Indemnification in Litigation of the Business Divorce

Robert Royal,  |  March 16, 2017

In my last article I reviewed how directors, officers and employees may receive an advancement of their attorney fees prior to judgment when they are brought in to a proceeding based on actions taken in their official capacities for the company.However, the ultimate authority to indemnify, allowing the person to keep their advancement and further obtain from the company payment for any judgment or settlement, is governed by the indemnification statutes in Arizona.If litigation is settled or goes to trial, indemnification requires that the company pay the judgment or settlement, including expenses, again providing the company’s financial support for actions taken on behalf of the company if certain conditions are met.

Authority to Indemnify

A company may indemnify a director or officer, made a party to a proceeding if the individual’s conduct was in good faith and, the individual reasonably believed that while acting in their official capacity the conduct was in the company’s best interest or in all other cases the conduct was at least not opposed to the company’s best interest.In criminal proceedings, if the individual had no reasonable cause to believe their conduct was unlawful they may obtain indemnification. A second basis allowing such permissive indemnification is if the director or officer engaged in conduct for which broader indemnification allowances exist in the Articles of Incorporation.

Permissive indemnification is not available when a director or officer receives a financial benefit to which the person is not entitled, intentionally inflicts harm on the corporation or shareholders, intentionally violates criminal law, or unlawfully makes a distribution of company funds.In addition, the company may indemnify after the termination of a proceeding resolved by judgment, order, settlement or conviction if it is not itself determinative of whether the director met the good faith, best interest standard of conduct.

Required Indemnification

The company is required to indemnify a director or officer who was a prevailing party in the defense of any proceeding to which a person was a party in their official capacity for the reasonable expenses incurred by another person in connection with that proceeding.If a director was not an officer, employee or stockholder holding more than 5%, who then qualifies as an outside director, they are entitled to receive mandatory indemnification. But an outside director shall not receive indemnification if the director did not meet the standard of good faith and acting in the best interests or not opposed to the best interests of the company as described above.

Who Decides Indemnification

A company may not indemnify a director or officer under permissive indemnification without a determination regarding the individual’s conduct of meeting the good faith in the best interests standard.This determination is made by a majority vote of the directors not parties to the proceeding; legal counsel selected by the disinterested directors; or by shareholders who independently vote their shares.Fortunately, no liability attaches to such a vote.The director may also apply for indemnification to the court where the proceeding was being conducted or to any other court for indemnification.An outside director must establish they are entitled to mandatory indemnification under A.R.S. S 10-852 or that the director is fairly and reasonably entitled to indemnification even if the director has not met the standard of conduct referenced above, was adjudged liable and in which case their indemnification is limited to reasonable expenses, not the amount of judgment or settlement.

Insurance and Key Issues

While the Articles of Incorporation may limit the ability to indemnify, most often, indemnification is sought to the broadest extent provided by law.Hopefully, insurance has been procured by the company to protect the company coffers from the large expense of defense costs and paying any settlement or judgment for directors or officers in litigation.

Indemnification is available when the person is acting in their “official capacity” relating to action taken with respect to the office of the director or officer of the corporation involved.Indemnification “against liability” as that term is used in the statutes means any obligation to pay a judgment, settlement, penalty or a fine, broadly covering the damages arising out of a proceeding that a director or officer may incur.Permissive and mandatory indemnification only applies to directors or officers serving the corporation.

The key issues of indemnification arise from whether the person was actually acting in their official capacity within the scope of their duties as a director and officer and whether in their actions they really had a reasonable belief that they were acting in the best interests of the company and in good faith.Other important issues related to indemnification arise from whether there was an improper financial benefit received and if truly disinterested persons properly authorized indemnification.

The LLC statutes do not expressly provide for or set the rules of indemnification.The statutory structure is geared to having such matters put into the Operating Agreement and giving counsel an opportunity to write indemnification provisions as they deem proper, without violating Arizona law.Presumably, judges would accept guidance from Arizona corporate statutes when deciding issues related to LLC indemnification

When litigating business divorce, a shareholder, director or officer bringing claims must recognize that any judgment or settlement they may obtain may still be subject to payment by the company, that they may never have the company recover the expenses of the defense, and that a culpable director or officer may escape personal payment.