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What are your rights if you are sued as a director or an officer of a Corporation by either a third party or a shareholder in a derivative action (meaning a suit belonging to the Corporation but brought by a shareholder). The answer to that question involves analysis of two things. First, Pennsylvania’s Associations Statute, 15 Pa. C. S. A. section 102 et seq. (the “ACT”) and the Corporation’s governing documents, specifically its Bylaws.
The ACT breaks down the Corporation’s obligations under four scenarios. First, the corporation’s obligation to indemnify an officer or director sued by a third party. Second, the corporation’s obligation to indemnify an officer or director sued by a shareholder in a derivative action. Third, the corporation’s mandatory obligation to indemnify an officer or director. Fourth, the ability of a corporate director or officer to request the “advancement of expenses”, including attorneys’ fees, to fund the on-going defense before any determination of liability is reached. We will review each scenario below.
When a current or former officer or director of a Corporation is sued by a third party in any pending or completed action, or even threatened to be named by a third party as a defendant in any action or proceeding (broadly defined to include civil, criminal, administrative or investigative matters) because he/she is or was a representative of the corporation, or is or was serving at the request of the corporation as a representative of another entity, the Corporation shall have the power to indemnify the officer/director against expenses (including attorneys' fees), judgments, fines and amounts paid in settlement actually and reasonably incurred by him/her in connection with the action or proceeding if he/she acted in good faith and in a manner he/she reasonably believed to be in, or not opposed to, the best interests of the corporation, and with respect to any criminal proceeding, had no reasonable cause to believe his/her conduct was unlawful, UNLESS OTHERWISE RESTRICTED BY THE BYLAWS. Therefore, many corporations’ Bylaws mirror the language of the ACT to avoid restricting the right to indemnification for its officers and directors, but no one should ever assume that the Bylaws mirror the ACT. There are times when they do not. Rather, each person should check the language of the Bylaws in conjunction with the language of the ACT (or better yet, have counsel review the Bylaw language).
The indemnification language in the ACT is virtually verbatim when a current or former officer or director is sued by a shareholder in a derivative action/proceeding with the exception that indemnification shall not be made when the current or former officer or director has been adjudged to be liable to the corporation unless and only to the extent that the court determines, upon application that, despite the adjudication of liability but in view of all the circumstances of the case, the person is fairly and reasonably entitled to indemnity for the expenses that the court of common pleas or other court deems proper.
The Act further provides for mandatory indemnification of expenses (including attorneys’ fees) reasonably incurred when a current or former officer or a director has successfully defended an action on the merits or otherwise in defense of any action or proceeding (again defined broadly) by either a third party or by a shareholder.
The good news about the indemnification provisions above is that they apply to even former directors and officers. The bad news about those provisions is that the current or former officer/director only gets indemnification after the fact and they are left to their own devices to fund their defense, which can be costly.
But all is not lost. The ACT also makes provision for current and former officers and directors to request “advancement of expenses”, including attorneys’ fees incurred in defending any action or proceeding referred in advance of the final disposition of the action or proceeding. However, the director or officer must provide an “undertaking by or on behalf of the representative to repay the amount if it is ultimately determined that he is not entitled to be indemnified by the corporation as authorized” by the ACT or otherwise. Except as otherwise provided in the Bylaws, advancement of expenses shall be authorized by the board of directors. Luckily, for small and closely held corporations the provisions of the ACT relating to interested directors or officers/quorums and approval of transactions with interested shareholders are not applicable to the advancement of expenses. Thus, even directors who have themselves been sued can request and vote to authorize the advancement of expenses, including attorneys’ fees.
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