Corporate boards should review and update the arrangements with the corporation for indemnification and advancement of expenses of directors and officers in light of a disturbing decision earlier this year in which the Delaware Chancery Court upheld a bylaw amendment retroactively eliminating a former director’s rights.

In Schoon v. Troy Corporation, 2008 WL 821666 (Del. Ch.), a former director (Bohnen) and his ally on the board (Schoon) got into a dispute with the rest of the current board of Troy Corporation. In September 2005, Schoon sued Troy to obtain certain corporate books and records under §220 of the Delaware General Corporation Law. The board answered the complaint in October 2005 suggesting past fiduciary breaches by Bohnen and Schoon as part of Troy’s defense but not actually including counterclaims against them. In November 2005, the board amended Troy’s bylaws to eliminate mandatory advancement of expenses for former directors (as opposed to current directors) made parties to litigation as a result of their service on the board. In February 2006, Troy brought a separate action against Bohnen and Schoon for breach of fiduciary duties.

When Bohnen sought advancement of his attorney’s fees, Troy refused, arguing that it was no longer subject to mandatory advancement of expenses to former directors because of the bylaw amendment. Bohnen sued under the advancement bylaw, claiming it had created a vested contractual right to advancement at the time he took office that could not subsequently be changed without his consent.

Vice Chancellor Lamb held that Bohnen was not entitled to advancement because his rights under the bylaw did not vest until he was actually named as a party in the February 2006 fiduciary duty lawsuit – after the November 2005 bylaw amendment. The allegations of fiduciary breach in Troy’s answer to the previous §220 lawsuit were not sufficient to vest the rights because they did not amount to actual filed claims against Bohnen.

The Schoon decision should serve as a wake-up call to corporate directors and officers that mandatory indemnification and advancement rights may not be as protective as they believed if contained only in corporate bylaws. Under Delaware and other state corporate statutes, bylaws may be changed unilaterally by the board. Unless the bylaw is absolutely clear that such rights become vested at the point of taking office or at the point when the acts and omissions that are the subject of subsequent litigation occur, the Delaware courts will apparently take the position that rights do not vest until an action naming the director or officer as defendant is actually filed. This leaves far too much room for retroactive tampering.

What should boards do to provide greater certainty of protection in light of Schoon? Some commentators have suggested verifying that the bylaws are clear that indemnification and advancement rights are contractual, vest upon taking office or upon occurrence of the acts or omissions in question and may not be amended to the detriment of the director or officer after that point. The board’s unilateral ability to modify bylaws, however, makes it uncertain whether even the most well-drafted bylaw provision may not be subject to retroactive modification. Others have suggested putting mandatory indemnification and advancement arrangements in the corporation’s certificate of incorporation, which cannot be amended without both board and shareholder approval. Although this makes retroactive modification more difficult, it still may not make consent by the director or officer necessary in a situation in which indemnification or advancement is crucial.

Unless or until the Delaware Supreme Court overturns Schoon or the Delaware legislature acts, the only way to ensure that these important protections may not be altered retroactively without the director’s or officer’s consent is to put them into an indemnification and advancement contract signed by the corporation and the relevant director or officer. Many corporations already have such contracts. Delaware corporations that do not currently have such contracts with their directors and officers should reassess their indemnification and advancement arrangements in light of Schoon and seriously consider putting such contracts in place without delay.

Originally published as a Dorsey Corporate Update.