Protecting Directors from Civil Liability Through Indemnification

Protecting Directors from Civil Liability Through Indemnification

A likely question an entrepreneur may ask themselves early in their venture is “how do I protect the directors of my company?”  They may (or perhaps should) think about this because in all likelihood, they will be one of, if not the only director of their business during its early phases following incorporation. Please note: this post assumes that the company in question is incorporated under the Business Corporations Act of Alberta
 
Indemnifying Directors
Indemnification refers to one party’s agreement to secure another against responsibility for their actions, or to give security for the reimbursement of a person in case of an anticipated loss[1].  In this case, it refers to a corporation’s agreement to make a director whole, should they be subject to legal proceedings as a result of their actions in their capacity as a director of the corporation.
 
Generally speaking, the Business Corporations Act (the Act) allows corporations to indemnify their directors for both legal costs incurred, as well as any monetary damages that arise from a director’s conduct in relation to the business.  In order to benefit from such indemnification, a director must have “acted honestly and in good faith with a view to the best interests of the corporation[2].”
 
An Alberta corporation is not permitted to indemnify its directors for their actions if they have not acted honestly and in good faith with a view to the best interests of the corporation – that is, if they have breached their fiduciary duty to the corporation.  If a director has breached his or her fiduciary duties to the corporation, any indemnity the corporation has offered will be void.
 
The scope of conduct that may be indemnified under the Act is very broad.  Section 124(1) of the Act states:
“…a corporation may indemnify a director or officer of the corporation, a former director or officer of the corporation…against all costs, charges and expenses, including an amount paid to settle an action or satisfy a judgment, reasonably incurred by the director or officer in respect of any civil, criminal, or administrative action or proceeding to which the director or officer is made a party by reason of being or having been a director of that corporation or body corporate…”
 
When Are Directors Entitled to Indemnification?
In Alberta, a director is only entitled to indemnification by the corporation for all costs, charges and expenses, including an amount paid to settle an action or satisfy a judgment in a civil context if they (i) were substantially successful in defending the claim; (ii) acted honestly and in good faith with a view to the best interest of the corporation; and (iii) is fairly and reasonably entitled to indemnity[3].

A corporation that does not contain indemnity provisions in its by-laws will still be liable for any loss incurred so long as these criteria are met. If indemnification provisions found in either the corporation’s by-laws, or in an agreement between the corporation and a director impose mandatory indemnification, it will of course be liable to do so.
 
How to Indemnify Directors
Indemnification provisions can be found within a corporation’s by-laws.  If a corporation seeks to provide its directors with a wide range of protection, these provisions do not need to be particularly robust.  Any attempt to predict the types of conduct or liabilities that the corporation anticipates indemnifying its directors against may simply limit its ability to protect its directors.
 
If the company’s bylaws do not provide indemnification provisions that are acceptable to a potential director, indemnification provisions may be included within a written agreement between the corporation and the director.  This method provides the greatest flexibility as each agreement can be tailored to suit the needs of both the corporation and the individual director.
 
Some things that indemnification provisions should contemplate include whether the corporation is required, or simply permitted to indemnify its directors (and in which circumstances), the timing of indemnity payments, and out of court settlement.  Indemnification provisions that do not require the corporation to indemnify its directors should also consider a mechanism to oblige the corporation to do so such as arbitration.
 
Corporations that provide the widest range of indemnity to their directors often simply state in its indemnification provisions that the corporation must indemnify the director to the greatest extent authorized under the relevant law.  Where it is desirable to minimize the short-term financial impact of litigation on directors, indemnity provisions may require the corporation to advance defence costs as they are incurred.  Such provisions should also contemplate whether the corporation is required to indemnify the director for out of court settlements, as opposed to simply court judgments.

What Indemnification Provisions Do Not Cover
Indemnification provisions do not cover directors’ actions when they are not made in good faith with a view to the best interests of the corporation. 

In cases where a director is being sued by the corporation or its shareholders, including in derivative actions, a corporation may only indemnify a director for their legal expenses.  This leaves directors exposed to liability for corporate or shareholder damages arising from their action (or inaction as the case may be).  Why is this? Most derivative actions against directors include a claim for breach of fiduciary duty.  If this claim is successful, and a breach has been found, a director will have been found not to have acted in good faith with a view to the best interests of the corporation, and indemnity would not be available in any event.
 
Hamish Gray is a member of the BLG Business Venture Clinic and is a third-year law student at the Faculty of Law, University of Calgary. 

REFERENCES:
[1] Black’s Law Journal; 2nd ed; online, <a href="https://thelawdictionary.org/indemnify/" title="INDEMNIFY">INDEMNIFY</a>
[2] Business Corporations Act, RSA 2000 cB-9 s124 [the Act]
[3] Act supra note 2 s124(3)