Indemnification is a legal concept included in many contracts whereby one party agrees to compensate and defend the other party for any damage or liability incurred due to certain acts. Indemnity clauses are a way to contractually transfer financial liability. When an indemnity clause is triggered, the party agreeing to indemnify (the indemnitor) pays the costs, expenses, and fees incurred by the indemnified party (the indemnitee).
General principles of indemnity are governed by state statue. Many companies are incorporated in Delaware, and other states often look to Delaware law on indemnification. In general, a company may indemnity its executives when they have acted in good faith, in a manner reasonably believed to be in the best interests of the company, and had no reasonable cause to believe their conduct was unlawful. In some states (Minnesota for example), the power to indemnify a corporate officer becomes an obligation to do so, with indemnification for certain types of claims being mandatory.
How Indemnity Clauses Benefit Corporate Executives
An indemnity provision can be negotiated into an employment contract to provide the executive with an enforceable right to have the company cover all expenses if the executive is sued in connection with the executive’s current or previous employment with the company. When the company agrees to indemnify the executive, he or she will not be personally responsible for any debts or liability incurred while acting on behalf of the company. Thus, indemnity clauses essentially provide a protective shield for executives.
One way in which an indemnity provision can lend protection is against claims by an executive’s former employer. For example, Ed Executive leaves Company 1 to join Company 2. Ed Executive signs an employment agreement with Company 2 that contains an indemnity clause stating that Company 2 shall indemnify and defend Ed Executive against claims, damages, attorney’s fees and costs connected with Ed Executive’s duties with Company 2. After Ed Executive begins working for Company 2, Company 1 sues him, claiming that his new employment with Company 2 violates various post-restrictive covenants contained in his employment agreement with Company 1. Because Company 2 has agreed to indemnify Ed Executive, Company 2 must pay any fees and expenses incurred by Ed Executive in defending the claims by Company 1.
Indemnity Should Extend Beyond Executive’s Tenure
Further, to maximize an executive’s indemnification shield, the company’s duty to indemnify should continue even after the executive leaves a company. This keeps the company under an obligation to reimburse the executive for future claims stemming from the executive’s previous work for the company even after the employment relationship is terminated.
If a plaintiff sues Company X and its entire executive team, including Ellen Executive, for damages arising from a data breach, one would expect Company X to provide a defense for the executive team while employed by the company. However, an indemnity provision ensures that even former executives are protected. Thus, if Ellen Executive has an indemnity clause in her employment agreement, resignation or retirement should not impair her ability to make demand on Company X to provide her with counsel or pay her costs of defense.
Advancement – Not Reimbursement – of Attorneys’ Fees
An executive should negotiate for advancement of attorneys’ fees rather than reimbursement of expenses. Advancement is indemnification up-front for expenses incurred, with a promise to repay the amounts advanced if it is judicially determined that the executive was not entitled to be indemnified.
Although some corporate bylaws contain indemnity provisions for officers and directors, executive employees should not simply rely on such general provisions for protection. The indemnity provisions contained in bylaws may be permissive, vague, or may not cover all potential issues that could arise.
Further, bylaws may be amended from time to time at the company’s discretion, meaning there is a risk of the protections being eliminated. Contractual rights, on the other hand (such as those in an employment agreement) may not be amended or terminated without the executive’s written consent. Thus, an individually negotiated indemnity provision in an executive’s individual employment agreement provides the best security for executives. Similarly, Directors’ and Officers’ (D&O) insurance coverage may have exclusions or limitations that leave an executive at risk for certain types of claims. A contractual indemnity clause can bridge the gap to provide full coverage.
What’s in It for the Employer?
Why would an employer agree to contractually indemnify an executive considering the risk of liability for expensive attorney’s fees and costs? Key talent is at a premium, and employers are competing to hire top executives. The great responsibility entrusted in a company’s senior management exposes them to a high risk of personal liability. Thus, many companies wish to protect their executive employees from this liability to permit full focus and attention to duties.
Further, indemnity allows a company to build trust among its officers and directors by demonstrating a strong level of commitment and support to its executives. It is often in the company’s best interest for the executive to have competent legal counsel. Indemnity provisions with advancement may allow the employer to retain some degree of control over selection of counsel, hourly rates, and expenses. Companies that provide indemnity may attempt to reduce their liability by including a clause limiting the types of expenses for which indemnity is available or by including a monetary cap on the total amount that the company may be obligated to pay out. Thus, the terms of indemnity provisions are often extensively negotiated.
Decisions regarding indemnification of corporate executives require factual, legal, economic, and strategic analysis. For assistance with issues arising from indemnity provisions in employment contracts, contact Clouse Brown PLLC. Our attorneys are available to counsel executives who need assistance negotiating indemnity provisions. We also advise employers and business owners on minimizing risks associated with indemnity provisions and drafting executive employment agreements.