New York Permits Broad Protection of Officers and Directors

Executive Insurance Advisor

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PUBLISHED ON: June 5, 2005

Whether D&O insurance coverage is available, and how much, in a particular matter may depend on whether indemnification by the corporation is mandatory or optional. The answer to that question can be found in the interplay between the language of the corporation’s organizational documents and the corporate laws of the jurisdiction of incorporation.

When a corporation makes no provision with respect to indemnification of its officers and directors,one must look to the New York Business Corporation Law (“NYBCL”) for guidance. Most states have statutes similar to the NYBCL which set forth the criteria for indemnification of directors and officers. Section 722(a) of the NYBCL states that, in general, a corporation may indemnify any director or officer, who is a target of proceeding because he served in such capacity. This section provides fairly rigorous criteria for indemnification:

the director or officer should have acted (in good faith) for a purpose (reasonably believed by him) to be in the best interest of the corporation, or, if the indemnitee also serves another corporation, for a purpose not opposed to the best interest of the indemnifying corporation: A corporation may indemnify any person, made, or threatened to be made, a party to an action or proceeding (other than one by or in the right of the corporation to procure a judgment in its favor), whether civil or criminal, including an action by or in the right of any other corporation of any type or kind, domestic or foreign,or any partnership, joint venture, trust, employee benefit plan or other enterprise,which any director or officer of the corporation serve in any capacity at the request of the corporation, by reason of the fact that he, his testator or intestate, was a director or officer of the corporation, or served such other corporation, partnership, joint venture,trust, employee benefit plan or other enterprise in any capacity against judgments, fines, amounts paid in settlement and reasonable expenses, including attorneys’ fees actually and necessarily incurred as a result of such action or proceeding, or any appeal therein, if such director or officer acted, in good faith, for a purpose which he reasonably believed to be in, or, in the case of service for any other corporation or any partnership, joint venture, trust, employee benefit plan or other enterprise, not opposed to, the best interest of the corporation and, in criminal actions or proceedings, in addition, had no reasonable cause to believe that his conduct was unlawful.

NYBCL § 722(a) (emphasis added)

This Section arguably requires the director or officer to meet the difficult burden of demonstrating that he or she consciously considered and reasonably believed his or her actions advanced the interests of the Corporation, or at the very least, were not antagonistic to them. Even if the criteria are met, indemnification is only optional, not mandatory, under § 722, which could have an impact on insurance coverage. The New York statutes and courts tend to favor expansive indemnification rights on behalf of independent directors and officers for reasons of public policy, applicable especially in the era of Sarbanes Oxley, so that corporations may attract the highest caliber independent directors. This public policy is reflected in NYCBL § 721, which permits corporations to provide broader protections than those set forth in § 722. Section 721 specifically provides that the indemnification rights set forth in “this article” are “not exclusive of the rights that a corporation”may provide. Because “this article” includes § 722, it is clear that § 722 was not intended to and does not limit the scope of a corporation’s ability to provide indemnification rights. Indemnification cannot be granted under § 721, however, if the director or officer’s liability arises as a result of “bad faith,” or “active and deliberate dishonesty”:

[N]o indemnification may be made to or on behalf of any director or officer if a judgment or other final adjudication adverse to the director or officer establishes that his acts were committed in bad faith or were the result of active and deliberate dishonesty and were material to the cause of action so adjudicated,or that he personally gained in fact a financial profit or other advantage to which he was not legally entitled.

NYBCL § 721 (emphasis added).1

Accordingly, if a corporation drafted a by law provision which requires indemnification “to the full extent of the law,” indemnification is mandatory, subject only to the implied condition that the director or officer’s conduct not fall below the minimum standards set forth in § 721. Analyzing and updating existing indemnification provisions (or adding them if they do not exist) in company charter or by-laws, from the perspective of the current rules and case law, may be crucial — the result could be more predictable protection under a D&O policy, avoidance of costly litigation and more clarity in the response to prospective directors and officers’ concerns about protection.

1 Indemnification is prohibited under this section only if a final judgment or adjudication has established that the suspect conduct was both prohibited and was material to the cause of action brought, or that the trustee has realized an advantage to which he had no legal right. NYBCL § 721