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Vice Chancellor, Must I? Chancery Court Tackles Issue of First Impression regarding Permissive Indemnification

Monday, March 5, 2012
Adrienne Kitchen Moeller | Bloomberg Law Hermelin v. K-V Pharmaceutical Co., C.A. No. 6936-VCG, 2012 BL 29045 (Del. Ch. Feb. 7, 2012) In an opinion filled with thought-provoking historical references, Vice Chancellor Glasscock of the Delaware Court of Chancery discussed the development of the indemnification and advancement provisions under the Delaware General Corporation Law (DGCL) in the context of whether a former CEO was entitled to mandatory or permissive indemnification. Notably, the court addressed an issue of first impression in Delaware: what evidence is relevant to an inquiry into whether an indemnitee acted in good faith for the purposes of permissive indemnification under DGCL §§ 145(a) and (b).

Monster Pills Lead to Monster Problems for Former CEO

The court noted at the outset of the opinion what the DGCL says must happen and what cannot happen with respect to director and officer indemnification. On the one hand, the DGCL requires a corporation to indemnify a person who was made a party to a proceeding by virtue of his service to the corporation and achieved success on the merits of such proceeding. On the other hand, a corporation may not indemnify a corporate official who was unsuccessful in the underlying proceeding and acted in bad faith. In situations that fall within these outer boundaries, indemnification is generally permissible, and corporations are free to contract with their directors and officers to indemnify them against expenses incurred by them personally as a result of their service to the corporation. In the instant case, plaintiff Marc S. Hermelin, the former chief executive officer of defendant K-V Pharmaceutical Co., was a party to an indemnification agreement with K-V that generally made mandatory "what are permissive provisions for indemnification under the DGCL." Hermelin at 3-4. Hermelin sued K-V after the company refused to indemnify him in connection with several proceedings arising out of investigations by the U.S. Food & Drug Administration (FDA) and the U.S. Department of Justice involving K-V's distribution of oversized morphine sulfate tablets. He sought a declaration from the court that he was entitled to indemnification for six proceedings arising from his conduct, four of which were at issue for the court: the Audit Committee Matter, the Criminal Matter, the FDA Consent Decree Matter, and the Department of Health and Human Services (HHS) Exclusion Matter (explained further below). The parties disagreed as to whether Hermelin succeeded on the merits of the subject proceedings and whether he acted in good faith, which would entitle him to indemnification under his contract with K-V.

Mandatory Indemnification Rests on "Success"

The court framed the central issue with respect to mandatory indemnification as whether Hermelin was "successful on the merits or otherwise" in the four matters. The parties disagreed as to how closely the court must scrutinize the outcome of a proceeding to determine whether the prospective indemnitee was successful under DGCL § 145. The court explained that when determining success on the merits, the court would not look "behind the result," stating that investigating "how" and "why" the result came to be was unnecessary. Id. at 30. Comparing for each of the matters what Hermelin was charged with or formally accused of with the result Hermelin actually achieved, the court found that:
  • Hermelin was not entitled to mandatory indemnification in the Criminal Matter. The court explained that Hermelin was clearly not successful, pleading guilty to two federal strict liability misdemeanors and being ordered to pay fines and serve jail time. The court rejected Hermelin's argument that a guilty plea was not necessarily an adverse judgment. For the purposes of DCGL § 145(c), anything less than a conviction constitutes "success," but because Hermelin pled guilty to all charges, paid a sizeable fine and served jail time, he did not achieve a successful result.
  • Hermelin was not entitled to mandatory indemnification in the HHS Exclusion Matter. The Office of the Inspector General (OIG) of HHS informed Hermelin that it was considering excluding him from federal healthcare programs, and Hermelin submitted information in his defense. After receiving this information, the OIG decided to exclude him for 20 years. The court again found that this was not a successful result by Hermelin, considering that it was effectively a lifetime ban.
  • Hermelin was entitled to mandatory indemnification for the FDA Consent Decree Matter. The FDA originally sought an injunction prohibiting Hermelin and others from manufacturing, holding, or distributing any drug until they brought their operations into conformity with specified rules and regulations. The Consent Decree ultimately issued by the FDA, however, did not place any additional restrictions on Hermelin and specifically stated that the provisions of the Consent Decree did not apply to him, with certain exceptions relating to a change in circumstances. Hermelin therefore avoided a personally negative result in connection with the Consent Decree, which the court deemed "successful."

Permissive Indemnification: What Evidence Demonstrates "Good Faith"?

Having rejected mandatory indemnification for three of the matters (including the Audit Committee Matter, which Hermelin did not argue), the court turned to whether Hermelin was entitled to permissive indemnification. The parties disagreed as to what evidence was relevant to a good faith analysis under Section 145(a), since the company bylaws and the indemnification agreement both mandated indemnification where it was permissive under the DGCL. The court pointed out that the issue of what evidence was relevant to an inquiry into whether an indemnitee acted in good faith for the purposes of permissive indemnification had not been squarely addressed under Delaware law and was an issue of first impression. The court looked to the indemnification agreement to begin its analysis, noting that under the agreement, the termination of any proceeding "shall not . . . of itself" adversely affect the right of the indemnitee to indemnification or create a presumption that the indemnitee did not act in good faith. Id. at 41. Finding that the provision "clearly establishes that the particular outcome of a proceeding does not itself create a presumption that the indemnitee had a 'non-indemnifiable state of mind,' the court reasoned that if a showing of bad faith was indeed made, it would be conclusive evidence that the indemnitee was not entitled to indemnification. Id. at 45. The court found that none of the matters for which Hermelin was seeking indemnification contained a finding that he had acted in bad faith or admitted culpability. Thus, the court advised that the parties were required to supplement the record before it could make a determination under Section 145. The court held that a plenary trial on the issue of whether Hermelin acted "'in good faith and in a manner [he] reasonably believed to be in or not opposed to the best interests of [KV], and, with respect to any criminal action or proceeding, had no reasonable cause to believe [his] conduct was unlawful'" was necessary. Id. The court further held that evidence submitted at the trial would be limited to Hermelin's conduct underlying the Criminal, HHS Exclusion, and Audit Committee Matters, and the facts relating to that conduct. In so ruling, the court rejected Hermelin's argument that discovery on the issue of good faith should be limited to the papers and transcripts already on the record in the various underlying proceedings. DisclaimerThis document and any discussions set forth herein are for informational purposes only, and should not be construed as legal advice, which has to be addressed to particular facts and circumstances involved in any given situation. Review or use of the document and any discussions does not create an attorney-client relationship with the author or publisher. To the extent that this document may contain suggested provisions, they will require modification to suit a particular transaction, jurisdiction or situation. Please consult with an attorney with the appropriate level of experience if you have any questions. Any tax information contained in the document or discussions is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code. Any opinions expressed are those of the author. The Bureau of National Affairs, Inc. and its affiliated entities do not take responsibility for the content in this document or discussions and do not make any representation or warranty as to their completeness or accuracy.©2014 The Bureau of National Affairs, Inc. All rights reserved. Bloomberg Law Reports ® is a registered trademark and service mark of The Bureau of National Affairs, Inc.

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