Publications /

Chancery Court Provides Guidance on Advancement, Indemnification Under Delaware Law

By

In a question of first impression, the Delaware Court of Chancery considered whether and to what extent discovery is necessary to determine whether a fiduciary acted with the requisite good faith to justify permissive indemnification under (1) Delaware General Corporation Law, (2) the organic documents of K-V Pharmaceuticals Inc. and (3) an indemnification agreement between the company and its former chief executive officer, Marc Hermelin, that made mandatory the permissive advancement and indemnification provisions of the DGCL. Vice Chancellor Sam Glasscock III’s decision in Hermelin v. K-V Pharmaceutical Co. recognizes the procedural realities underlying summary advancement and indemnification proceedings and is instructive for several reasons.

First, the court clarified the scope of indemnification and advancement permissible under Delaware’s statutory regime. As the court wrote in the opinion, Delaware law “sets two boundaries for indemnification: The statute requires a corporation to indemnify a person who was made a party to a proceeding by reason of his service to the corporation and has achieved success on the merits or otherwise in that proceeding [mandatory indemnification]. At the other end of the spectrum, the statute prohibits a corporation from indemnifying a corporate official who was not successful in the underlying proceeding and has acted, essentially, in bad faith.”

Between these extremes, the DGCL leaves to the corporation the flexibility to indemnify its officers and directors, if they acted in good faith and without a reasonable belief that their conduct was criminal (permissive indemnification). Second, the court explained that the success inquiry for mandatory indemnification is straightforward, conducted on a limited record and requires a comparison of the potential outcomes faced with the results actually achieved. Third, for the first time, the court addressed the scope of discovery relevant to the analysis of a fiduciary’s good faith in evaluating a demand for permissive indemnification. For these reasons, Hermelin offers corporations, corporate officers and directors, and those representing them some greater guidance for litigating indemnification demands under Delaware law.

FACTUAL BACKGROUND

According to the opinion, this advancement and indemnification action arose from Hermelin’s ownership of and position as KV’s chief executive officer and his involvement in several criminal, civil and regulatory matters relating to KV’s distribution of oversized morphine sulfate tablets. Following employee complaints about these manufacturing irregularities, KV’s audit committee undertook investigation of the allegations and Hermelin’s response to them. Based on the audit committee’s investigation, KV decided to terminate Hermelin. The public announcement of Hermelin’s termination in KV’s securities filings spurred investigations by the U.S. Attorney’s Office, the Food and Drug Administration and the Department of Health and Human Services.

The opinion said that, though Hermelin claimed that the government could have charged him with a variety of criminal offenses in the criminal matter, he was charged with and pled guilty to only two strict liability offenses, for which he paid a fine of approximately $1.9 million and served 15 days of a 30-day jail sentence. In seeking indemnification for the criminal matter, Hermelin claimed that he was successful because the government could have charged him with a variety of additional criminal offenses.

In the FDA matter, Hermelin fared better. The opinion noted that the FDA sought an injunction to prevent Hermelin, KV and other related targets from manufacturing drugs without certain FDA-mandated, quality-control measures in place. To resolve the matter, Hermelin, KV and others entered into a consent decree with the FDA intended to ensure the required quality controls. Because KV already terminated Hermelin and he was not actively engaged in manufacturing regulated pharmaceuticals, the consent decree only applied to him if he ever rejoined KV.

The opinion noted that Hermelin’s problems did not end with the criminal and FDA matters. As a result of his guilty plea, HHS gave Hermelin notice of its intention to exclude him from participating in federal health care programs for the rest of his life. Hermelin defended the exclusion action and ultimately convinced HHS to exclude him for 20 years. Given his age, however, a 20-year exclusion was effectively a lifetime ban. By virtue of Hermelin’s ownership in KV, his exclusion (and KV’s ownership of the subsidiary that actually manufactured the irregular drugs) would also require the exclusion of KV from participation in the federal health care programs. To avoid KV’s exclusion, Hermelin “fell on his sword,” according to the opinion, agreeing to sell his interest in KV and not contest his own exclusion. KV independently agreed to dissolve its subsidiary, thereby avoiding exclusion on separate grounds.

While incarcerated for his conviction in the criminal matter, certain of Hermelin’s private conversations were recorded pursuant to jail policy. The St. Louis-Post Dispatch filed a request under Missouri’s Sunshine Law to obtain records, including the recordings relating to Hermelin’s incarceration, for a story about the demise of KV. After receiving the request, jail officials announced their intention to release the recordings unless a court order prohibited their release. Hermelin sought and obtained an injunction preventing disclosure of his personal recordings, the opinion said.

Hermelin demanded advancement of fees incurred in the injunction proceeding, which KV opposed because the indemnification agreement explicitly excepted proceedings initiated by an indemnitee. Hermelin argued that initiating the injunction proceeding was the only way he could defend against the disclosure of his private conversations and analogized the injunction petition to a compulsory counterclaim. Despite his success, the court disagreed and declined to enforce the advancement demand because it was not covered by the indemnification agreement or the mandatory indemnifications provisions of the DGCL.

ADVANCEMENT AND INDEMNIFICATION UNDER DELAWARE LAW

Section 145 of the DGCL sets forth Delaware’s statutory scheme for advancement and indemnification. As the court explained in Hermelin, a fiduciary who succeeds on the merits of a proceeding brought against him by virtue of his service as a corporate agent is entitled to mandatory indemnification. A fiduciary who is unsuccessful still may have permissive indemnification rights if he can prove that he acted with the requisite good faith (or in the criminal context, without knowledge that his acts were unlawful). Though Delaware law prohibits its corporations from indemnifying faithless fiduciaries, a director or officer found to have breached his duty of care does not necessarily forfeit his indemnification rights.

To the contrary, permissive indemnification is available to careless corporate managers. Similarly, although no Delaware court has explicitly addressed the issue, even a fiduciary who breaches his duty of loyalty may still have permissive indemnification rights, as long as he acted with good faith not withstanding his disloyal actions. Under Section 145(e), a corporation may advance fees and costs incurred in defending a covered proceeding where indemnification is otherwise permitted.

MEASURING SUCCESS

Hermelin sought mandatory advancement for the criminal, FDA and HHS matters because of his success on the merits or otherwise in the underlying proceedings. KV conceded that each of these proceedings implicated its indemnification obligations, so the court limited its inquiry to whether Hermelin succeeded with respect to each matter. To determine success, the court explained, one must look solely to the outcome of a proceeding: “Where the outcome of a proceeding signals that the indemnitee has avoided an adverse result, the indemnitee has succeeded ‘on the merits or otherwise,’ and further inquiry into the ‘how’ and ‘why’ of the result is unnecessary.” Notably, the indemnification agreement defined “success” as any outcome that did not result in an adverse judgment against Hermelin, according to the opinion.

In the criminal matter, Hermelin claimed success because he allegedly convinced the government to bring fewer charges than his conduct ultimately might have justified. KV argued that Hermelin was not successful because he pled guilty to the only two counts with which he was charged, paid a hefty fine and was incarcerated.

Recognizing the long line of cases that define “success” for indemnification purposes in the criminal context as anything other than a conviction, the court found a guilty plea to an adverse judgment on all charged counts the equivalent of a conviction that left Hermelin decidedly unsuccessful in the criminal matter. Though the court acknowledged that if Hermelin’s plea had resulted in the dismissal of any criminal charges, he would have succeeded for purposes of mandatory indemnification, it concluded that to find success where he pled to all charged counts would entitle any other fiduciary who pled guilty to all counts against him to mandatory indemnification – an absurd result not justified under Delaware law. Success, the court explained, does not require moral exoneration – escape from adverse judgment or other detriment is determinative.

With respect to the FDA matter, the court again refused to look behind the result, comparing the charges Hermelin faced with the outcome he achieved to measure his success. Hermelin argued that he was successful because the consent decree did not apply to him unless he returned to the industry. KV countered that because the consent decree prevented Hermelin from regaining his employment with the company, he had not succeeded in the FDA matter and was not entitled to mandatory indemnification. Glasscock disagreed with KV and found Hermelin had been successful because the consent decree did not impose on him any new restrictions, obligations or penalties.

The HHS matter presented a closer call. Again, the court undertook a straightforward analysis and compared the penalty Hermelin faced (lifetime exclusion from federal health care programs) with the penalty he received (20-year exclusion from federal health care programs). Observing that, at Hermelin’s age, a 20-year exclusion was effectively a lifetime ban, Glasscock found him unsuccessful and declined to award mandatory indemnification. Hermelin argued that by giving up his right to challenge his exclusion (to avoid KV’s mandatory exclusion), he “took one for the team” or “fell on his sword” such that principles of equity required KV to indemnify him. The court rejected Hermelin’s efforts to incorporate equitable principles into the indemnification analysis, which rights the court emphasized, arose from contract and statute, not equity. Though a company is permissively free to indemnify a fiduciary who falls on his sword or takes one for the team, such actions do not constitute success on the merits necessary to prevail on a claim for mandatory indemnification.

DEVELOPING A RECORD FOR PERMISSIVE INDEMNIFICATION

Having found that Hermelin was not entitled to mandatory indemnification with respect to criminal and HHS exclusion matters, the court next turned to Hermelin’s demand for permissive indemnification for the audit committee matter. The court noted that, where potential indemnitees are not successful on the merits, a Delaware corporation may nonetheless permissively indemnify them as long as they acted in good faith (or in the criminal context, without a reasonable belief that their behavior was unlawful) and in a manner not opposed to the best interests of the corporation. In addition, KV’s bylaws and the indemnification agreement mandated indemnification where it is permissive to do so. As a result, the court permitted discovery on permissive indemnification related to the audit committee, criminal and HHS matters in order to permit the parties to develop a record upon which it could assess Hermelin’s “good faith.”

The court noted that a finding of bad faith, made in the underlying proceeding, is, in a fundamental application of res judicata, dispositive evidence of a nonindemnifiable bad faith. Because none of the underlying matters for which Hermelin sought permissive indemnification contained such a finding, the court instructed the parties to develop a more thorough record.

Deciding a question of first impression, the court concluded that discovery relating to permissive indemnification need not be limited to the record developed in the underlying proceeding and can extend to an inquiry about the factors that motivated the underlying decision for which indemnification is sought. The court did not, however, write a blank check for broad discovery. Rather, the court limited discoverable evidence to the conduct underlying the proceedings for which the fiduciary seeks indemnification. To place the inquiry in context, for the criminal and HHS matters, the court limited discovery to KV’s manufacture of the oversized tablets and Hermelin’s response to the production.

With respect to the audit committee matter, the court permitted broader inquiry – allowing discovery into the employee complaints that triggered the investigation as well as other instances of misconduct that factored into KV’s decision to terminate Hermelin. To prevail, KV will have to prove that the audit committee relied on an incident in which Hermelin’s actions constituted actual bad faith. As a result, Glasscock noted, KV may have won a Pyrrhic victory because the costs of a trial on “good faith” will likely exceed the cost of its indemnification obligation.


Reprinted with permission from the November 16, 2011 issue of Delaware Business Court Insider. (c) 2011 ALM Media Properties, LLC. Further duplication without permission is prohibited.

Scroll to top