The ACE Report is a periodic publication distributed to policyholders and other interested parties as a service by ACE. Its purpose is to address insurance concerns worldwide, as well as present timely information on current developments in liability issues surrounding directors and officers. The Editor of The ACE Report is Dan A. Bailey, a lawyer at Arter & Hadden in Columbus, Ohio, USA and a respected voice in the complex area of directors and officers liability.

Although prepared by professionals, this publication should not be utilized as a substitute for legal counseling in specific situations. Readers should not act upon the information contained herein without professional guidance.

DIRECTOR AND OFFICER INDEMNIFICATION
Many corporations and their risk managers largely ignore indemnification issues when evaluating and structuring a risk management program for directors and officers. This apparently is based upon the naive assumption that the indemnification protection is adequate notwithstanding constantly evolving statutory amendments, case law and state-of-the-art indemnification concepts.

This edition of The ACE Report summarizes a typical state indemnification statute, identifies concepts for inclusion in a state-of-the-art corporate indemnification document, and describes the primary areas in which corporations are unable to indemnify and thus where D&O insurance is necessary to protect the personal assets of the D&Os.

A. INDEMNIFICATION STATUTES
Each state has designed its own unique indemnification statute, which is typically contained within the state's corporation laws. The discussion below primarily summarizes the Delaware indemnification statute (Section 145, Delaware General Corporation Law), which is typical of many state statutes.

1. Permissive/Mandatory. Except as noted below, the Delaware indemnification statute merely permits a corporation to indemnify certain protected persons for certain loss or expenses actually and reasonably incurred in connection with a claim. The corporation is obligated by statute only to indemnify for expenses incurred if the person has been successful on the merits or otherwise in defense of the claims against the person. (Section 145(c)). Because the statute is primarily permissive only, a director and officer is not entitled to indemnification unless the corporation's certificate of incorporation, by-laws or other internal document mandates the indemnification.

2. Protected Persons. The statute permits indemnification of any person who was or is a party or is threatened to be made a party to any threatened, pending or completed action, suit or proceeding, whether civil, criminal, administrative or investigative, by reason of the fact that he is or was a director, officer, employee or agent of the corporation. (Section 145(a), (b)). Because the statute applies to a D&O who is made a "party" to a proceeding, the Delaware Supreme Court has ruled that indemnification is not limited to defendants. Rather, indemnification is available even if the D&Os role in the litigation is as a plaintiff, intervenor or amicus curiae. Hibbert v. Hollywood Park, Inc., 457 A.2d 339 (Del. 1983).

3. Standard of Conduct. The Delaware statute permits indemnification only if the person acted in good faith and in a manner he reasonably believed to be in or not opposed to the best interest of the corporation. With respect to any criminal proceeding, the person must also have had no reasonable cause to believe his conduct was unlawful. The termination of any proceeding by judgment, order, settlement, conviction or upon a plea of nolo contendere does not alone create a presumption that the person's conduct did not satisfy this standard. (Section 145(a), (b)).

4. Indemnifiable Loss. In any proceeding other than one by or in the right of the corporation, the corporation is permitted to indemnify expenses (including attorneys' fees), judgments, fines and amounts paid in settlement actually and reasonably incurred by the indemnified person in connection with the proceeding. (Section 145(a)). However, in order to avoid a circular and meaningless result, the Delaware statute permits indemnification of only expenses (not judgments or amounts paid in settlements) in proceedings brought by or in the right of the corporation, including most notably shareholder derivative suits. Even as to the expenses, no indemnification is permitted if the indemnified person is adjudged to be liable to the corporation unless and only to the extent at a court determines that despite the adjudication but in view of all the circumstances, such person is fairly and reasonably entitled to indemnity for the expenses. (Section 145 (b)).

5. Indemnification Procedures. Permissive indemnification must be authorized on a case-by-case basis, upon a determination that indemnification is proper to in the circumstances because the person has met the applicable standard of conduct. The determination must be made by one of the following:

• By the Board of Directors by a majority vote of a quorum consisting of directors who are not parties to the proceedings;
• If such a quorum of the Board is not obtainable or even if obtainable a quorum of disinterested directors so directs, by independent legal counsel in a written opinion; or
• By a majority vote of all stockholders.

If the corporations do not confirm to the proper procedure in approving indemnification, not only is the indemnification payment arguably improper, but also coverage under the corporation reimbursement insuring clause of the D&O insurance policy may be jeopardized.

6. Advancement. Because the requisite determination as to whether the applicable standard of conduct was satisfied typically cannot be made until the end of the proceeding against the indemnified person, the Delaware statute permits a corporation to pay in advance of the final disposition of a proceeding expenses incurred by an officer or director in defending the proceeding. Such advancement is authorized only if the indemnified person submits to the corporation a written undertaking to repay the amounts advanced if it should ultimately be determined that he is not entitled to be indemnified by the corporation. (Section 145 (e)). "Advancement" is legally distinct from "indemnification". If an internal indemnification provision mandates only "indemnification", no advancement if required.

7. Nonexclusively. The indemnification and advancement of expenses recognized by the Delaware statute are not deemed exclusive of any other rights which may be available to a person under a by-law, agreement, vote of stockholders or disinterested directors or otherwise. (Section 145 (f)). For this reason, corporations can craft ultra protection for its directors and officers through carefully drafted by-laws of other internal corporate documents.

The courts have not yet resolved the issue whether this non-exclusivity clause in the statute permits indemnification otherwise prohibited by the indemnification statute. For example, can an internal corporate indemnification provision authorize or require a corporation to indemnify settlements by or judgments against its directors and officers in derivative suits? At least two courts have held that the nonexclusivity clause permits that type of expansion of the indemnification statute. Heffernan v. Pacific Dunlop GNB Corp., 1993 U.S. Dist. LEXIS 5 (N.D. Ill., Jan. 5, 1993); PepsiCo, Inc. v. Continental Casualty Co., 640 F. Supp. 656, 660 (S.D.N.Y. 1986). Another recent case held the opposite, finding that the nonexclusivity clause does not authorize indemnification otherwise prohibited by the indemnification statute. Waltuch v. Conticommodity Services, Inc., 833 F. Supp. 302 (S.D.N.Y. 1993).

B. INTERNAL INDEMNIFICATION PROVISION
If a company wishes to assure maximum financial protection to its directors and officers, the company's internal indemnification provision in its certificate of incorporation, by-laws or indemnification agreement is crucial. The primary goal of such a provision is to mandate the indemnification and advancement which is otherwise permitted by the Delaware statute. However, numerous other "bells and whistles" can be included within such a provision to assure maximum protection.

When evaluating the adequacy of a company's current indemnification protection, one must identify the criteria to be used in that evaluation. The broader and more protective the provision, the greater the corporation's potential liability to its directors and officers for indemnification reimbursement. Although most corporate mangers wish to afford the maximum protection available to the directors and officers (thereby creating the maximum potential corporate liability), even that decision should be periodically re-evaluated.

Some of the concepts which could be incorporated into an internal indemnification provision to provide maximum protection include:

1. Provide for indemnification "to the full extent permitted by law."
2. Require not only indemnification by also advancement of defense expenses, subject only to an unsecured obligation to repay the expenses if a court subsequently determines indemnification was not permitted.
3. Shift the burden of proof to the corporation to proved that the director or officer is not entitled to the requested indemnification.
4. Require the corporation to reimburse the director or officer for any expenses incurred in enforcing the D&Os indemnification rights if the director or officer is successful in whole or in part.
5. Provide that the director or officer has the right to an appeal or an independent de novo determination as to indemnification entitlement.
6. State that the indemnification rights constitute a contract, are intended to be retroactive to events occurring prior to its adoption and shall continue to exist after the rescission or restrictive modification of the provision with respect to events occurring prior to that rescission or modification. Alternatively, a separate indemnification contract could be executed by the corporation and the director or officer.
7. State that any director or officer who serves a subsidiary of the corporation or any employee benefit plan of the corporation or such subsidiary is deemed to be providing such service at the request of the corporation. Thus, a D&O of a subsidiary would be entitled to indemnification from the subsidiary and the parent company.
8. Require indemnification of expenses incurred by a director or officer as a plaintiff in a suit only if the Board of Directors approves prosecution of the suit by the D&O.

When drafting these broad, ultra protective provisions, the corporation must decide whether only its directors and officers or others will be entitled to the broad protections. Although the Delaware statute permits indemnification of employees and agents, most corporations do not include such persons in the internal indemnification provision, instead relying upon the Board of Directors' ability to indemnify such persons as appropriated under the circumstances. A few companies deem it appropriate to include employees within the broad indemnification provisions, although it is highly questionable whether it is appropriate to include agents, which could include among others outside legal, accounting and investment banker professionals

Because directors and officers frequently face uninsured exposures in pollution and regulatory claims or claims by other insured directors and officers (among others), the scope of indemnification protection can be crucial. Therefore, periodic, competent review and revision of a corporation's internal indemnificaiton provision should be an essential element of any D&O risk management program.

C. NEED FOR D&O INSURANCE
From a legal standpoint, the need for D&O insurance is based upon the premise that financial protection through an applicable state indemnificaiton statute may be inadequate. The primary areas in which indemnificaiton may be inadequate to provide sufficient D&O protection are as follows:

D. CONCLUSION
The area of D&O indemnification is complex and raises difficult corporate, management, legal and financial issues. Because the law and legal creativity relating to indemnificaiton are constantly evolving, a corporation's indemnification program should similarly evolve. Absent thoughtful analysis and state-of-the-art implementation of indemnification planning, directors and officers may forego financial protection which is otherwise available for uninsured exposures, thereby unnecessarily subjecting their personal assets to risk.

This analysis also is important as corporations maintain higher D&O insurance retentions for the corporate reimbursement coverage and as corporations consider alternative D&O insurance products such as the CODA policy which provides only D&O but not corporate reimbursement coverage.