By Ryan Bruderer and Ladd Hirsch

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Just as an excessively lavish desert can ruin a fine dinner, including an overly broad indemnity provision in a private company agreement can prove to be too much of a good thing for the company.  The point of indemnity provisions is to protect company executives (e.g., officers, directors, managers) from claims made against them in the good faith performance of their duties.  To ensure the net is broad enough to include all types of claims made against executives, however, these clauses are often drafted quite broadly.  But when the provisions are so inclusive they exceed their intended scope, another truism may apply—the cure may be worse than the disease.  This post discusses the effective use of indemnity provisions in private company governance documents and reviews potential drawbacks that can result when these provisions are drafted without appropriate limits.

The Need for Indemnity Provisions

Private company executives are exposed to the risk of suit by both investors and other third parties who do business with the companies served by these executives.  Providing indemnity protection for executives can therefore increase a company’s ability to recruit and retain skilled leaders as many capable individuals will not join a company that declines to indemnify them from personal liability. In addition to being a useful recruiting tool, proper indemnity provisions assure executives that they can make tough decisions in the company’s best interests without concern for their personal liability.

The scope of indemnity protection granted to executives can be divided into two types—liabilities for which the company will fully indemnify the executive and liabilities for which the company provides only limited indemnity protection.  In general, companies will indemnify executives in an unqualified way from personal liability for their actions taken in good faith for the company.  Companies will either decline outright to grant indemnity or they will limit the scope of the indemnity granted to executives who breach their fiduciary duties to the company (e.g., duty of loyalty, duty of care).

As discussed below, companies and their advisors must exercise care in drafting indemnity clauses, because the grant of unlimited indemnity protection to executives may create serious financial and other types of problems for the company.  Specifically, indemnity provisions should clearly identify the scope and the extent of the executive’s right to receive indemnity protection from the company. The indemnity provision should also identify specific carve outs—the types of claims made against executives for which the company will not provide indemnity protection.

The Company’s Right to Sue

The primary goals of indemnity provisions in private company governance documents is to protect executives from: (i) paying large amounts of legal fees and costs in defending against claims and litigation by the third parties and (ii) paying a judgment issued against the executives in third party lawsuits, often filed by disgruntled minority shareholders.  To accomplish this goal, many private companies adopt provisions that provide indemnity protection to their executives “to the fullest extent permitted by law.”  Including this broad language may seem appropriate as it will achieve the goal of providing the company’s executives with broad indemnity protection, but it may also result in unintended, negative outcomes for the company.

For example, providing indemnity protection to the full extent allowed by law may commit the company to indemnify the executive even in a lawsuit filed by the company.  The practical effect is that if a company provides a sweeping indemnity provision and then sues one of its former executives, the company may find itself having to pay the executive’s legal defense costs. To make matters worse, without a carve out in place, even if the litigation is decided in the company’s favor, the company may be obligated to indemnify the executive and pay the judgment obtained against the executive.

To address this potential issue, private companies should expressly limit the scope of the indemnity provision solely to third party claims (especially minority shareholder claims) and make clear that the company does not provide any indemnity protection to the executive from claims that the company files against the executive.  If the executive balks at accepting this more narrowly drafted indemnity provision, an alternative is to allow the scope of the provision to include indemnity protection for claims filed by the company against the executive for negligence and, perhaps, for certain breaches of contract, but to eliminate indemnity protection from all claims made by the company against the executive for fraud, gross negligence and intentional torts.

Advancement of Legal Defense Fees and Costs

One of the most critical aspects of executive indemnity provisions is the company’s duty to pay or reimburse the executive’s legal fees and expenses once a claim is made, because legal fees are often quite large even before the case ever goes to trial.  Indemnity provisions often provide that the company will advance funds to the executive to cover legal expenses incurred in investigating, preparing to defend or defending any lawsuit in connection with the executive’s actions at the company.  While defense costs are paid by the company up front, the executive will ultimately be required to repay these funds if a court later determines that the executive was not entitled to indemnity.

From a practical perspective, however, companies often find it difficult to recover the fees and costs they paid to executives who are ultimately found to not be entitled to indemnity.  In cases where executives misuse company funds to support a gambling habit or other excessive spending problem, these executives are unlikely to be able to repay the funds the company advanced after a court determination that they are not entitled to indemnity by the company.  To avoid problems of this type, a well-drafted indemnity provision will provide that when the company sues an executive directly for claims that are not subject to indemnity protection, such as fraud or gross negligence, the company will not be obligated to advance the executive’s legal fees or costs in defending against this claim.

Executives may balk at restrictions of this type placed on indemnity provisions, and one way to find common ground and address this gap is through the company’s purchase of directors and officers liability (“D&O”) insurance coverage.  The D&O coverage and indemnity protection may be broader in scope than the company’s indemnity obligation.  This enables the executive to also rely on the D&O policy protection rather than solely on an indemnity provided by the company.

“Reasonable” Litigation Expenses

An issue related to the advancement of legal fees is the reasonableness of the executive’s defense fees and costs after a claim is made.  As discussed above, most executive indemnity provisions require payment of the executive’s legal fees and costs but do not place any limits on the fees and expenses the executive incurs.  This type of “blank check” reimbursement of the executive’s fees and costs can lead to costly outcomes for the company.  If no expense or fee cap is included in the indemnity provision, the executive may retain defense counsel charging fees of $1,000 per hour or more. As billing rates are now charged at this level by a growing number of attorneys, the company would be hard-pressed to argue convincingly that these upper tier billing rates are excessive or unreasonable.

To hold the line on defense costs incurred by the executive, companies are advised to provide an indemnity provision that establishes an hourly fee cap on all attorneys retained by the executive.  The scope of the company’s reimbursement obligation to the executive will then not apply to any fees that are charged at hourly rates above the cap that has been set by the company.

Conclusion

Indemnity provisions in private company governance documents have a necessary purpose – they protect executives from the threat of personal liability from claims made by third parties. These clauses can go too far, however, and indemnity provisions may require private companies to provide indemnity protection that goes beyond their intended scope, resulting in the company incurring fees and costs it never expected.  The recommendations in this post are intended to help private companies protect their executives without saddling the company with fees and costs it never planned to pay.  Governance documents including indemnity provisions need to strike the right balance for the company and its executives, and stop short of providing too much of a good thing.