Few things are more important to a limited-liability entity’s officers and directors than the sanctity of that entity’s obligations of advancement and indemnification should such officers or directors be named personally in litigation related to their roles on behalf of that entity. And as noted in a previous post to Weil’s Private Equity Insights blog, “[t]here is both a distinction and a definite difference between an advancement obligation and an indemnification obligation . . . [because] a simple obligation to indemnify an individual does not by itself include any obligation to advance expenses that may ultimately be indemnifiable.”1 “Indemnification” provides a director or officer monetary coverage from the entity for any adverse judgement or out-of-pocket costs sustained as a result of such litigation regarding such director’s or officer’s actions on behalf of the entity after the fact (and dependent upon whether the officer or director complied with the applicable standard of conduct required for such indemnification), while “advancement” provides concurrent payment of the costs of defense as those costs are incurred (independent of whether the applicable standard of conduct required for ultimate indemnification was complied with, but subject to a reimbursement agreement if it is determined that such standard was not in fact complied with). And because the cost of litigation in the face of unjustified claims can be prohibitive to individuals serving as officers and directors, the obligation of advancement has been carefully guarded by the Delaware courts despite frequent efforts by limited-liability entities to avoid paying the cost of an officer’s or director’s defense of third party claims as they are incurred.2
While most advancement obligations occur in the context of a current officer or director seeking payment of its defense costs from the entity he or she serves based upon a lawsuit that seeks to hold that current officer or director personally liable for some action taken on behalf of that entity, advancement also occurs when former officers and directors are sued for actions they took while serving in that capacity. Moreover, while most advancement obligations are incurred outside of the context of a private company acquisition agreement context, advancement obligations are so sacrosanct that the Delaware Court of Chancery has held that officers and directors, who as selling shareholders agreed to indemnify a buyer for breaches of the representations and warranties made by the target in a stock purchase agreement, are entitled to have their defense costs advanced by the buyer in an action brought by the buyer against an escrow fund established by the selling stockholders who were also officers or directors.3 As noted in a previous post to Weil’s Private Equity Insights blog regarding that holding, “[b]ecause the claimed breach of the representations and warranties made by the target company necessarily involved the actions of the former officers and directors in exercising their ‘decision-making authority on behalf of the corporation,’ the buyer’s claims against the named selling shareholders to recover the escrow funds ‘require[d] them to defend their actions as former officers and directors,’ even though ‘they do not face liability in their capacity as officers and directors’ with respect to such claims.”4 Thus, while it is common to preserve advancement and indemnification obligations of the target company in favor of the resigning officers and directors of the target in a stock purchase agreement, buyers have been previously advised to negotiate carveouts to those obligations to avoid funding the cost of defending claims made against selling stockholders by the buyer respecting the purchase of the target company.5
That advice appears particularly salient given an even more recent decision of the Delaware Court of Chancery. In Davis v. EMSI Holding Co.,6 the court held that officers and directors of the target company (who were also selling stockholders) were entitled to advancement by the target company of the costs of defending a suit brought by the buyer against such selling stockholders (who were also former officers/directors) based on fraud they allegedly committed in connection with the sale of the target company. This decision is a second installment of the EMSI Acquisition v. Contrarian Funds case7, which involved the question of whether a broad undefined fraud carveout entitled the buyer to uncapped indemnification from all the selling stockholders or only those alleged to have actually been involved in the fraud. As noted in a recent Weil Private Equity Insights blog on that case, the court held that, as a result of the broad fraud carveout, even the innocent selling stockholders were subject to uncapped indemnification claims.8 And now to add to the pain of the innocent selling stockholders, the officer and director selling stockholders, who were the ones alleged to have actually committed the fraud, are entitled to advancement from the buyer for the costs of their defense while the innocent selling stockholders must fund their own defense.
Because the officers and directors (who were also selling stockholders) used their status an officers and directors of the target to allegedly commit the fraud, the claims of fraud were deemed to be claims made “by reason of” their status as an officer or director of the target. And even when there is doubt about whether a claim is brought “by reason of” a person’s status as an officer or director (and therefore subject to advancement and indemnification) or for a reason independent of that status (and therefore not subject to advancement and indemnification), Delaware courts “generally [draw] in favor of advancement.”
This most recent case suggests that some previous advice (slightly revised in light of this most recent decision) bears repeating:
As a buyer you can avoid this outcome by either (a) negotiating a complete waiver and release of all continuing target company indemnification and advancement obligations to former officers and directors who are selling stockholders, or (b) specifically carv[ing] out any proceedings against the escrow funds [or claims of intentional fraud respecting the representations and warranties made by the target or selling stockholders in the stock purchase agreement against the sellers who committed such fraud] by buyer from the continuation of advancement and indemnification obligations by the target company. But from the sell-side, selling stockholders who are also officers and directors, will would want to be careful that such a carve out did not deprive the officers and directors of advancement and indemnification for third party claims that might have given rise to the buyer’s claims for breach of the representations and warranties [or claims for fraud that do not actually constitute intentional fraud respecting such express representations and warranties], or be otherwise comfortable that the tail officer’s and director’s policy will cover [at least the third party claims]. Moreover, the selling stockholders representative will want to ensure that there is separate fund set aside from the proceeds of the sale to fund expenses of any dispute with the buyer regarding entitlement to the escrow funds on behalf of the selling stockholders.9
We thank Weil summer associate Courtney Luster for her contributions to this blog.