Indemnification Revisited

The starting point is with the business statutes of the state of incorporation. With sometimes subtle differences, most states impose some form of 'mandatory indemnification' for a defined or specified category of directors, officers, agents, and/or employees (current or former) who have been 'successful' in a legal action or proceeding arising out of their position or relationship with the corporation. It is equally common for state law to authorize corporations to provide 'permissive indemnification' to some broader category of persons, under specified circumstances. A typical condition of such 'permissive indemnification' is a requirement that the party to be indemnified acted 'in good faith,' or otherwise in such a manner that was reasonably believed to be not opposed to the best interests of the corporation. The statutes by and large leave the details of the application and interpretation of these conditions to the corporations themselves.

While after-the-fact indemnification for a successful litigant is well and good, the far more important consideration to most affected parties is the corporation's stance with respect to advancing legal fees and expenses prior to any ultimate determination of 'success.' With rare exceptions, business corporation laws provide that advancing legal fees is within the discretion of the corporation.

Statutory 'advancement' provisions uniformly require that the corporation obtain an undertaking from the person to be indemnified, in which he or she affirms that actions were taken in good faith and promises to repay any amounts advanced should it ultimately be determined that indemnification was inappropriate. Precisely who makes the 'good faith' determination, and how, are left to the affected parties to sort out. A further complicating factor is that most state statutes specifically note that even the fact of a criminal conviction does not necessarily mean that the party was not entitled to indemnification or advancement of fees.

Given the relative flexibility of most state statutes governing indemnification and advancement of fees, what the corporation's documents say about these matters take on heightened significance (and may provide fodder for zealous prosecutors). The more expansively the corporate documents provide for indemnification and/or advancement of fees, the less flexibility the corporation may find it has down the road when a complex and costly investigation takes on a life of its own. A case worth noting is United States v. Weissman, 1997 U.S. Dist. Lexis 12975 (S.D.N.Y. 1997). Weissman was the Chief Financial Officer of Empire Blue Cross Blue Shield of New York in the early 1990s, when it (and he) came under investigation by the U.S. Attorney and District Attorney in Manhattan. Weissman sought and obtained advancement of his legal fees from Empire pursuant to by-laws that provided the most expansive indemnification permitted under New York's Not-For-Profit Corporation laws. In relevant part, Empire's by-laws provided: 'The Corporation shall ' indemnify any person ' against ' expenses, including attorneys' fees ' provided, however, that no indemnification shall be provided to any person if a judgment or other final adjudication' establishes that the person acted in bad faith or with deliberate dishonesty. Empire's agreement to advance Weissman's legal fees turned out to be costly. His attorneys were from some of the largest law firms in New York.

After several years of investigation, the U.S. Attorney's Office obtained an indictment charging Weissman with perjury and obstruction of justice, and a jury convicted him on three of four charges. At that point, Empire informed Weissman that it would no longer advance his attorneys' fees, and would not pay the outstanding fees and costs. No doubt, Empire acted on the view that the jury's conclusion ' beyond a reasonable doubt ' that Weissman committed perjury and obstruction of justice had settled the question of whether 'his acts were committed in bad faith or were the result of actual and deliberate dishonesty.'

Weissman and his attorneys promptly filed a motion before the trial judge seeking an order compelling Empire to continue advancing funds necessary to his defense. The situation raised difficult questions, including the scope of the court's ancillary jurisdiction, whether the issue was more properly decided in state court (where Empire had filed a declaratory judgment action seeking a determination that it could stop advancing funds for Weissman's defense), and the ultimate issue over the interpretation of Empire's by-laws concerning indemnification.

In a thoughtful decision, Judge Haight worked his way through the issues to conclude that Empire was bound to pay not only Weissman's fees through the conclusion of the trial, but also whatever fees might be incurred through appeal or any applications for post-conviction relief. The court reached this result despite a clear record indicating Weissman's financial condition was such that there was no possibility he could ever make good on his original undertaking to repay the advanced funds should it ultimately be determined that indemnification had been inappropriate.

Judge Haight's decision was based on an expansive construction of the provision of Empire's by-laws that indemnification would not be provided, 'if a judgment or other final adjudication adverse' to Weissman established his bad faith or dishonesty. In Judge Haight's view, 'final adjudication' in a criminal case is not obtained until the defendant has exhausted or foregone his post-trial remedies. As the court observed: 'It was for Empire, in its drafting of the by-laws, and for the New York State legislature, in its promulgation of rules establishing the contours for indemnification of corporate officers, to decide when a director's dishonesty was sufficiently established so that advancement of his attorney's fees should cease.' Since Weissman's case arose before either of the DOJ memos regarding the prosecution of corporations was promulgated, no particular guidance can be taken from the case on that point. The cost issue, however, was clearly of significance to Empire.

Interestingly enough, Qwest's by-laws contain the very same language as Empire's, that indemnification is prohibited 'where a judgment or other final adjudication' adverse to the party is obtained. Qwest's provision is qualified, however, by a clause that indemnification may also be prohibited 'where it is determined in accordance with applicable law' that the indemnified party breached a duty of loyalty to the company, acted in bad faith, or received an improper benefit. It will be instructive to follow how Qwest's indemnification situation, and many others like it, play themselves out over time. Of particular interest will be the DOJ's treatment of corporations with the most expansive indemnification provisions.

Andrew P. Gaillard, a former federal prosecutor, is a partner at Day, Berry & Howard, LLP in Stamford, CT.

A recent Wall Street Journal story asked, 'How much does it cost to defend a company and its executives when they are under investigation for accounting fraud?' In the case of Qwest Communications International, Inc., the Denver-based telephone company currently under parallel SEC and Department of Justice investigations, the answer is staggering. Over the course of the previous year, $75 million was expended on outside counsel. As 'legal pressures' continue to mount, the Journal reported that 'more than $7 million per month' in legal fees was anticipated. For the beleaguered company, there appears to be no end in sight. In late February, four former Qwest executives were indicted in what Attorney General Ashcroft described as the 'first phase' of the investigation.

If simple economics were not enough to motivate corporate counsel to take a fresh look at what their company's corporate documents say about indemnification, a recent pronouncement from the DOJ should. On January 20, 2003, the Deputy Attorney General issued a memorandum to all U.S. Attorney's offices entitled 'Principles of Federal Prosecution of Business Organizations.' In large measure, the memorandum restates a June 16, 1999 DOJ memorandum entitled 'Bringing Criminal Charges Against Corpor- ations.' Each of these memos sets forth guidelines and factors to be used by prosecutors in determining whether to charge a corporation or other business entity in a particular case.

Both versions of the memorandum include a number of factors such as the nature and seriousness of the offense, the pervasiveness of wrongdoing, the company's history of problems, and its timely and voluntary disclosure of wrongdoing. On this last point, both memos direct prosecutors to consider 'whether the corporation appears to be protecting its culpable employees and agents ' through the advancing of legal fees ' ' The 2003 version, however, drawing from the experiences of the DOJ's Corporate Fraud Task Force (the teams prosecuting the Enron and Arthur Andersen matters, among others), goes several steps further: 'Another factor to be weighed by the prosecutor is whether the corporation, while purporting to cooperate, has engaged in conduct that impedes the investigation (whether or not rising to the level of criminal obstruction). Examples of such conduct include: overly broad assertions of corporate representation of employees or former employees ' ' In light of the DOJ's heightened focus on this factor, corporations are well-advised to reconsider exactly what their indemnification provisions say and mean.

The starting point is with the business statutes of the state of incorporation. With sometimes subtle differences, most states impose some form of 'mandatory indemnification' for a defined or specified category of directors, officers, agents, and/or employees (current or former) who have been 'successful' in a legal action or proceeding arising out of their position or relationship with the corporation. It is equally common for state law to authorize corporations to provide 'permissive indemnification' to some broader category of persons, under specified circumstances. A typical condition of such 'permissive indemnification' is a requirement that the party to be indemnified acted 'in good faith,' or otherwise in such a manner that was reasonably believed to be not opposed to the best interests of the corporation. The statutes by and large leave the details of the application and interpretation of these conditions to the corporations themselves.

While after-the-fact indemnification for a successful litigant is well and good, the far more important consideration to most affected parties is the corporation's stance with respect to advancing legal fees and expenses prior to any ultimate determination of 'success.' With rare exceptions, business corporation laws provide that advancing legal fees is within the discretion of the corporation.

Statutory 'advancement' provisions uniformly require that the corporation obtain an undertaking from the person to be indemnified, in which he or she affirms that actions were taken in good faith and promises to repay any amounts advanced should it ultimately be determined that indemnification was inappropriate. Precisely who makes the 'good faith' determination, and how, are left to the affected parties to sort out. A further complicating factor is that most state statutes specifically note that even the fact of a criminal conviction does not necessarily mean that the party was not entitled to indemnification or advancement of fees.

Given the relative flexibility of most state statutes governing indemnification and advancement of fees, what the corporation's documents say about these matters take on heightened significance (and may provide fodder for zealous prosecutors). The more expansively the corporate documents provide for indemnification and/or advancement of fees, the less flexibility the corporation may find it has down the road when a complex and costly investigation takes on a life of its own. A case worth noting is United States v. Weissman, 1997 U.S. Dist. Lexis 12975 (S.D.N.Y. 1997). Weissman was the Chief Financial Officer of Empire Blue Cross Blue Shield of New York in the early 1990s, when it (and he) came under investigation by the U.S. Attorney and District Attorney in Manhattan. Weissman sought and obtained advancement of his legal fees from Empire pursuant to by-laws that provided the most expansive indemnification permitted under New York's Not-For-Profit Corporation laws. In relevant part, Empire's by-laws provided: 'The Corporation shall ' indemnify any person ' against ' expenses, including attorneys' fees ' provided, however, that no indemnification shall be provided to any person if a judgment or other final adjudication' establishes that the person acted in bad faith or with deliberate dishonesty. Empire's agreement to advance Weissman's legal fees turned out to be costly. His attorneys were from some of the largest law firms in New York.

After several years of investigation, the U.S. Attorney's Office obtained an indictment charging Weissman with perjury and obstruction of justice, and a jury convicted him on three of four charges. At that point, Empire informed Weissman that it would no longer advance his attorneys' fees, and would not pay the outstanding fees and costs. No doubt, Empire acted on the view that the jury's conclusion ' beyond a reasonable doubt ' that Weissman committed perjury and obstruction of justice had settled the question of whether 'his acts were committed in bad faith or were the result of actual and deliberate dishonesty.'

Weissman and his attorneys promptly filed a motion before the trial judge seeking an order compelling Empire to continue advancing funds necessary to his defense. The situation raised difficult questions, including the scope of the court's ancillary jurisdiction, whether the issue was more properly decided in state court (where Empire had filed a declaratory judgment action seeking a determination that it could stop advancing funds for Weissman's defense), and the ultimate issue over the interpretation of Empire's by-laws concerning indemnification.

In a thoughtful decision, Judge Haight worked his way through the issues to conclude that Empire was bound to pay not only Weissman's fees through the conclusion of the trial, but also whatever fees might be incurred through appeal or any applications for post-conviction relief. The court reached this result despite a clear record indicating Weissman's financial condition was such that there was no possibility he could ever make good on his original undertaking to repay the advanced funds should it ultimately be determined that indemnification had been inappropriate.

Judge Haight's decision was based on an expansive construction of the provision of Empire's by-laws that indemnification would not be provided, 'if a judgment or other final adjudication adverse' to Weissman established his bad faith or dishonesty. In Judge Haight's view, 'final adjudication' in a criminal case is not obtained until the defendant has exhausted or foregone his post-trial remedies. As the court observed: 'It was for Empire, in its drafting of the by-laws, and for the New York State legislature, in its promulgation of rules establishing the contours for indemnification of corporate officers, to decide when a director's dishonesty was sufficiently established so that advancement of his attorney's fees should cease.' Since Weissman's case arose before either of the DOJ memos regarding the prosecution of corporations was promulgated, no particular guidance can be taken from the case on that point. The cost issue, however, was clearly of significance to Empire.

Interestingly enough, Qwest's by-laws contain the very same language as Empire's, that indemnification is prohibited 'where a judgment or other final adjudication' adverse to the party is obtained. Qwest's provision is qualified, however, by a clause that indemnification may also be prohibited 'where it is determined in accordance with applicable law' that the indemnified party breached a duty of loyalty to the company, acted in bad faith, or received an improper benefit. It will be instructive to follow how Qwest's indemnification situation, and many others like it, play themselves out over time. Of particular interest will be the DOJ's treatment of corporations with the most expansive indemnification provisions.

Andrew P. Gaillard, a former federal prosecutor, is a partner at Day, Berry & Howard, LLP in Stamford, CT.