DE Court Provides Important Guidance on Indemnification of Directors and Officers

Marc Hermelin served as CEO and a member of the board of directors of K-V Pharmaceutical Company from 1975 through 2008. In connection with his service, Hermelin was provided with an Indemnification Agreement requiring K-V to “indemnify Indemnitee to the fullest extent permitted by the General Corporation Law ' .”

In 2008, two pharmacy customers alerted K-V that they had received oversized morphine sulfate tablets from the company. An internal investigation revealed that K-V had produced other oversized tablets as well. K-V notified the Food and Drug Administration (FDA) regarding the oversized morphine sulfate tablets, but not the others.

Following this investigation and complaints from K-V employees that Hermelin failed “to take appropriate action in response to the discovery that K-V's manufacturing process had produced several oversized tablets,” the Audit Committee of K-V's board conducted its own investigation. Based on the results, the Audit Committee terminated Hermelin as CEO “for cause.”

K-V's public announcement of these events spawned four separate governmental proceedings:

• The U.S. Attorney's Office for the Eastern District of Missouri charged Hermelin with two federal strict liability misdemeanors based solely on his status as a “responsible corporate officer” rather than any personal misconduct. Hermelin pled guilty, paid $1.9 million in penalties and spent 15 days in jail.
• The U.S. Department of Health and Human Services excluded Hermelin from all federal healthcare programs for 20 years, again based solely on his relationship to K-V. To prevent K-V from suffering a similar fate, Hermelin agreed to sell his stake in the company and waive his right to appeal his own exclusion.
• K-V signed a consent decree with the FDA requiring it to destroy certain drugs and cease production of others until completion of various FDA-mandated remedial measures. Hermelin was relieved from compliance with the consent decree “so long as (1) K-V's Board's resolutions to terminate Hermelin's employment remain in effect and (2) Hermelin 'has no role in the decisionmaking, management, or operation of the Defendant K-V that could affect the company's compliance with' … [FDA rules and regulations].”

While Hermelin was incarcerated following his guilty plea, prison officials recorded his private conversations “per the jail's policy.” In response to a local reporter's request for these recordings, Hermelin successfully petitioned a state court to enjoin their release on the ground they were “purely private matters.”

Per his Indemnification Agreement, Hermelin sought indemnification in respect of the various government proceedings. K-V disputed each of these claims.

The Court's Analysis

Initially, the court explained that the DGCL “sets two boundaries for indemnification.” At one “end of the spectrum,” DGCL ' 145(c) requires indemnification of any director or officer who is made a party to a proceeding by reason of his or her service to the corporation and has achieved success on the merits. At the “other end,” DGCL Sections ' 145(a) and (b) prohibit indemnification of any director or officer who is unsuccessful in the proceeding and has acted in bad faith.

Between “the extremes of 'success' and 'bad faith',” a corporation's ability to provide indemnification is “permissive,” such that “when a corporation has established by contract the indemnification rights of a corporate official, the agreement controls unless it conflicts with a mandatory statutory provision.”

The court noted that Hermelin's Indemnification Agreement provided sweeping coverage insofar as it both “tracks the language” of the mandatory provisions of DGCL ' 145(c) and “generally makes mandatory what are permissive provisions for indemnification under the DGCL.” Further, the Indemnification Agreement stated that “where a proceeding to which Hermelin is a party 'is resolved in any manner other than by adverse judgment against [Hermelin] ' it shall be presumed that [Hermelin] has been successful on the merits', '” and placed the burden on K-V to overcome this presumption.

The dispute between Hermelin and K-V centered on whether he had “succeeded on the merits'” of any of the proceedings brought against him, “thus entitling him to indemnification as a matter of law,” or whether discovery was required to determine whether Hermelin had “acted in good faith, in which case he will be entitled to [permissive] indemnification under the Indemnification Agreement.”

Mandatory Indemnification

In assessing Hermelin's entitlement to mandatory indemnification in respect of the other proceedings, the court recognized that the Indemnification Agreement supplied “additional clarification” of the concept “successful on the merits” by providing that “a settlement or other disposition short of final judgment may be successful if it permits a party to avoid expense, delay, distraction, disruption and uncertainty.” Notably, the court refused to look “behind the result” to determine whether Hermelin had been successful in any of the proceedings, emphasizing instead that “where the outcome of a proceeding signals that the indemnitee has avoided an adverse result, the indemnitee has succeeded ' ,' and further inquiry into the 'how' and 'why' of the result is unnecessary.” Accordingly, the court proceeded to examine “what Hermelin was charged with or formally accused of, and ' compare[d] that with the result Hermelin actually achieved.”

Criminal Proceeding

Although he pleaded guilty in the criminal proceeding, paid a significant fine and served prison time, Hermelin argued that he actually was successful because his guilty plea avoided conviction on harsher charges. In the court's view, “[t]his was not a successful outcome.” The court also found Hermelin's argument that his guilty plea avoided “expense, delay, distraction, disruption, and uncertainty” to be “unpersuasive.” Otherwise, the court explained, “[i]f an indemnitee could 'succeed' by pleading guilty on all counts, those indemnitees utterly without a defense ' would nonetheless be 'successful' on the merits ' .”

Hermelin's contention that his plea dissuaded the U.S. Attorney from charging him “with more serious claims” also failed. Simply put, “[t]he substance of these negotiations ' is beyond the scope of a determination of success on the merits under Section 145(c). ' The proper analysis instead considers the outcome achieved by the indemnitee in light of the formal charges or claims against him.”

HHS Exclusion

Hermelin claimed that because his 20-year exclusion from all federal healthcare programs was based on his association with K-V rather than misconduct on his part, he was successful in that proceeding. Given Hermelin's age, the court saw no difference between the penalty initially sought (a lifetime ban from federal healthcare programs) and the actual outcome of this proceeding (a 20-year ban).

Hermelin also argued that he should not be “punished” because he voluntarily took actions that benefitted K-V. While “good corporate policy may support the indemnification of officers who, in good faith, 'take one for the company' to avoid bringing down the whole enterprise,” the court explained that this consideration is irrelevant when assessing entitlement to mandatory ' as opposed to permissive ' indemnification.

FDA Consent Decree

Hermelin characterized the resolution of the FDA's proceeding as a victory because: 1) the FDA did not find him personally guilty of misconduct; and 2) the consent decree, at least initially, did not apply to him. Unlike its analysis of the other proceedings, the court found that because “the restrictions contained in the Consent Decree ' did not place any additional restrictions on Hermelin,” he avoided “a personally negative result” and therefore was entitled to mandatory indemnification.

Injunctive Action

Although his Indemnification Agreement contained “a key exception” for actions initiated by him, Hermelin sought to characterize his injunctive action to enjoin release of the recorded jail conversations as a “compulsory counterclaim.” On this basis, Hermelin argued that he was not the initiating party in the litigation and therefore was entitled to expense reimbursement.

The court rejected this argument, concluding that Hermelin was in fact the initiator of the injunctive action: Hermelin's position “simply misconstrues the language” of the Indemnification Agreement by failing “to recognize the distinction between an act that gives rise to a [legal claim] and an act that actually initiates a proceeding ' .” The court explained that “[u]nder Hermelin's interpretation, the Indemnitee could never be seen as having 'initiated' a proceeding, even as a plaintiff, so long as he had in the first place a [legal claim] that he wished to vindicate.”

Permissive Indemnification

Finally, the court considered whether Hermelin was entitled to permissive indemnification under his Indemnification Agreement for those claims for which the court did not award mandatory indemnification. The key question in this regard was whether Hermelin had “acted in good faith and in a manner ' reasonably believed to be in or not opposed to the best interest of the corporation ' .”

The court recognized the “starting point” for its analysis provided by the Indemnification Agreement:

The termination of any Proceeding … by judgment, order, settlement or conviction, … shall not … of itself adversely affect the right of Indemnitee to indemnification or create a presumption that Indemnitee did not act in good faith and in a manner which Indemnitee reasonably believed to be in or not opposed to the best interests of the Company ' .

In other words, “the particular outcome of a proceeding does not itself create a presumption that the indemnitee had a 'non-indemnifiable state of mind' ” unless “ the underlying proceeding established that the indemnitee acted in bad faith ' .” Absent such a finding, “additional discovery ' in some instances mimicking the very litigation avoided by the settlement ' may be required to permit a determination on whether the indemnitee acted in good faith.”

Given the “scant evidence” available to it, the court ordered a trial to determine whether Hermelin had acted in good faith. This was not to be an open-ended proceeding, but rather one “limited to Hermelin's conduct underlying the proceedings for which Hermelin seeks indemnification.” At the same time, the court rejected Hermlin's attempt to restrict the fact-finding to “the records established in the matters for which he seeks indemnification.” Instead, a determination that “the indemnitee did not act in bad faith [is] a fact-intensive inquiry that will most likely require a trial and credibility determinations.”

Conclusion

The “dearth” of case law concerning entitlement to permissive indemnification under a bylaw or indemnification agreement, the Hermelin court explained, exists because “where, as here, it is clear that the employee's right to indemnification turns on 'good faith,' economics militate in favor of resolving the matter outside of court, given the costs associated with a plenary trial on the indemnitee's conduct.” In such litigation, “we will essentially be conducting the litigation that the parties have thus far avoided through settlements, consent decrees, and plea agreements.” In a warning not only to K-V and Hermelin, but to any corporation and potential indemnitee that might be considering whether to litigate a disputed claim for permissive indemnification, the court cautioned that it left it “to the parties to determine whether the elusive joys and potential benefits of such litigation outweigh the substantial costs that will result.”

Robert S. Reder has been serving as a consulting attorney for Milbank, Tweed, Hadley & McCloy LLP in New York City since his retirement as a partner in March 2011, and is an Adjunct Professor at Fordham Law School. This article also appeared in The Corporate Counselor, an LJN sister publication of this newsletter.

In our litigious society, individuals are understandably reluctant to serve as directors or officers of publicly traded corporations without certain safeguards to protect their personal assets. Moreover, absent such protections, individuals serving in such capacities may be risk-averse in terms of both making bold business decisions and fighting (rather than settling) spurious lawsuits. Recognizing this reality, Section 145 of the Delaware General Corporation Law (DGCL ' 145) provides rules of the road for corporations to indemnify and obtain insurance to shield their directors and officers from personal liability for acts taken in their official capacities.

Although director and officer indemnification is not a new concept, there is limited judicial precedent interpreting DGCL ' 145. Thus, this year's Delaware Court of Chancery decision in Hermelin v. K-V Pharmaceutical Company (Civil Action No. 6936-VCG (Del. Ch. Feb. 7, 2012)) is most welcome. The Hermelin court was asked to consider indemnity claims of a deposed CEO under an expansive indemnification agreement. The court not only provided helpful guidance on the “two boundaries for indemnification” and required elements of proof under DGCL ' 145, but also explained the “dearth” of guiding case law by warning that the costs of litigating indemnification claims generally outweigh the potential benefits to the litigants.

Background

Marc Hermelin served as CEO and a member of the board of directors of K-V Pharmaceutical Company from 1975 through 2008. In connection with his service, Hermelin was provided with an Indemnification Agreement requiring K-V to “indemnify Indemnitee to the fullest extent permitted by the General Corporation Law ' .”

In 2008, two pharmacy customers alerted K-V that they had received oversized morphine sulfate tablets from the company. An internal investigation revealed that K-V had produced other oversized tablets as well. K-V notified the Food and Drug Administration (FDA) regarding the oversized morphine sulfate tablets, but not the others.

Following this investigation and complaints from K-V employees that Hermelin failed “to take appropriate action in response to the discovery that K-V's manufacturing process had produced several oversized tablets,” the Audit Committee of K-V's board conducted its own investigation. Based on the results, the Audit Committee terminated Hermelin as CEO “for cause.”

K-V's public announcement of these events spawned four separate governmental proceedings:

• The U.S. Attorney's Office for the Eastern District of Missouri charged Hermelin with two federal strict liability misdemeanors based solely on his status as a “responsible corporate officer” rather than any personal misconduct. Hermelin pled guilty, paid $1.9 million in penalties and spent 15 days in jail.
• The U.S. Department of Health and Human Services excluded Hermelin from all federal healthcare programs for 20 years, again based solely on his relationship to K-V. To prevent K-V from suffering a similar fate, Hermelin agreed to sell his stake in the company and waive his right to appeal his own exclusion.
• K-V signed a consent decree with the FDA requiring it to destroy certain drugs and cease production of others until completion of various FDA-mandated remedial measures. Hermelin was relieved from compliance with the consent decree “so long as (1) K-V's Board's resolutions to terminate Hermelin's employment remain in effect and (2) Hermelin 'has no role in the decisionmaking, management, or operation of the Defendant K-V that could affect the company's compliance with' … [FDA rules and regulations].”

While Hermelin was incarcerated following his guilty plea, prison officials recorded his private conversations “per the jail's policy.” In response to a local reporter's request for these recordings, Hermelin successfully petitioned a state court to enjoin their release on the ground they were “purely private matters.”

Per his Indemnification Agreement, Hermelin sought indemnification in respect of the various government proceedings. K-V disputed each of these claims.

The Court's Analysis

Initially, the court explained that the DGCL “sets two boundaries for indemnification.” At one “end of the spectrum,” DGCL ' 145(c) requires indemnification of any director or officer who is made a party to a proceeding by reason of his or her service to the corporation and has achieved success on the merits. At the “other end,” DGCL Sections ' 145(a) and (b) prohibit indemnification of any director or officer who is unsuccessful in the proceeding and has acted in bad faith.

Between “the extremes of 'success' and 'bad faith',” a corporation's ability to provide indemnification is “permissive,” such that “when a corporation has established by contract the indemnification rights of a corporate official, the agreement controls unless it conflicts with a mandatory statutory provision.”

The court noted that Hermelin's Indemnification Agreement provided sweeping coverage insofar as it both “tracks the language” of the mandatory provisions of DGCL ' 145(c) and “generally makes mandatory what are permissive provisions for indemnification under the DGCL.” Further, the Indemnification Agreement stated that “where a proceeding to which Hermelin is a party 'is resolved in any manner other than by adverse judgment against [Hermelin] ' it shall be presumed that [Hermelin] has been successful on the merits', '” and placed the burden on K-V to overcome this presumption.

The dispute between Hermelin and K-V centered on whether he had “succeeded on the merits'” of any of the proceedings brought against him, “thus entitling him to indemnification as a matter of law,” or whether discovery was required to determine whether Hermelin had “acted in good faith, in which case he will be entitled to [permissive] indemnification under the Indemnification Agreement.”

Mandatory Indemnification

In assessing Hermelin's entitlement to mandatory indemnification in respect of the other proceedings, the court recognized that the Indemnification Agreement supplied “additional clarification” of the concept “successful on the merits” by providing that “a settlement or other disposition short of final judgment may be successful if it permits a party to avoid expense, delay, distraction, disruption and uncertainty.” Notably, the court refused to look “behind the result” to determine whether Hermelin had been successful in any of the proceedings, emphasizing instead that “where the outcome of a proceeding signals that the indemnitee has avoided an adverse result, the indemnitee has succeeded ' ,' and further inquiry into the 'how' and 'why' of the result is unnecessary.” Accordingly, the court proceeded to examine “what Hermelin was charged with or formally accused of, and ' compare[d] that with the result Hermelin actually achieved.”

Criminal Proceeding

Although he pleaded guilty in the criminal proceeding, paid a significant fine and served prison time, Hermelin argued that he actually was successful because his guilty plea avoided conviction on harsher charges. In the court's view, “[t]his was not a successful outcome.” The court also found Hermelin's argument that his guilty plea avoided “expense, delay, distraction, disruption, and uncertainty” to be “unpersuasive.” Otherwise, the court explained, “[i]f an indemnitee could 'succeed' by pleading guilty on all counts, those indemnitees utterly without a defense ' would nonetheless be 'successful' on the merits ' .”

Hermelin's contention that his plea dissuaded the U.S. Attorney from charging him “with more serious claims” also failed. Simply put, “[t]he substance of these negotiations ' is beyond the scope of a determination of success on the merits under Section 145(c). ' The proper analysis instead considers the outcome achieved by the indemnitee in light of the formal charges or claims against him.”

HHS Exclusion

Hermelin claimed that because his 20-year exclusion from all federal healthcare programs was based on his association with K-V rather than misconduct on his part, he was successful in that proceeding. Given Hermelin's age, the court saw no difference between the penalty initially sought (a lifetime ban from federal healthcare programs) and the actual outcome of this proceeding (a 20-year ban).

Hermelin also argued that he should not be “punished” because he voluntarily took actions that benefitted K-V. While “good corporate policy may support the indemnification of officers who, in good faith, 'take one for the company' to avoid bringing down the whole enterprise,” the court explained that this consideration is irrelevant when assessing entitlement to mandatory ' as opposed to permissive ' indemnification.

FDA Consent Decree

Hermelin characterized the resolution of the FDA's proceeding as a victory because: 1) the FDA did not find him personally guilty of misconduct; and 2) the consent decree, at least initially, did not apply to him. Unlike its analysis of the other proceedings, the court found that because “the restrictions contained in the Consent Decree ' did not place any additional restrictions on Hermelin,” he avoided “a personally negative result” and therefore was entitled to mandatory indemnification.

Injunctive Action

Although his Indemnification Agreement contained “a key exception” for actions initiated by him, Hermelin sought to characterize his injunctive action to enjoin release of the recorded jail conversations as a “compulsory counterclaim.” On this basis, Hermelin argued that he was not the initiating party in the litigation and therefore was entitled to expense reimbursement.

The court rejected this argument, concluding that Hermelin was in fact the initiator of the injunctive action: Hermelin's position “simply misconstrues the language” of the Indemnification Agreement by failing “to recognize the distinction between an act that gives rise to a [legal claim] and an act that actually initiates a proceeding ' .” The court explained that “[u]nder Hermelin's interpretation, the Indemnitee could never be seen as having 'initiated' a proceeding, even as a plaintiff, so long as he had in the first place a [legal claim] that he wished to vindicate.”

Permissive Indemnification

Finally, the court considered whether Hermelin was entitled to permissive indemnification under his Indemnification Agreement for those claims for which the court did not award mandatory indemnification. The key question in this regard was whether Hermelin had “acted in good faith and in a manner ' reasonably believed to be in or not opposed to the best interest of the corporation ' .”

The court recognized the “starting point” for its analysis provided by the Indemnification Agreement:

The termination of any Proceeding … by judgment, order, settlement or conviction, … shall not … of itself adversely affect the right of Indemnitee to indemnification or create a presumption that Indemnitee did not act in good faith and in a manner which Indemnitee reasonably believed to be in or not opposed to the best interests of the Company ' .

In other words, “the particular outcome of a proceeding does not itself create a presumption that the indemnitee had a 'non-indemnifiable state of mind' ” unless “ the underlying proceeding established that the indemnitee acted in bad faith ' .” Absent such a finding, “additional discovery ' in some instances mimicking the very litigation avoided by the settlement ' may be required to permit a determination on whether the indemnitee acted in good faith.”

Given the “scant evidence” available to it, the court ordered a trial to determine whether Hermelin had acted in good faith. This was not to be an open-ended proceeding, but rather one “limited to Hermelin's conduct underlying the proceedings for which Hermelin seeks indemnification.” At the same time, the court rejected Hermlin's attempt to restrict the fact-finding to “the records established in the matters for which he seeks indemnification.” Instead, a determination that “the indemnitee did not act in bad faith [is] a fact-intensive inquiry that will most likely require a trial and credibility determinations.”

Conclusion

The “dearth” of case law concerning entitlement to permissive indemnification under a bylaw or indemnification agreement, the Hermelin court explained, exists because “where, as here, it is clear that the employee's right to indemnification turns on 'good faith,' economics militate in favor of resolving the matter outside of court, given the costs associated with a plenary trial on the indemnitee's conduct.” In such litigation, “we will essentially be conducting the litigation that the parties have thus far avoided through settlements, consent decrees, and plea agreements.” In a warning not only to K-V and Hermelin, but to any corporation and potential indemnitee that might be considering whether to litigate a disputed claim for permissive indemnification, the court cautioned that it left it “to the parties to determine whether the elusive joys and potential benefits of such litigation outweigh the substantial costs that will result.”

Robert S. Reder has been serving as a consulting attorney for Milbank, Tweed, Hadley & McCloy LLP in New York City since his retirement as a partner in March 2011, and is an Adjunct Professor at Fordham Law School. This article also appeared in The Corporate Counselor, an LJN sister publication of this newsletter.