Corporate Governance

Stockman v. Heartland Industrial Partners: In the Case of Indemnification, Goals Trump Contract

By J. Robert Brown

This blog extensively covered United States v. Stockman, involving criminal charges brought against officers and directors of Collins & Aikman Corporation ('C & A') for defrauding investors, banks, and creditors. The U.S. Attorney dropped its charges on January 9, 2009, providing a cursory explanation for its decision.

The case illustrated the problems that arise in connection with the costs of defending a complex, high profile and very expensive piece of litigation.  The defendants in Stockman confronted a rapid burn rate of the Director & Officer Insurance used to fund the defense, ultimately exhausting the proceeds.  This included proceeds from the D&O policies held by C&A and by Heartland, the private equity funded that had acquired C&A.  When the insurance proceeds ended, the parties turned to Heartland directly.  

In doing so, the defendants had to deal with the problem of private ordering.  Whether an LLC or a partnership, Delaware (with other states following) has moved in a direction of freedom of contract, providing for default rules in the statute but allowing parties great freedom on altering them contractually.  The state even permits, with respect to LLCs, the waiver of fiduciary duties, saving only the duty of good faith and fair dealing.

Freedom of contract, however, is not necessarily good for management.  There is a discernable trend in these cases to see the contracts turn on principles and language that is not in the contract, arguably negating the concept of freedom of contract.  There is an argument that this is exactly what happened here.    

Two defendants, David Stockman and J. Michael Stepp ('defendants'), filed suit against C & A and its majority investor Heartland Industrial Partners, L.P. ('Heartland'). The defendants sought advancement of legal fees and indemnification in accordance with Heartland's Partnership Agreement.  In Stockman v. Heartland Industrial Partners, L.P., 2009 WL 2096213, *1 (Del. Ch. July 14, 2009), the Court of Chancery of Delaware granted the defendant's summary judgment on their advancement claims and denied Heartland's motion to dismiss the indemnification claims.

In connection with the claim for indemnification, the partnership agreement borrowed from § 145 of the Delaware General Corporation Law.  Both the Section and the Agreement provided that indemnification was only permissible if "in the case of a criminal action or proceeding, the Indemnitee had no reasonable cause to belive his conduct was unlawful."  Section 145 also, however, also required payment of expenses where the party involved "has been successful on the merits or otherwise." The Indemnification Agreement contained no similar requirement. 

The absence of the language suggested that payment was not automatic upon success.  Instead, there had to be specific findings that the officers acted in "good faith."  The court, however, chose instead to read the language of Section 145 into the agreement itself and to make indemnification mandatory.

Doing so required a two step analysis.  First, the Vice Chancellor concluded that "[a]n indemnitee in a criminal proceeding is successful any time she avoids conviction," including when the government simply dismisses the case.  The authority for the proposition was thin, a single sentence from a 1974 Superior Court case.  There was no analysis and no attempt to examine why the case was dismissed, suggesting that any dismissal was equal to exoneration.  

To the extent an accurate reading of Section 145, it would explain why parties might change the default rule and instead require an affirmative finding of good faith.  It would protect the company in cases where there was a dismissal of a case yet the evidence of bad faith remained clear.  Thus, for example, a case might be dismissed because of the statute of limitations, not because of exoneration.  In those circumstances, a company might want the ability to deny indemnification.

Having made a leap with respect to Section 145, the opinion had to address the problem that the language (and the leap in logic) was not expressly in the partnership agreement.   

• Here, the drafters of the Partnership Agreement used their contractual freedom to craft an approach to indemnification that employs language drawn from § 145, but in a selective way that creates some room for confusion. In a nutshell, the Indemnification Provision adopts § 145's standard for good faith and lawful conduct, but is silent about the effect of a disposition of the underlying proceeding in favor of the Indemnitee, which is a key consideration when determining whether a corporate official is entitled to indemnification under § 145.

Nonetheless, the court read it into the agreement.  It did so on "public policy" grounds.  As the court reasoned: 

• Given these realities, the requirements of §§ 145 (a) and (b) seem best read as public policy limits designed to prevent corporations from indemnifying corporate officials in only the most incentive-distorting circumstances: when the officials have been convicted or otherwise incurred liability as a result of culpable conduct and that liability was the result of conduct that involved a certain level of scienter. Nothing cited by Heartland suggests that these requirements — which are baked into the Indemnification Provision — were designed to require an indemnitee who faced civil or criminal liability claims and had those claims dismissed to then put on, or even defend, a merits case about the purity of their state of mind regarding the conduct alleged in the dismissed claims.

In short, the court found in favor of the officers seeking indemnification by first concluding that a criminal dismissal amounted to vindication and then by reading a provision from the statute into the agreement, despite its explicit absence. 

The motivation was clear. "[T]urning an indemnification case into a hypothetical trial on the merits of a dismissed case is a bizarre notion to propose and would be counterproductive to Delaware's policy goal of assuring indemnitees 'that their reasonable expenses will be borne by the corporation they have served if they are vindicated.'"  The goal, apparently, was more important than the language of the agreement.

Given that "success" could be dismissal, Heartland had a reason why it might require evidence of good faith before agreeing to indemnification.  The omission of the language from Section 145, therefore, had a reasonable explanation.  The court, however, was unwilling to give much weight to what could have been the intent of the parties.  In an era of freedom of contract, this case did not turn on the contract but on a judicial rewriting of the contract. 

The primary sources for this post are available at the DU Corporate Governance website.

Full post as published by The Race to the Bottom on September 10, 2009 (boomark / email).