Schoon v. Troy: Delaware Vice Chancellor Allows Retroactive Repeal of Director Advancement Rights
May 29, 2008
A recent Delaware Chancery Court decision,
Schoon v. Troy Corp.,
[1] may have important ramifications for the indemnification and fee-advancement rights of Delaware corporation directors. In
Schoon, the Court enforced a bylaw amendment that eliminated the company’s advancement obligations to former directors, even though the director seeking advancement had served under the company’s prior bylaws and had left the board before the bylaw amendment. The director did not appeal the decision, and the time to do so recently expired. Thus, unless and until the Delaware Supreme Court decides otherwise,
Schoon stands as important precedent in determining the circumstances under which advancement rights are triggered and may be limited.
Until November 2005, defendant Troy Corporation’s bylaws obligated the company to (i) advance attorneys’ fees of current and former officers and directors during company-related investigations and litigations, and (ii) indemnify officers and directors for ultimate liability arising out of those matters.
[2] Such broad indemnification bylaws are common; in fact, most companies provide advancement and indemnification to Delaware law’s fullest extent,
[3] leaving them with practically no discretion to deny advancement, even where the company sues its current or former executives for theft, fraud, or fiduciary-duty breaches.
[4]
But Troy amended its indemnification bylaws in November 2005, after director William Bohnen retired. The amendments, among other things, eliminated the Company’s obligation to advance fees of former directors, such as Bohnen. At the time of the amendments, the Company was already engaged in a books-and-records lawsuit with a current director, Richard Schoon. The company resisted turning over its records to Schoon based on its concern that Schoon would share that information with third parties while trying to sell company stock. During the discovery phase of this lawsuit, the company investigated whether Schoon and Bohnen, both of whom were nominees of the same large shareholder, had shared confidential company information with third parties. The company later sued Schoon and Bohnen for sharing confidential information in breach of their fiduciary duties. Schoon and Bohnen sought advancement for litigation costs in connection with these pre-amendment acts.
Bohnen believed that he would be covered by the bylaws in place at the time of his service, and that the company could not retroactively limit or eliminate his indemnification rights. This belief is consistent with a 1992 Delaware Superior Court decision,
[5] and likely comports with the then-prevailing view of most Delaware directors. The Court in
Schoon held, however, that a director’s advancement rights are not triggered by the underlying wrongdoing, but rather, by the later lawsuit
[6] or discovery of that wrongdoing.
[7] The problem for Bohnen was that he retired and the Company amended its bylaws to eliminate former directors’ advancement rights before it started to investigate his alleged bad acts as a director. Thus, the Company had no obligation to advance Bohnen’s defense costs.
Schoon reflects the tension that Delaware courts often encounter in advancement and indemnification cases. On the one hand, broad advancement and indemnification bylaws are good for companies because they (i) help attract the best and most qualified officers and directors, who may be less inclined to accept a position from a company unwilling to hold them harmless for their company-related legal expenses,
[8] and (ii) encourage corporate risk-taking.
[9] On the other hand, broad advancement and indemnification rights can expose the company to run-away costs, including to current and former fiduciaries who have harmed the company.
[10]
Schoon also provides Delaware companies with a flexibility that most boards probably did not realize they had. Companies can, like Troy, amend their bylaws to limit advancement and indemnification for already-occurred (but undiscovered) wrongdoing, or at least retain the ability to do so in the future. Alternatively, companies may choose to cement their advancement and indemnification obligations by amending their bylaws to make clear that any current provisions will apply to current acts or omissions, regardless of any future amendments or when those acts or omissions are discovered, investigated, or litigated. Directors may similarly seek to cement current protections by signing individual advancement and indemnification agreements with the company. Bilateral contracts, unlike bylaws, cannot be unilaterally rescinded by a company.
In reevaluating their bylaws in light of
Schoon, boards should generally consider whether their bylaws’ obligations are too broad for the company’s needs. In so doing, they should keep in mind the potentially conflicting interests of retaining and encouraging competent fiduciaries on the one hand, and limiting the company’s exposure to draconian costs on the other.
[11]
If you have questions about the decision and its impact, you may contact Jonathan Rosenberg at (212) 408-2409 or or Alexandra Lewis-Reisen at (212) 326-2080 or .
This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. Jonathan Rosenberg, an O’Melveny partner licensed to practice law in New York, and Alexandra Lewis-Reisen, an O’Melveny counsel licensed to practice law in New York, have contributed to the content of this newsletter. The views expressed in this memo are those of the authors.
[1] C.A. No. 2362, 2008 WL 821666 (Del. Ch. Mar. 28, 2008) (Lamb, V.C.).
[2] 2008 WL 821666, at *2, n.8.
See also 8 Del. C. § 145 (providing for mandatory, permissive, and forbidden indemnification under varying circumstances, and allowing companies to pre-commit themselves to pay permissive advancement and indemnification).
[3] Advanced Min. Sys., Inc. v. Fricke, 623 A.2d 82, *83 (Del. Ch. 1992) (Allen, C.) (“in fact most corporations and virtually all public corporations have by by-law exercised the authority . . . so as to mandate the extension of indemnification rights in circumstances in which indemnification would be permissible”).
[4] See, e.g.,
DeLucca v. KKAT Management, LLC, C.A. No. 1384-N, 2006 WL 224058 (Del. Ch. Jan. 23, 2006) (requiring fund investment manager and affiliate to advance attorneys’ fees to former money manager they were suing for fiduciary duty and contract breaches);
Weinstock v. Lazard Debt Recovery GP, LLC, C.A. No. 20048, 2003 WL 21843254, at *5 (Del. Ch. Aug. 1, 2003) (requiring fund general partner and investment manager to advance attorneys’ fees of former fund portfolio managers they were suing for fraud and fiduciary duty and contract breaches).
[5] See, e.g., Salaman v. Nat’l Media Corp., 1992 WL 808095 (Del. Super. Ct. Oct. 8, 1992) (invalidating a company’s attempt “retroactively” to rescind a former director’s advancement rights by amending its bylaws after the alleged wrongdoing took place, the director was sued, and the company started advancing his fees).
[6] Schoon, 2008 WL 821666, at *5.
[8] Homestore, Inc. v. Tafeen, 2005 WL 3091887, *6 (Del. Nov. 17, 2005) (“Indemnification encourages corporate service by capable individuals by protecting their personal financial resources from depletion by the expenses they incur during an investigation or litigation that results by reason of that service. . . . Advancement is an especially important corollary to indemnification as an inducement for attracting capable individuals into corporate service.”);
Shearin v. E.F. Hutton Group, Inc., 652 A.2d 578, 593 (Del. Ch. 1994).
[9] Scharf v. Edgcomb Corp., C.A. No. 15224, 1997 WL 762656, at *4 (Del. Ch. Dec. 4, 1997) (describing advancement as a “desirable underwriting of risk by the corporation in anticipation of greater corporate-wide rewards for its shareholders.”).
[10] See, e.g.,
Waltuch v. Conticommodity Servs., Inc., 88 F.3d 87 (2d Cir. 1996) (applying Delaware law) (awarding indemnification of legal fees to former officer after company paid shareholders $35 million as settlement to dismiss claims regarding the officer’s trading in the silver market — indemnity found mandatory because officer did not have to accede or contribute to settlement);
Merritt-Chapman & Scott Corp. v. Wolfson, 321 A.2d 138, 141 (Del. Super. 1974) (officer can be indemnified for defending dismissed charges, even though he was criminally convicted on others).
[11] For suggestions and an analysis of potential changes to broad advancement and indemnification bylaws, see Jonathan Rosenberg and Alexandra Lewis,
The Truck Stops Here: Closing the Holes in Loosely Written Public Company Advancement and Indemnification Bylaws, 22 Corp. Couns. Q. 1, 2006. A copy of the article is available
here.
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