18 December 2008

Lessons from Schoon: protecting yourself in the future from past board participation

This article appears in the Winter 2008 edition of the Journal of Private Equity and may not be reproduced.

Participants in the private equity and venture capital world, whether buyers, sellers, investors or founders, typically serve as directors of Delaware corporations.  These positions are accepted willingly and often necessarily because the terms of a transaction require it or because of the need to have ultimate decision-making authority. However, as we have seen over the last decade, board membership can bring “with it some hazards of the road. Whether from creditors or unhappy stockholders, directors can find themselves the targets of lawsuits solely by virtue of their role in a corporation.  With that inherent risk has always come the knowledge and comfort that costs of defending such litigation would be indemnified by the corporation so long as directors have acted in a manner consistent with their fiduciary duties. Moreover, this indemnification protection has typically included advancement of such expenses subject to certain conditions so that individuals would not have to pay such costs up front and be put in a position where they cannot afford to seek adequate representation.  Another basic assumption has been that if past service on a board of directors leads to scrutiny in the future, a board member's conduct “will be protected even if he or she is no longer a member of such board. A recent Delaware decision has cast some doubt on that assumption.

Schoon v. Troy Corporation held that a Delaware corporation could retroactively eliminate the right of former directors to obtain advancement of expenses. In Schoon:

  • A former director of Troy Corporation, William Bohnen, and his family held 33% of the outstanding equity in Troy through an investment vehicle, Steel Investment Company.
  • While Steel was a minority stockholder in Troy, it did hold 95% of the Series B Common Stockin Troy, which entitled it to designate a member of Troy's board of directors.
  • When Bohnen resigned, Richard Schoon became Steel's designee on the Troy board.
  • Steel decided that it wanted to sell its stake in Troy and made a books and records demand in order to value its Troy interest.
  • Schoon, claiming that he sought such information to fulfill his fiduciary duties as a director of Troy, also made a books and records request.
  • Steel/Schoon and Troy could not agree on terms for a confidentiality agreement governing the requested information, and Schoon and subsequently Steel both filed Section 220 actions (seeking access to the books and records of Troy) in Delaware Chancery Court.
  • After Schoon filed his Section 220 action, Troy amended its bylaws to, among other things, eliminate the right to advancement of expenses for “former” directors of the corporation and to limit the right of advancement of expenses to any director who initiates a proceeding against Troy (not including counterclaims etc.).
  • In the Section 220 action, Troy made counterclaims against Schoon and Bohnen claiming breach of fiduciary duty for having previously provided confidential information of Troy to third parties.
  • Schoon and Bohnen sought indemnification and advancement of expenses under Troy's certificate of incorporation and by-laws for defending the claims raised by Troy which Troy subsequently denied.
  • Bohnen argued that when he took office as a director of Troy he had a vested contract right to advancement of expenses incurred as a result of being a director of Troy and that such right could not be eliminated without his consent.
  • The court upheld Troy's refusal to advance expenses to Bohnen as a former director of the corporation and determined that the right to advancement of expenses (if any) does not vest until an indemnifiable claim is made against a director.
  • The court's holding effectively makes it valid under Delaware law for a corporation to retroactively eliminate a director's right to advancement of expenses.

While the decision in Schoon has other significant legal implications, its holding regarding advancement of expenses affects virtually all private equity and venture capital participants and other high net worth investors who serve as directors. In particular, if a director serves on a board at the request of a stockholder who either does not hold a controlling stake or might not in the future hold a controlling stake in the corporation, that individual could be at risk of losing this valuable protection. Additionally, if a director designee ends up in a dispute with the controlling stockholder, he or she risks having the protection of advancement of expenses removed. The Schoon decision also brings into question whether the right to indemnification itself could be retroactively eliminated.

It is often critical to the transaction that principals of companies sold to private equity firms agree to serve as a director of the acquiring company. Prior to Schoon, it was assumed that the standard protections afforded by a corporation's certificate of incorporation and by laws would provide indemnification protection to those individuals for claims made against them in such capacities and provide them with advancement of expenses to fund the cost of defense, regardless of their status with respect to the corporation at the time of the action, and that such rights could not be arbitrarily taken away. Most individuals would not agree to assume such roles without this protection. However, Schoon evidences that, without appropriate safeguards, this protection can be given and then taken away. The same risk exists for private equity investors who form portfolio companies and for venture capitalists who make preferred stock investments and take board seats. If such investors give up control of the portfolio company either as a result of a partial liquidation or dilutive financings, these protections could be removed and the individuals (or their designating stock-holders) would have to finance personally the defense of any claims arising from service as a director. Especially in today's tumultuous climate, even if one were willing to advance such expenses, a person would not want to bear the risk that the corporation might not be solvent long enough to reimburse the expenses when the action concludes.

How can individuals and the institutions that designate them protect themselves? The following are some safeguards that can be employed:

  • Enter into an indemnification agreement with the corporation providing for advancement of expenses-this is the strongest protection possible, as it is a binding contract that cannot be altered without the consent of both parties. While these agreements are standard in larger transactions (especially involving publicly traded companies), they are unusual in smaller, middle-market private company transactions but ought to be considered for the benefit of anyone serving as a director of these corporations.
  • If the corporation will not agree to an indemnification agreement, get a contractual covenant that the corporation will not eliminate indemnification and expense advancement protections, or, in connection with a preferred stock investment have a protective provision precluding amendment of the charter and by-laws without consent of a majority in interest of the preferred holders so that consent is required to remove the protections. However, this may not be satisfactory protection in the event an investor sells down its position.
  • Provide for the indemnification and advancement of expenses protections in both the certificate of incorporation and the by-laws. By-laws typically can be amended by board action but generally it takes both board and stockholder action to amend the certificate of incorporation.
  • Put a savings clause in the certificate of incorporation and by-laws that would prohibit retroactive repeal of the rights to indemnification and advancement. The drawback to this approach is that these documents can be amended to remove the savings clause and the indemnification and advancement rights, and courts have not yet spoken as to the validity of such action.
  • When taken to its logical conclusion, the decision in Schoon could have the following effects:
  • Discourage qualified people from serving as directors.
  • Lead to retroactive elimination of the right to indemnification itself for directors.
  • Provide a mechanism for boards to entrench themselves by using the right to eliminate advancement and indemnification as a defense mechanism against suitors who are former directors.
  • Give corporations away to shift costs to third parties by eliminating the right to advancement and indemnification so that the investor will have to protect its director designees.
  • Provide corporations with leverage against former sellers in disputes by threatening to remove retroactively the protections of indemnification and advancement for former seller/directors.

Litigation, whether frivolous or substantive, can be costly and could financially ruin an individual or severely affect the cash flow of an investor who might otherwise backstop one of its designees. The right to indemnification and advancement are fundamental to anyone serving on a board of directors, and based on the decision in Schoon, it appears that both may be at risk if proper steps are not taken to preserve such rights.

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