November 16, 2011
Chancery Court Provides Guidance on Advancement, Indemnification Under Delaware Law
By Stephen B. Brauerman
In a question of first impression, the Delaware Court of Chancery considered whether and to what extent discovery is necessary to determine whether a fiduciary acted with the requisite good faith to justify permissive indemnification under (1) Delaware General Corporation Law, (2) the organic documents of K-V Pharmaceuticals Inc. and (3) an indemnification agreement between the company and its former chief executive officer, Marc Hermelin, that made mandatory the permissive advancement and indemnification provisions of the DGCL. Vice Chancellor Sam Glasscock III's decision in Hermelin v. K-V Pharmaceutical Co. recognizes the procedural realities underlying summary advancement and indemnification proceedings and is instructive for several reasons.
First, the court clarified the scope of indemnification and advancement permissible under Delaware's statutory regime. As the court wrote in the opinion, Delaware law "sets two boundaries for indemnification: The statute requires a corporation to indemnify a person who was made a party to a proceeding by reason of his service to the corporation and has achieved success on the merits or otherwise in that proceeding [mandatory indemnification]. At the other end of the spectrum, the statute prohibits a corporation from indemnifying a corporate official who was not successful in the underlying proceeding and has acted, essentially, in bad faith."
Between these extremes, the DGCL leaves to the corporation the flexibility to indemnify its officers and directors, if they acted in good faith and without a reasonable belief that their conduct was criminal (permissive indemnification). Second, the court explained that the success inquiry for mandatory indemnification is straightforward, conducted on a limited record and requires a comparison of the potential outcomes faced with the results actually achieved. Third, for the first time, the court addressed the scope of discovery relevant to the analysis of a fiduciary's good faith in evaluating a demand for permissive indemnification. For these reasons, Hermelin offers corporations, corporate officers and directors, and those representing them some greater guidance for litigating indemnification demands under Delaware law.
According to the opinion, this advancement and indemnification action arose from Hermelin's ownership of and position as KV's chief executive officer and his involvement in several criminal, civil and regulatory matters relating to KV's distribution of oversized morphine sulfate tablets. Following employee complaints about these manufacturing irregularities, KV's audit committee undertook investigation of the allegations and Hermelin's response to them. Based on the audit committee's investigation, KV decided to terminate Hermelin. The public announcement of Hermelin's termination in KV's securities filings spurred investigations by the U.S. Attorney's Office, the Food and Drug Administration and the Department of Health and Human Services.
The opinion said that, though Hermelin claimed that the government could have charged him with a variety of criminal offenses in the criminal matter, he was charged with and pled guilty to only two strict liability offenses, for which he paid a fine of approximately $1.9 million and served 15 days of a 30-day jail sentence. In seeking indemnification for the criminal matter, Hermelin claimed that he was successful because the government could have charged him with a variety of additional criminal offenses.
In the FDA matter, Hermelin fared better. The opinion noted that the FDA sought an injunction to prevent Hermelin, KV and other related targets from manufacturing drugs without certain FDA-mandated, quality-control measures in
In a question of first impression, the Delaware Court of Chancery considered whether and to what extent discovery is necessary to determine whether a fiduciary acted with the requisite good faith to justify permissive indemnification under (1) Delaware General Corporation Law, (2) the organic documents of K-V Pharmaceuticals Inc. and (3) an indemnification agreement between the company and its former chief executive officer, Marc Hermelin, that made mandatory the permissive advancement and indemnification provisions of the DGCL. Vice Chancellor Sam Glasscock III's decision in Hermelin v. K-V Pharmaceutical Co. recognizes the procedural realities underlying summary advancement and indemnification proceedings and is instructive for several reasons.
First, the court clarified the scope of indemnification and advancement permissible under Delaware's statutory regime. As the court wrote in the opinion, Delaware law "sets two boundaries for indemnification: The statute requires a corporation to indemnify a person who was made a party to a proceeding by reason of his service to the corporation and has achieved success on the merits or otherwise in that proceeding [mandatory indemnification]. At the other end of the spectrum, the statute prohibits a corporation from indemnifying a corporate official who was not successful in the underlying proceeding and has acted, essentially, in bad faith."
Between these extremes, the DGCL leaves to the corporation the flexibility to indemnify its officers and directors, if they acted in good faith and without a reasonable belief that their conduct was criminal (permissive indemnification). Second, the court explained that the success inquiry for mandatory indemnification is straightforward, conducted on a limited record and requires a comparison of the potential outcomes faced with the results actually achieved. Third, for the first time, the court addressed the scope of discovery relevant to the analysis of a fiduciary's good faith in evaluating a demand for permissive indemnification. For these reasons, Hermelin offers corporations, corporate officers and directors, and those representing them some greater guidance for litigating indemnification demands under Delaware law.
FACTUAL BACKGROUND
According to the opinion, this advancement and indemnification action arose from Hermelin's ownership of and position as KV's chief executive officer and his involvement in several criminal, civil and regulatory matters relating to KV's distribution of oversized morphine sulfate tablets. Following employee complaints about these manufacturing irregularities, KV's audit committee undertook investigation of the allegations and Hermelin's response to them. Based on the audit committee's investigation, KV decided to terminate Hermelin. The public announcement of Hermelin's termination in KV's securities filings spurred investigations by the U.S. Attorney's Office, the Food and Drug Administration and the Department of Health and Human Services.
The opinion said that, though Hermelin claimed that the government could have charged him with a variety of criminal offenses in the criminal matter, he was charged with and pled guilty to only two strict liability offenses, for which he paid a fine of approximately $1.9 million and served 15 days of a 30-day jail sentence. In seeking indemnification for the criminal matter, Hermelin claimed that he was successful because the government could have charged him with a variety of additional criminal offenses.
In the FDA matter, Hermelin fared better. The opinion noted that the FDA sought an injunction to prevent Hermelin, KV and other related targets from manufacturing drugs without certain FDA-mandated, quality-control measures in