PARTNERSHIPS, CORPORATIONS AND THE VARIANTS PROF. BRUCE MCCANN SPRING SEMESTER LECTURE 7 INDEMNIFICATION AND INTRO TO SEC PP Business Organizations Lectures

Protecting Directors and Officers Lec.7 Sem 2, pp Corps Prof. McCann Three principal approaches:  1. Buy “D&O” insurance  2. Provide “contractual indemnification” through agreements with directors and officers  3. Exculpate directors through available statutes and/or by- laws 2

Calif. Corp. Code Sec. 317(b) Lec.7 Sem 2, pp Corps Prof. McCann 3 (b) A corporation shall have power to indemnify any person who was or is a party or is threatened to be made a party to any proceeding (other than an action by or in the right of the corporation to procure a judgment in its favor) by reason of the fact that the person is or was an agent of the corporation, against expenses, judgments, fines, settlements, and other amounts actually and reasonably incurred in connection with the proceeding if that person acted in good faith and in a manner the person reasonably believed to be in the best interests of the corporation and, in the case of a criminal proceeding, had no reasonable cause to believe the conduct of the person was unlawful.

Mandatory Indemnification Lec.7 Sem 2, pp Corps Prof. McCann 4 Calif. Corp. Code §317(d) (d) To the extent that an agent of a corporation has been successful on the merits in defense of any proceeding …or in defense of any claim, issue, or matter therein, the agent shall be indemnified against expenses actually and reasonably incurred by the agent in connection therewith.

Permissive Indemnification Lec.7 Sem 2, pp Corps Prof. McCann Delaware: Corporation may indemnify where director sued “by reason of the fact” he or she was a director. Heffernan says policy of exculpation requires expansive interpretation of “by reason of the fact.” Model Act: Indemnification authorized if director acting in good faith and in best interests of corporation, even if her conduct didn’t satisfy duty of care.  Articles/By-laws may expand or limit this duty to indemnify 5

Permissive Indemnification Lec.7 Sem 2, pp Corps Prof. McCann DGCL Sec. 145(a): (a) A corporation shall have power to indemnify any person who was or is a party or is threatened to be made a party to any threatened, pending or completed action, suit or proceeding, whether civil, criminal, administrative or investigative (other than an action by or in the right of the corporation) by reason of the fact that the person is or was a director, officer, employee or agent of the corporation, or is or was serving at the request of the corporation as a director, officer, employee or agent of another corporation, partnership, joint venture, trust or other enterprise, against expenses (including attorneys' fees), judgments, fines and amounts paid in settlement actually and reasonably incurred by the person in connection with such action, suit or proceeding if the person acted in good faith and in a manner the person reasonably believed to be in or not opposed to the best interests of the corporation, and, with respect to any criminal action or proceeding, had no reasonable cause to believe the person's conduct was unlawful. The termination of any action, suit or proceeding by judgment, order, settlement, conviction, or upon a plea of nolo contendere or its equivalent, shall not, of itself, create a presumption that the person did not act in good faith and in a manner which the person reasonably believed to be in or not opposed to the best interests of the corporation, and, with respect to any criminal action or proceeding, had reasonable cause to believe that the person's conduct was unlawful. 6

Heffernan Rule Widely Followed Lec.7 Sem 2, pp Corps Prof. McCann 7 Directors may be eligible for indemnification whether the plaintiff was a third party or was the corporation itself. Where third party: Director needs to show GOOD FAITH, REASONABLY BELIEVED ACTING IN CORPORATION’S INTERESTS AND, IF A CRIMINAL PROCEEDING, NO REASONABLE CAUSE TO BELIEVE WAS ACTING UNLAWFULLY Where corp is plaintiff: Director needs only to show GOOD FAITH, AND REASONABLE BELIEF ACTIN G IN CORPORATION’S INTERESTS

145(f) Lec.7 Sem 2, pp Corps Prof. McCann (f) The indemnification and advancement of expenses provided by, or granted pursuant to, the other subsections of this section shall not be deemed exclusive of any other rights to which those seeking indemnification or advancement of expenses may be entitled under any bylaw, agreement, vote of stockholders or disinterested directors or otherwise, both as to action in such person's official capacity and as to action in another capacity while holding such office. A right to indemnification or to advancement of expenses arising under a provision of the certificate of incorporation or a bylaw shall not be eliminated or impaired by an amendment to such provision after the occurrence of the act or omission that is the subject of the civil, criminal, administrative or investigative action, suit or proceeding for which indemnification or advancement of expenses is sought, unless the provision in effect at the time of such act or omission explicitly authorizes such elimination or impairment after such action or omission has occurred. 8

Waltuch Lec.7 Sem 2, pp Corps Prof. McCann Corporation may agree to broader indemnification rights for its directors and officers than are provided by statute, but Those rights cannot be inconsistent with the statutory scheme, including “good faith” requirement 9

Schoon and Vesting of Indemnification Right Lec.7 Sem 2, pp Corps Prof. McCann In Schoon v. Troy Corporation, 948 A.2d 1157 (2008), the court allowed the board of directors of Troy Corporation (“Troy”) to amend Troy’s bylaws to revoke a former director’s right to receive advancement even though the bylaws that were in place during his service expressly stated that the director’s right to receive advancement would continue even after his tenure on the board ended. Before Schoon, it was commonly believed that a director’s right to require a company to provide advancement vested upon the director’s service and could not be singlehandedly terminated by the company after the director’s tenure ended. This belief was at least in part based on a prior Delaware Superior Court case where the court stated that the director’s “right to advancement…[was] a vested contract right which [could not] be unilaterally terminated.” The court held that a director’s right to receive advancement provided for in charter documents does not vest until a “triggering event” occurs. 10

Response To Schoon Lec.7 Sem 2, pp Corps Prof. McCann In 2009, the Delaware legislature amended Section 145(f ) of the DGCL to adopt a rule that was contrary to the holding in Schoon. As revised, Section 145(f ) provides that a director’s right to receive indemnification or advancement pursuant to a company’s charter or bylaws generally may not be impaired or eliminated after the occurrence of the act or the omission that is the subject of the indemnification or advancement. Note, however, that an exception to this rule occurs if the company’s charter or bylaws as in effect at the time of the act or omission contains a provision that expressly authorizes such elimination or impairment after the occurrence of the questioned act or omission. The amendment resolves the uncertainty surrounding the occurrence of a “triggering event” by clarifying that the right to receive indemnification or advancement vests upon the occurrence of a potentially litigious act, rather than upon the filing of a lawsuit or the threat of litigation 11

Insurance Issues Lec.7 Sem 2, pp Corps Prof. McCann A corporation can often use D&O (“Directors and Officers”) coverage to indemnify risks that the corporation itself could not indemnify. Insurance Coverage can be broader than statutory limits of indemnification allowed the corporation itself. BUT Public policy forbids indemnifying against criminal conduct, willful conduct or fraudulent conduct 12

D&O Policies Lec.7 Sem 2, pp Corps Prof. McCann Typically provide: 1. “Company Reimbursement” – compensates company for monies it expends for mandatory indemnification expenses. (Side B) 2. “Directors and Officers Liability” – covers losses incurred by the directors and officers and not reimbursed by the company for statutory or other reasons. (Side A) 3. “Entity Coverage” – insures for the company’s direct liability to the plaintiff. (Side C) 13

THE SECURITIES LAWS AN INTRODUCTION Chapter 16

The Federal Statutory Framework Lec.7 Sem 2, pp Corps Prof. McCann 15 The Securities Act of 1933  Requires registration of covered securities before they can be issued The Securities Exchange Act of 1934  Requires disclosures by corporations in connection with transactions in that corporation’s stock  Requires disclosures by parties acquiring shares sufficient to affect control The Sarbanes-Oxley Act of 2002  Requires corporations to institute audit controls  Requires certification as to the truth of financial statements

Securities Act of 1933 Lec.7 Sem 2, pp Corps Prof. McCann 16 Requires registration with the federal government if you propose to “offer or sell” a “security” and the transaction is not exempt from registration.

Sarbanes-Oxley Lec.7 Sem 2, pp Corps Prof. McCann Section 302 of the Act mandates a set of internal procedures designed to ensure accurate financial disclosure. The signing officers must certify that they are “responsible for establishing and maintaining internal controls” and “have designed such internal controls to ensure that material information relating to the company and its consolidated subsidiaries is made known to such officersinternal controlscompanyconsolidated subsidiaries Under Section 404 of the Act, management is required to produce an “internal control report” as part of each annual Exchange Act report. See 15 U.S.C. § The report must affirm “the responsibility of management for establishing and maintaining an adequate internal control structure and procedures for financial reporting.” 15 U.S.C. § 7262(a). The report must also “contain an assessment, as of the end of the most recent fiscal year of the Company, of the effectiveness of the internal control structure and procedures of the issuer for financial reporting.15 U.S.C.§ U.S.C.§ 7262(a)Company Section 802(a) of the SOX, 18 U.S.C. § 1519 states:18 U.S.C.§ 1519 “ Whoever knowingly alters, destroys, mutilates, conceals, covers up, falsifies, or makes a false entry in any record, document, or tangible object with the intent to impede, obstruct, or influence the investigation or proper administration of any matter within the jurisdiction of any department or agency of the United States or any case filed under title 11, or in relation to or contemplation of any such matter or case, shall be fined under this title, imprisoned not more than 20 years, or both. 17

Simply Stated: Lec.7 Sem 2, pp Corps Prof. McCann 18 A security is: “An investment of money in a common enterprise where the hoped for profit will come from the labor of others, not the investor.”

Less simply stated: Lec.7 Sem 2, pp Corps Prof. McCann "Security" means any note; stock; treasury stock; membership in an incorporated or unincorporated association; bond; debenture; evidence of indebtedness; certificate of interest or participation in any profit- sharing agreement; collateral trust certificate; preorganization certificate or subscription; transferable share; investment contract; viatical settlement contract or a fractionalized or pooled interest therein; life settlement contract or a fractionalized or pooled interest therein; voting trust certificate; certificate of deposit for a security; interest in a limited liability company and any class or series of those interests (including any fractional or other interest in that interest…; certificate of interest or participation in an oil, gas or mining title or lease or in payments out of production under that title or lease; put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof); or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency; any beneficial interest or other security issued in connection with a funded employees' pension, profit sharing, stock bonus, or similar benefit plan; or, in general, any interest or instrument commonly known as a "security"; or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing. All of the foregoing are securities whether or not evidenced by a written document. "Security" does not include: (1) any beneficial interest in any voluntary inter vivos trust which is not created for the purpose of carrying on any business or solely for the purpose of voting, or (2) any beneficial interest in any testamentary trust, or (3) any insurance or endowment policy or annuity contract under which an insurance company admitted in this state promises to pay a sum of money (whether or not based upon the investment performance of a segregated fund) either in a lump sum or periodically for life or some other specified period, or (4) any franchise subject to registration under the Franchise Investment Law (Division 5 (commencing with Section 31000)), or exempted from registration by Section or Calif. Corporations Code Sec

Securities Exchange Act of 1934 Lec.7 Sem 2, pp Corps Prof. McCann 20 Broader than the 1933 Act in that governs transactions that may not require registration Rule 10b-5, anti-fraud provision: unlawful to make materially untrue statement in connection with purchase or sale of a security (anti-insider trading statute) Registration required if >500 shareholders and >$10,000,000 in assets in corporation. (Sec. 12)

Securities Exchange Act of 1934 Lec.7 Sem 2, pp Corps Prof. McCann 21 Requires periodic reports from registered corporations. (Sec. 13) Sets out requirements for the contents and truthfulness of proxy solicitations (Sec. 14) Includes the Williams Act governing tender offers, outlaws materially untrue statements in connection with tender offer and requires registration of any tender offer which will result in 5% or more of ownership of shares Outlaws “short swing profits” by insiders (Sec. 16)

SEC Rule 14(a) Lec.7 Sem 2, pp Corps Prof. McCann Rule 14a-9 -- False or Misleading Statements No solicitation subject to this regulation shall be made by means of any proxy statement, form of proxy, notice of meeting or other communication, written or oral, containing any statement which, at the time and in the light of the circumstances under which it is made, is false or misleading with respect to any material fact, or which omits to state any material fact necessary in order to make the statements therein not false or misleading or necessary to correct any statement in any earlier communication with respect to the solicitation of a proxy for the same meeting or subject matter which has become false or misleading. 22

The Essence of 10b-5 Lec.7 Sem 2, pp Corps Prof. McCann Persons (insiders or not) Having material information not known to the investing public (or others with whom the person is dealing) Must disclose it prior to transacting or Must abstain from transaction until it is disclosed 23

10b-5 Lec.7 Sem 2, pp Corps Prof. McCann "Rule 10b-5: Employment of Manipulative and Deceptive Practices": It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange, (a) To employ any device, scheme, or artifice to defraud, (b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or (c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security." 24