Indemnification of Directors of Corporations and Managers of LLCs in Private Equity and Venture Capital Backed Companies

The rights and protections available to directors of corporations and managers of limited liability companies (LLCs) against liability, including rights to advancement of expenses, indemnification, exculpation, and D&O insurance, operate within a broader framework. That framework requires reference to the precise terms of the organizational documents of the company they serve and any additional contractual rights or benefits those directors and managers obtain by or through the company. In the context of private equity and venture capital backed companies, the rights and protections afforded to directors or managers must also be considered in light of any rights and protection given by the private equity or venture capital fund (or an entity affiliated with the fund) to directors or managers designated by the private equity or venture capital fund.

This outline addresses the rights and protections available to directors of Delaware corporations and managers of Delaware LLCs. While we recognize that differences in the laws of the jurisdiction of incorporation or formation of a particular fund or any particular portfolio company may affect the drafting of provisions establishing the rights and protections of directors or managers, or the availability of such rights and protections, the principles of Delaware law discussed herein are useful for illustrating the issues directors and managers of private equity and venture capital backed entities (and the sponsors) should consider. This outline does not expressly address the rights of officers, employees, or other agents of corporations or LLCs, although we note that many of the basic concepts set forth herein with respect to the contractual protections that may be afforded to directors and managers are also applicable to such other parties.

Under Delaware law, there are multiple layers of structural protection for directors of corporations and managers of LLCs against liability, including rights to advancement of expenses, exculpation, and indemnification. In addition, corporations and LLCs are entitled to purchase and maintain D&O insurance to protect directors and managers. All such protections operate within a system and must be considered together. Moreover, the specific language used to establish rights and protections must be consulted to determine the specific availability of rights and protections. Private equity and venture capital funds frequently want to ensure that the directors or managers that they appoint to a portfolio company receive a robust set of rights and protections from that portfolio company—and that the portfolio company is the so-called “indemnitor of first resort,” with no rights to seek contribution from the fund.

Exculpation

Section 102(b)(7) of the Delaware General Corporation Law (“DGCL”) permits a corporation to include in its certificate of incorporation a provision eliminating personal monetary liability for a director’s breach of fiduciary duties except (1) breaches of the duty of loyalty, (2) acts or omissions not in good faith or involving intentional misconduct or a knowing violation of law, (3) transactions where a director derives an improper personal benefit, and (4) illegal dividends or stock repurchases. In general, the existence of an exculpatory provision contemplated by Section 102(b)(7) that is applicable to the maximum extent permitted by law will result in the dismissal of a claim for monetary damages based solely on a breach of the duty of care. No exculpatory provision, however, will operate to prevent an injunction for breach of the duty of care, nor will it result in a dismissal of claims where the plaintiff has adequately pled a breach of the duty of loyalty or bad faith (or any other non-exculpable conduct).

Section 18-1101(e) of the Delaware Limited Liability Company Act (“LLC Act”) provides that a limited liability company agreement may provide for the limitation or elimination of any and all liabilities for breach of contract and breach of duties (including fiduciary duties) of a manager to the company or to another member or manager or to another person that is a party to or is otherwise bound by the agreement. However, a limited liability company agreement may not limit or eliminate liability for any act or omission that constitutes a bad faith violation of the implied contractual covenant of good faith and fair dealing. Unlike the DGCL, which only allows for exculpation of directors against monetary damages to the corporation or its stockholders for a breach of the duty of care, the LLC Act allows the limited liability company agreement to provide broad rights to exculpation, subject only to the bad faith violations of the implied contractual covenant of good faith and fair dealing. Although the LLC Act provides for broad exculpation of managers, many limited liability company agreements will contain exceptions and qualifications on rights to exculpation, including standard of conduct or other requirements or conditions. Parties should take care in reviewing these exceptions and qualifications, specifically those relating to “gross negligence” (which is the standard for assessing a breach of the duty of care).

Indemnification

The DGCL contains three principal subsections dealing with indemnification of directors. Section 145(a) of the DGCL empowers a corporation to indemnify its directors against expenses, judgments, fines, and amounts paid in settlement incurred in connection with actions other than those brought by or in the right of the corporation, subject to a determination that the indemnitee has met the requisite standard of conduct. Section 145(b) empowers a corporation to indemnify its directors against expenses incurred in connection with the defense or settlement of an action brought by or in the right of the corporation, subject to the standard of conduct determination, and except that no indemnification may be made as to any claim to which the person has been adjudged liable unless the court determines such person is fairly entitled to indemnification. Section 145(c)(1) provides that to the extent a director has been successful on the merits or otherwise in defense of any action, suit, or proceeding referenced in Section 145(a) or Section 145(b), the director shall be indemnified against expenses actually and reasonably incurred by the director in connection therewith.

Under Section 145(f) of the DGCL, the rights to indemnification under Section 145(a) and Section 145(b) may be made mandatory through the certificate of incorporation, bylaws, resolution, or other agreement. The use of the words “shall indemnify” or “must indemnify” generally provides mandatory rights, while the use of the words “may indemnify” or “shall have the power to indemnify” generally connotes permissive rights. The specific language used will be critically important in determining the protection available to a director.

Nevertheless, even if rights are made mandatory, except where Section 145(c) obligates the corporation to indemnify the director against expenses, there must be a determination that the director met the standard of conduct necessary to obtain rights to indemnification. That determination must be made, with respect to a current director, by one of: a majority of the directors not party to the proceeding, a committee of such directors, independent counsel, or the stockholders. Private equity and venture capital funds may consider negotiating for the right for their director designees to have such determination made by independent counsel.

In considering rights to indemnification, it is important to highlight that the protection afforded under Section 145(b), which relates to indemnification for claims brought by or in the right of the corporation, including derivative claims, only provides protections against expenses—but not judgments or amounts paid in settlement. Due to the corporation’s lack of power to indemnify against such potential liabilities, corporations frequently seek insurance to provide coverage against such claims. Section 145(g) of the DGCL permits corporations to purchase and maintain insurance to protect directors against all manner of liabilities, whether or not the corporation would be permitted to indemnify the director.

Section 18-108 of the LLC Act provides that a limited liability company may, and shall have the power to, indemnify and hold harmless any member or manager or other person from and against any and all claims and demands whatsoever. Unlike the DGCL, the LLC Act does not contain any specific limitations on the availability of indemnification, such as the standard of conduct requirements in Sections 145(a) and 145(b) or any of the limitations on the type of liabilities for which indemnification is available under Section 145(b). Conversely, the LLC Act does not include any supervening rights to indemnification; thus, managers will not have any rights to indemnification unless (and only to the extent) they are provided by contract.

Advancement

Section 145(e) of the DGCL provides that expenses incurred by a current director of the corporation in defending a proceeding may be paid by the corporation in advance of the final disposition of the proceeding upon receipt of an undertaking by such person to repay the advanced amounts if it is determined that the person is not entitled to be indemnified. As with rights to indemnification, rights to advancement may be made mandatory pursuant to Section 145(f). Again, the specific language used to create the mandatory rights will be critical in determining the availability of rights. The use of the words “shall advance” will generally be construed to create mandatory rights, while the use of “may advance” or “shall have the power to advance” will generally be construed as permissive rather than compulsory.

Section 145(e) provides that such expenses incurred by a former director may be paid in advance upon such terms as the corporation deems appropriate. Section 145(e), by its terms, relates to the expenses a director incurs in defending a proceeding. Thus, where rights to advancement merely make mandatory the permissive advancement rights set forth in Section 145(e), a director generally will not be entitled to require the corporation to advance their expenses incurred in connection with affirmative actions brought by the director, subject to limited exceptions, such as affirmative defenses and compulsory counterclaims.

The basic philosophy behind advancement is that the corporation should pay the expenses incurred by its directors as those expenses are incurred to enable the directors to mount a defense against claims and to vindicate their actions. For that reason, it is often advisable to ensure that rights to advancement are not made subject to any conditions or other requirements other than the requirement, imposed under Section 145(e), that current directors must provide an undertaking to repay any amounts advanced if it is ultimately determined that they are not entitled to indemnification.

The Delaware courts have held that rights to indemnification and advancement are distinct rights that must be separately provided. Thus, a provision providing that the corporation shall “indemnify and hold harmless” directors, of itself, will not be sufficient to give directors separate rights to advancement of expenses. Each of the rights must be separately identified and made mandatory in order to ensure that directors have the protection of both layers.

Although Section 18-108 of the LLC Act does not expressly reference “advancement,” the Delaware courts have made clear that they defer completely to the contracting parties to create and delimit rights and obligations with respect to indemnification and advancement. The LLC Act does not include express restrictions or requirements on advancement rights (such as undertakings to repay amounts advanced). Again, LLCs are contractual in nature. Rights to advancement will not be assumed or implied unless they (and only to the extent) they are expressly provided by contract (i.e., the limited liability company agreement).

Indemnitor of First Resort

Private equity and venture capital funds often seek to ensure that the portfolio companies to which they designate directors include rights to indemnification and advancement of expenses via so-called “indemnitor of first resort” provisions in the companies’ governing documents or other agreements. These provisions are designed to ensure, among other things, that a private equity or venture capital fund that has its own obligation to indemnify or advance expenses of the persons whom it designates to the governing body is not subject to contribution in the event the corporation makes the payments.

These provisions generally require the portfolio company to expressly acknowledge that the director has rights of indemnification, advancement, and insurance from the sponsor; to agree that it is the indemnitor of first resort and that it is obligated to advance all expenses and indemnify for all judgments, penalties, fines, and amounts paid in settlement; and to waive any claims against the sponsor for contribution or subrogation. Where indemnitor of first resort provisions are included in portfolio company governing documents or other agreements, the private equity or venture capital fund should be made an express third-party beneficiary of the provision.

D&O Insurance

There are multiple issues that arise in connection with the purchase and maintenance of D&O insurance, and there are different types of insurance available.

In general, “Side-A” coverage insures individual executives of the company and provides for the advancement of defense costs where executives are not indemnified by the insured company. Side A coverages provides personal asset protection; it responds when the company is unable to indemnify the director (legally or financially). There are no retention amounts.

“Side-B” coverage pays for losses incurred by the insured company in indemnifying individual executives for claims against those executives. It provides balance sheet protection to the company and responds when the company has satisfied its policy retention for indemnifiable loss against individuals.

“Side-C” coverage provides “Entity Coverage.” It pays for “Losses” incurred by the company arising from claims against the company itself. For public companies, it usually for covers “securities claims” only. Side C coverage provides balance sheet protection for claims against the company and generally responds when the company is named in a securities claim.

In assessing D&O coverage, parties should consider various issues, if for no other reason than to set expectations. Major issues include resolving conflicts between the company and individuals if the company has the sole right to notice a claim or circumstance; whether individuals can recover “fees-on-fees” if they must sue the insurance company under the policy; whether individual insureds can obtain a copy of the policy when they need one; and the impact of “related” and “interrelated claims” provisions.