Insight Developing an Executive Protection Plan Part II: Exculpation

Last month we introduced a series of newsletters that will examine the elements of an executive protection plan. This month we focus on exculpatory provisions in a business’s governing documents and the role these provisions play in the executive protection plan.

We use the term “executive protection plan” to refer to the mechanisms available to mitigate the personal liability of the members of a business’s governing body, such as the board of directors, and the Business’s officers (collectively, “Executives”).

Almost all states allow corporations and limited liability companies (LLCs) to include provisions in their governing documents that limit an Executive’s liability to the business and its owners. Exculpatory provisions do not affect an Executive’s liability to third-parties. We will address protection against third-party liability in future newsletters on indemnification and insurance.

Although significant variation can exist from state to state and between corporations and LLCs in the exact phrasing or scope of the exculpatory provision, the general pattern is that exculpatory provisions will eliminate monetary liability except monetary liability for: (i) receiving an improper financial benefit; (ii) intentional inflicting harm on the business; (iii) approving an unlawful distribution; or (iv) intentionally violating criminal law. Because of the inevitable differences in state laws, we advise our clients to review the scope of the exculpation provisions in their governing documents within the context of the laws of the relevant jurisdiction, whether they are forming a corporation or LLC in Idaho, Delaware, or any other state.

The advantage of the exculpatory provision is that it permits Executives to operate the business in accordance with their best judgment and without concern that they will have personal monetary liability to the business’s owners, except under very limited circumstances. By contrast, if a business does not have an exculpatory provision in its governing documents, the Executives face monetary liability in any shareholder claim for breach of fiduciary duty, regardless of the facts of the case.

Exculpatory provisions also have a significant limitation: they may not keep an Executive from being ensnared in litigation. Court decisions are inconsistent regarding when an Executive may raise the exculpatory provision as a defense in litigation. When litigation concerns an alleged breach of the Executive’s duty of care, Delaware courts allow Executives to assert the exculpatory provision in a motion to dismiss that the Executive files as the Executive’s first response to a law suit. This rule allows the Executive a quick and relatively inexpensive exit from the litigation. Delaware courts, however, permit the Executive to assert the exculpatory provision only as an affirmative defense in a later stage of the litigation when the claim is for a breach of the Executive’s duty of loyalty. This rule significantly lowers the value of the exculpatory provision because the Executive cannot avoid the time, expense, and stress of litigation.

Although no Idaho court decisions have addressed this issue directly, we believe that Idaho law allows corporate directors to raise the exculpatory clause in a motion to dismiss that is the director’s first response to a law suit. The Idaho statute governing liability of corporate directors requires the plaintiff who sues a corporate director to allege and prove that the exculpatory provision does not bar the plaintiff’s claims. Idaho’s statute is based on the American Bar Association (ABA) Model Business Corporation Act, and the ABA Official Comment supports this view. Even so, if the plaintiff alleges conduct that is not protected by the exculpatory provision, such as intentional infliction of harm on the business or a breach of the duty of loyalty, the Executive will not be able to escape the litigation until sufficient facts are developed in discovery to disprove the allegations. The outcome for an Executive of an Idaho LLC is unclear but is more likely to follow the less favorable Delaware rule described above.

Despite the shortcomings, an exculpatory provision is an essential executive protection that should be included in the governing documents of almost every business. Yet in our experience many businesses omit this provision. Executives should review their business’s governing documents to determine if it includes an exculpatory provision, and if they do not, Executives should consider asking the business’s owners to amend the governing documents to include one. We can help businesses and Executives review their current governing documents for exculpatory provisions and related executive protections and can guide you through the process of amending the governing documents to correct gaps and weaknesses.

For more information please contact a member of our Business group or call 208.344.6000.