standpoint, it is perfectly fine to give agreements,” Steinberg adds. “By giving the agreement, the company is assuring the directors it will stand behind them.”

Individuals seeking a separate indemnification agreement do have a laundry list of details to address, Goodman says. Above all, she says, insist that such agreements cannot be amended retroactively. Also make sure the agreement defines legal proceedings or claims broadly to encompass proceedings such as informal regulatory probes where the director might appear as a witness. An actual lawsuit should not be the required trigger, she says.

The agreement should also identify who decides whether the board member is entitled to indemnification and specify that appeal rights are included if the company denies indemnification.

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