Summary

On February 7, 2012, the Delaware Chancery Court (the “Court”) decided Hermelin v. K-V Pharmaceutical Company.1 In Hermelin, the Court determined that certain aspects of former CEO Marc Hermelin’s actions were not entitled to mandatory indemnification because Hermelin failed to meet the “successful on the merits” requirements under Section 145(c) of the Delaware General Corporation Law (“DGCL”). Because DGCL 145(c) sets forth the terms for mandatory indemnification, it applies to all Delaware corporations regardless of any provision in a corporation’s bylaws, agreements or indemnification plan(s). Thus, the case is of special interest to both Delaware corporations and the directors and executives who serve for them. In addition, if the person is not entitled to mandatory indemnification under Section 145(c), the Court sketched a general outline of what evidence would be relevant to determine whether the person met the “good faith” standard under DGCL 145(a) or (b), the permissive indemnification provisions which are sometimes made mandatory by bylaws or agreements.

Background

K-V Pharmaceutical Company (“KV”) terminated CEO Marc Hermelin following an investigation into allegations that Hermelin had refused to take proper action in response to KV’s production of oversized medicine tablets. Hermelin sued KV for indemnification and advancement for several criminal, civil, and regulatory matters that arose out of his termination. Although Hermelin and KV had an Indemnification Agreement, in this decision the Court focused primarily on Hermelin’s claims under DGCL 145(c), which provides for mandatory indemnification in the event that the person is “successful on the merits” of any claim against such person. Hermelin sought mandatory indemnification or advancement for the following proceedings:

  • Criminal Matter – Hermelin was charged with two federal misdemeanors based on his corporate position at both KV and ETHEX.2 He pled guilty to both, paid a $1.9 million fine and served less than a month in jail.
  • FDA Consent Decree Matter – The FDA, KV, Hermelin, and others entered into a consent decree to cease manufacturing or distributing any drugs until KV complied with certain quality control measures. However, the consent decree did not apply to Hermelin as long as he did not resume any management role that would impact KV’s compliance with the consent decree.
  • HHS Exclusion Matter – The Department of Health and Human Services (“HHS”) moved to exclude Hermelin from all federal healthcare programs based on his association with ETHEX. After negotiations, HHS excluded Hermelin from all federal healthcare programs for 20 years (effectively his entire life), based on a federal law permitting the exclusion of an individual who has a control interest or is an officer in a sanctioned entity (ETHEX). In contrast, KV faced the threat of mandatory exclusion by state Medicaid agencies based on its ownership of ETHEX and its being controlled and majority owned by Hermelin. Consequently, Hermelin could either divest himself of KV and agree not to contest his own exclusion, or suffer the exclusion of KV. Hermelin chose to divest himself of KV and HHS agreed not to seek exclusion of KV.
  • Advancement for the Jail Records Matter – Hermelin sought advancement in obtaining injunctive relief against the jail where he stayed after his conviction in the Criminal Matter. A local newspaper requested a number of records from the jail pertaining to Hermelin’s incarceration and Hermelin succeeded in enjoining the release of the recordings because the conversations were private.

In addition, Hermelin also sought to limit discovery on the issue of whether he acted in good faith and not opposed to the best interests of KV (which, under the Indemnification Agreement, would have made permissive indemnification under DGCL 145(a) or (b) mandatory), on each matter listed in the written record of such matters. Hermelin presumably sought for limited discovery for the “good faith” mandatory indemnification under the Indemnification Agreement and Bylaws because under these documents it is presumed that he was entitled to indemnification and KV has the burden of providing otherwise. Broader discovery would presumably help KV overcome the indemnification entitlement presumption.

Analysis

Hermelin centered on whether the CEO succeeded on the merits of any of the above matters, thus entitling him to mandatory indemnification under DGCL 145(c). The Court held that Hermelin was (i) not entitled to mandatory indemnification for the Criminal Matter or the HHS Exclusion Matter, (ii) entitled to mandatory indemnification for the FDA Consent Decree Matter and (iii) not entitled to advancement of expenses for the Jail Records Matter.

Section 145(c) of the DGCL mandates indemnification where “a present or former director or officer of a corporation has been successful on the merits or otherwise in defense of any action, suit or proceeding” because of the person’s status as a director or officer. KV’s Bylaws and the Indemnification Agreement tracked the language of Section 145(c) almost exactly. Furthermore, Delaware law authorizes advancement in defending any “action, suit or proceeding” for which indemnification is permitted.

The Court, in analyzing whether Hermelin was “successful on the merits or otherwise” in the proceedings, looked at the outcome of the underlying action. Where the outcome results in the indemnitee avoiding an adverse result, the indemnitee has succeeded “on the merits or otherwise” and the Court will not look “behind the result.” Thus, the Court analyzed each of the matters by comparing what Hermelin was charged with or accused of, and the result he achieved.

  • In the Criminal Matter, the Court found that Hermelin did not succeed on the merits because Hermelin pled guilty to every charge he was accused of. The Court rejected Hermelin’s argument that he could have been charged with more serious crimes, but because of negotiations, only two claims were brought against him, as irrelevant. Because the outcome (guilty plea) matched the charges (misdemeanors), he was deemed unsuccessful.
  • In the HHS Exclusion Matter, the Court held that Hermelin did not succeed on the merits when HHS excluded him from federal healthcare programs for 20 years. By comparing the potential outcome Hermelin faced (effectively a lifetime exclusion) to the actual outcome of the proceeding (20 year exclusion), the Court found that Hermelin clearly did not succeed on the merits. In addition, the Court held that Hermelin’s voluntary agreement to undergo additional hardship to protect KV from exclusion was irrelevant to the “success on the merits or otherwise” test. Consequently, Hermlein’s decision to “fall on the sword” (by divesting himself of KV) in order to protect KV from exclusion did not entitle him to mandatory indemnification under DGCL 145(c).
  • In the FDA Consent Decree Matter, the Court found that the consent decree imposed no new restrictions or penalties against Hermelin (he was terminated before the consent decree was issued), and thus, in avoiding an adverse result, Hermelin achieved “success of the merits” under DGCL 145(c).
  • In the Jail Records Matter, the Court held that the terms of the Indemnification Agreement excluded advancement in connection with any proceeding, or part thereof (including claims) initiated by Hermelin unless the proceeding was authorized by KV’s Board. The Court explained that Hermelin’s actions for injunctive relief against the jail fell squarely within the exception because it constituted a “part” of the Jail Records Matter that he initiated and he failed to receive authorization from the Board.
  • The Court rejected Hermelin’s argument that discovery for mandatory indemnification under the Indemnification Agreement and Bylaws should be limited to the written record on the above matters because the scope of evidence relevant to the question could extend beyond mere written records and would encompass a number of acts related to Hermelin’s actions in connection with the allegedly defective medicine production. Noting that there was a dearth of case law on addressing the scope of relevant evidence with respect to DGCL 145(a), the Court ordered a separate trial to determine whether Hermelin acted in good faith and not opposed to the best interests of KV, and reasoned that, because the question of whether Hermelin acted in good faith was broad and fact-intensive, that Hermelin’s actions beyond the written record were relevant.

Practice Points for Companies or Directors/ Executives

  • This case highlights the need for well-thought out indemnification agreements. Although directors/executives are entitled to mandatory indemnification under DGCL 145(c) if they are “successful on the merits” even in the absence of an indemnification agreement, the Court’s mechanical reading of that phrase left little room for determining what “success” really means for either the corporation or the director/ executive as a statutory matter.
  • Companies and/or directors/executives should review their indemnification agreements and consider whether “success on the merits” should include, by definition, situations where the director/executive’s actions render a substantial benefit to the corporation, but at the expense or temporary hardship of the director/executive. Although these would be the situations where the board of directors would grant permissive indemnification, such decisions may be controversial when these provisions are most needed.
  • Companies and/or directors/executives should also clarify whether the “initiation” of matters by the director/executive includes those situations where the director/executive, while acting as the putative plaintiff, is really the defendant in interest. Although these would be the situations where the board of directors would grant permissive indemnification, such decisions may be controversial when these provisions are most needed.
  • Litigation counsel should note that the Court did not look “behind the facts” when deciding “success on the merits” and not automatically assume lesser charges result in a successful outcome under DGCL 145(c).