Tuesday, August 19, 2008

Can Directors' Indemnities Be Undone?

Angel Investors and VCs who read August 6's Globe and Mail must have had the bejesus scared out of them as they poured over the summary of Schoon v. Troy Corp., a Delaware Chancery Court case that has had boards buzzing south of the border since last spring.

Why? Schoon has established that companies may amend their by-laws and retroactively eliminate indemnity protection for former directors. In other words, investors can find themselves without protection long after their term on a board of directors has ended.

Here's the analysis: Like most North American companies, Troy Corp. had broad indemnification bylaws which entitled directors to seek advances from the company to pay their litigation costs in cases where a lawsuit was brought directors. The indemnification right applied even if the company sued its current or former directors for theft, fraud, or fiduciary-duty breaches (the money would be returned if it is ultimately found that the director was, in fact guilty).

The board suspected that a former director has been disclosing confidential information to third parties and, before proceeding further, took steps to eliminate its obligation to pay the former director's legal costs. So, even though there was an indemnity in place while the director was in office,the director found that the retroactive by-law amendment removed the protection he thought he enjoyed while in office. The court upheld the amendment.

Angel investors and VCs need to think carefully about how this impacts their own protection. Because investors typically wear many hats - advisor, director, controlling shareholder - there is perhaps a greater risk of conflict and dispute in the private company realm, particularly when start-ups go sideways. Sales of a company and highly dilutive "down round" financings are particularly contentious. I've always viewed the typical investor-required broad indemnity as a good check and balance against hard feelings: don't sue unless the harm is so great it justifies the nuisance of disputing the indemnity as well. Now, with Delaware's ruling, the incentive to act in a balanced manner is gone. Will repealing indemnities become a tool for litigation?

The American practice has been to create bilateral indemnification agreements between the company and each director, and this is probably the right apporach to take here (agreements, unlike by-laws, cannot be amended or terminated without the agreement of both parties). I'm not a fan of over-papering early stage investment deals (more on that later) but it seems like a proper response if we are to create a safe haven for angel investors.

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