The Delaware Supreme Court’s decision in Northeastern Aviation Corp. v. Pasternack1 is a recent example of how broadly indemnification obligations can extend under Delaware law. In Pasternack, the Delaware Supreme Court affirmed the Court of Chancery’s holding that a pilot, commissioned by a Delaware-incorporated aircraft charter company, was an “agent” of the corporation, and, therefore, was found to be entitled to indemnification under the corporation’s bylaws. The reasoning in Pasternack extends to advancement, which often has materially more profound consequences for the corporation.
Indemnification and advancement
Under Section 145(c) of the Delaware General Corporation Law (DGCL), Delaware corporations are required, in certain circumstances, to indemnify directors and officers of the corporation for costs incurred in connection with litigation and other proceedings arising from the official’s corporate role, including attorneys’ fees and expenses.2 The proceeding involving the corporate official must arise “by reason of the fact” that the person serves or served on behalf of the corporation, and the corporate official must be successful on the merits or otherwise in the defense of the proceeding. Delaware corporations may elect to provide greater indemnification than required by Delaware law, expanding the scope of indemnification in three ways:
- Delaware corporations can expand the class of potential parties entitled to indemnification beyond directors and officers to the corporation’s employees and agents.3
- In addition to costs actually and reasonably incurred in connection with the proceeding, Delaware corporations can provide indemnification for judgments, fines, and amounts paid in settlement actually and reasonably incurred in connection with proceedings by third parties (but not proceedings against the corporation).4
- Delaware corporations can expand indemnification rights so the indemnified party does not need to be successful on the merits or otherwise, so long as the indemnified party “acted in good faith and in a manner the person reasonably believed to be in the best interests of the corporation.”5
Delaware corporations are also permitted (but not required) to advance costs and expenses incurred by a corporate official in covered proceedings, provided the corporate official agrees to repay the advanced fees if it is ultimately determined that the official is not entitled to indemnification.6 Advancement provides a stronger protection than indemnification, as the corporate official has ongoing access to funds and does not have to cover the fees and costs. Advancement is required even when the corporation is pursuing claims against the corporate official as a result of the corporate official’s misconduct.7
Delaware’s strong enforcement of advancement rights, coupled with the prospect that corporate litigation is costly and the company may not recover the advanced fees, even if successful, frequently results in a company foregoing bringing claims (or quickly voluntarily dismissing claims) it would otherwise pursue against the corporate official. Advancement provisions are so potent that they can cause a company to sacrifice an otherwise strong claim, warranting careful consideration of the scope of a company’s advancement obligations.
A Delaware corporation is also obligated to pay the attorneys’ fees incurred by a corporate official when the corporate official is successful in a lawsuit seeking indemnification (and, if applicable, advancement).8 This is referred to as “fees on fees,” because the fees and expenses awarded are beyond the underlying action triggering indemnification and advancement.9
Northeastern Aviation Corp. v. Pasternack
The Delaware Supreme Court’s decision in Pasternack is a recent example of how broadly indemnification and advancement obligations can extend under Delaware law.10 The Delaware Supreme Court affirmed the Court of Chancery’s holding that a pilot was an “agent” of a Delaware corporation and, therefore, entitled to indemnification under the corporation’s bylaws.11 The reasoning in Pasternack could extend to advancement, which could have more profound consequences for Delaware corporations.
In Pasternack, the plaintiff sought indemnification under the bylaws of a Delaware-incorporated aircraft charter and management company (the Company) for legal expenses incurred in connection with his appeals.12 The dispute underlying the indemnification proceeding arose in connection with the pilot’s participation in drug testing required under the regulations governing the Company.13 The pilot challenged a revocation of his certificate to fly based on this drug testing, and, in the final resolution of the case, the Court of Appeals for the D.C. Circuit reversed the revocation.14 Like many Delaware corporations, the Company’s bylaws provided for mandatory indemnification of directors, officers, employees, and agents “to the extent permitted by the [DGCL].”15
The Court of Chancery held the Company was required to indemnify the pilot because (i) he was an agent of the Company in connection with the drug testing, (ii) he took the drug test by reason of his affiliation with the Company, and (iii) he acted in good faith and in a manner, at the very least, not opposed to the best interests of the Company.16 The Court also required the Company pay the pilot “fees-on-fees.”17 On appeal, the Delaware Supreme Court affirmed the Court of Chancery’s decision.
In Pasternack, the Court of Chancery noted, Delaware courts “limit agency in the indemnification context to ‘only those situations when an outside contractor . . . can be said to be acting as an arm of the corporation vis-à-vis the outside world.’”18 The underlying proceeding must also result from the purported agent’s “conduct on behalf of the corporation.”19 Thus, the Court of Chancery explained, a pilot is an agent of a charter flight operator when piloting a flight, because the charter flight operator “authorizes” the pilot to “exercise operational control” and the pilot is “acting as an arm of the corporation vis-à-vis” the Company’s passengers, air traffic controllers, and ground crew.20 Although the pilot in Pasternack was not piloting an aircraft at the time he was drug tested, the Court of Chancery and the Delaware Supreme Court found the pilot was still acting as an agent of the Company during the drug test because the Company instructed the pilot to report for the test.
- Indemnification and advancement are two of the most common ways in which Delaware corporations protect corporate officials from personal liability.21
- Rights to indemnification and advancement under Delaware law are broadly construed against the corporation.
- Indemnification and advancement encourage qualified individuals to serve on behalf of companies “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.”22
- Advancement of fees and costs during the proceeding provides an even stronger protection than indemnification, as the corporate official has ongoing access to the funds and does not have to cover fees and costs during the entire proceeding, which could last years and be extremely expensive.