Delaware Chancery Court Clarifies When Corporate Officers and Directors are Entitled to Mandatory Indemnification Under DGCL § 145

by Sheppard Mullin Richter & Hampton LLP

In Hermelin v. K-V Pharmaceutical Co., C.A. No. 6936-VCG, 2012 WL 395826 (Del. Ch. Feb. 7, 2012), the Delaware Court of Chancery considered whether the former chief executive officer (“CEO”) of a pharmaceutical company, against whom several regulatory and criminal actions had been brought, had been successful “on the merits or otherwise” such that he was entitled to mandatory indemnification under Section 145 of the Delaware General Corporation Law (“DGCL”) and/or under his indemnification agreement with the corporation. The court concluded that the CEO, who had pled guilty to certain criminal charges and was subjected to stiff regulatory penalties, had been successful (and thus entitled to indemnification) in only one of four underlying suits at issue. This decision provides guidance to corporate officers regarding their indemnification rights under Delaware law.

In May 2008, K-V Pharmaceutical Co. was notified that it had released oversized morphine tablets to the market. In response, the company conducted an internal investigation which revealed that it had improperly manufactured oversized tablets of several of its medications. After the company notified the Food and Drug Administration of this problem, multiple proceedings were initiated involving the company and its CEO. The CEO was terminated by the corporation’s board of directors, and eventually became involved in four matters in which he sought mandatory indemnification from the corporation: (1) a “Criminal Matter”; (2) an “FDA Consent Decree Matter”; (3) an “HHS Exclusion Matter”; and (4) a “Jail Records Matter.” The corporation refused to provide indemnification.

The court began its analysis by noting that Delaware law mandates that a corporation indemnify an officer who has been made a party to a proceeding by reason of his service to the corporation and has achieved a success on the merits or otherwise. “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’ or ‘why’ of the result is unnecessary. ” At the other end of the spectrum, DGCL Section 145 prohibits a corporation from indemnifying an officer who was not successful in the underlying proceeding and has acted in bad faith. Between the two poles, a corporation and its officials have great latitude to enter into an agreement that sets forth the scope of indemnification.

The indemnification agreement here was as broad as permitted by law. It provided that, in any proceeding to enforce the CEO’s right to indemnification, the company “shall, to the fullest extent not prohibited by law, have the burden of proof to overcome that presumption.” To the extent a matter did not conclude in an adverse judgment against the CEO, the indemnification agreement provided that the presumption was that the CEO had been successful on the merits or otherwise. Thus, to avoid indemnifying the CEO, the company would have to produce sufficient evidence to show that the he acted in “bad faith” in the underlying proceedings. Typically, a finding of “bad faith” in an underlying proceeding is conclusive evidence that the indemnitee is not entitled to indemnification. When an underlying proceeding involves a settlement or some sort of regulatory investigation, there may not be an underlying judicial record on which to base a finding of bad faith.

The court’s analysis of whether the CEO was entitled to indemnification under his agreement here was complicated by the fact that none of the underlying proceedings involved a finding of “bad faith.” For example, in the Criminal Proceeding, the CEO pled guilty to two strict liability offenses and was sentenced to a maximum of 30 days in jail and was ordered to pay a $1.9 million fine. The outcome of the proceeding — where the CEO pled guilty to every charge brought against him — precluded mandatory indemnification under DGCL Section 145. Nevertheless, because the CEO had been charged with strict liability crimes, the guilty plea did not, in and of itself, create a presumption that the CEO had acted in bad faith. To defeat permissive indemnification under the agreement between the company and CEO, the company would have to make a showing that the CEO knew that his actions were damaging the company or that his conduct was unlawful.

Ultimately, the court held that the CEO was entitled to mandatory indemnification in the FDA Consent Decree matter because he had been able to avoid a personally negative result: the company’s settlement with the FDA did not impose any genuine restrictions or penalties on the CEO. The court held the CEO was not entitled to mandatory indemnification with respect to the Criminal Matter, the HHS Exclusion Matter and the Jail Records Matter. The court, however, held that it did not have sufficient evidence to make a determination as to whether the CEO was entitled to permissive indemnification in those matters under his indemnification agreement. The court went on to acknowledge that the expense and uncertainty to the company of litigating whether the CEO acted in “bad faith” (thereby defeating permissive indemnification) likely would outweigh the benefit to the company from litigating the permissive indemnification issue — especially where, as in the instant matter, the indemnification agreement required the company to cover the CEO’s litigation costs. The Hermelin decision thus reinforces the general view that the Delaware courts apply the law in a way to support a broad indemnification rights to corporate officers and directors.

For further information, please contact John Stigi at (310) 228-3717 or Alejandro E. Moreno at (619) 338-6664.

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