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Article

Director and Officer Indemnification Agreements

Date

September 2, 2009

AUTHOR(s)

Jonathan R. Grant
Leila Rafi
William G. Scott


In the ongoing effort to attract highly qualified individuals to act as directors and officers, indemnification agreements have increasingly become a common way for Canadian public companies to supplement the protections typically afforded to their directors and officers by director and officer liability insurance (D&O insurance) and bylaw indemnification rights. Generally, indemnification agreements provide the director or officer with a stand-alone, contractual indemnity against liabilities incurred as a result of serving in that capacity, together with expense advancement and certain other rights.

Indemnification agreements offer several advantages over simply including indemnification provisions in the company’s bylaws or other organizational documents. Unlike a company’s bylaws, which may be unilaterally amended by the directors (subject to confirmation by the company’s shareholders at a later date), an indemnification agreement is a bilateral agreement between the director/officer and the company that cannot be amended to remove the indemnification protections without the consent of the director or officer. This right can take on added importance in the event of a change of control of the company, following which the company’s new owners may choose to amend the bylaws to alter or remove the indemnification rights. In addition, an agreement enables the parties to set out in greater detail the terms and conditions upon which indemnification, expense advancement, and other protections afforded to the director or officer are to be administered. This is typically not the case where indemnification rights are contained in a company’s bylaws.

Care must be taken in drafting indemnification agreements to ensure that the agreement strikes an appropriate balance between the interests of the individual director or officer, the interests of the company, and the statutory limitations imposed by the company’s governing statute (such as the Canada Business Corporations Act and similar provincial corporate statutes). Set out below is a summary of several issues to keep in mind when preparing a director and officer indemnification agreement:

  • Expense Advancement Rights. Most Canadian corporate statutes now permit a company to make advances to directors or officers for expenses incurred by them as a result of being involved in legal proceedings related to their role as a director or officer. Typically, the company’s governing statute will stipulate that an individual who receives those types of expense advances must repay the money if the individual has not acted honestly and in good faith with a view to the best interests of the company for which he or she acted as a director or officer or in a similar capacity. Accordingly, the indemnification agreement should require the director or officer to provide a written undertaking that he or she will repay any expense advances made by the company if it is determined that the director or officer did not meet those standards of conduct. This undertaking is usually unsecured.
  • Consistency with Insurance Policies & Bylaws. It is important to ensure that a company’s D&O insurance policy — which is intended to help protect the company’s balance sheet in the event of litigation involving its directors and officers — properly interacts with the terms of the indemnification agreement. Indemnification agreements are often drafted in a manner that puts an onus on the company to obtain and maintain D&O insurance. This type of boilerplate language should be avoided, as it is not possible to contractually ensure that a company will obtain and maintain insurance policies that cover all risks. This is because such coverage will likely not be available; insurance policies contain standard exclusions (for types of conduct and claims), including, for example, payment of fines and penalties. Any conflicts such as this must be addressed in the indemnification agreement, and properly worded to ensure the indemnity that is negotiated is, in fact, the indemnity that will be capable of being provided by the company to the directors or officers. Further, the indemnity provided should be consistent with any indemnification provisions of the company’s bylaws and applicable corporate law.
  • Establishing a Trust. As a result of the recent economic uncertainty, indemnification agreements sometimes require or permit the company to hold funds to be used to maintain the D&O insurance or satisfy indemnification claims or expense advances in the event the company undergoes a change of control or faces insolvency. It remains unclear whether such trusts, if contested by a third party, would withstand the scrutiny of a bankruptcy court.
  • Entity-Specific Considerations. Different types of corporate entities should be attuned to specific considerations in negotiating contractual indemnities with their directors and officers. For example, often a private equity fund requests its directors to serve on the boards of the fund’s portfolio companies. It should be determined whether the private equity fund will be responsible for the director’s conduct while on the board of the portfolio company or whether a separate indemnification agreement should be entered into with the portfolio company. If a separate indemnification agreement is entered into with the portfolio company, consideration should be given to whether the private equity fund’s obligations under the indemnification agreement are secondary or concurrent with those of the portfolio company.