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When a Director is Sued, Who Pays the Bill?
By Steven S. Weil, Esq., and Thomas M. Ware, II, Esq.
Must an association indemnify a current or prior director sued for conduct taken on the association’s behalf – in other words, pay for the director’s legal fees, settlements, or judgments? The answer is “sometimes and assuming certain conditions are met.”
Is indemnification mandatory?
California Corporations Code §7237 says a director is entitled to mandatory indemnification only if the director prevails “on the merits” of a claim based on conduct as the association’s agent. Thus, the right to indemnity is decided on a case-by-case basis and cannot be determined until the case concludes. There is no obligation to indemnify until the director wins.
Did the director prevail “on the merits” in the underlying claim?
Whether a director prevailed is not always obvious. If the director won the case because the plaintiff waited too long to sue (violating the statute of limitations), was it on the merits? What if the director prevailed on some but not all parts of the claim? Or what if there was a settlement and no resolution on the merits?
Sometimes, in the case against the director, the court will determine whether the director is entitled to indemnity. However, if not, the board must evaluate whether the director prevailed. All indemnification decisions should be made at an executive session meeting. The minutes should detail the board’s basis for agreeing or not agreeing to indemnify. Only directors who are not seeking indemnity should participate in the meeting. If the number of directors participating is less than a quorum, the indemnity question should be put to a membership vote.
Can the board indemnify a director who lost or settled the underlying claim? Can the Bylaws mandate indemnification when the director does not prevail?
Yes, if the board determines that the losing director acted in good faith and association’s best interest, the disinterested directors (or the membership) can authorize indemnification. The Bylaws can be amended to provide for this “discretionary indemnity.”
Can the director be indemnified even if the Bylaws are silent?
Yes. CC §7237 vests the board with discretion to indemnify the director irrespective of express authority to do so in the Bylaws so long as the director acts in good faith.
• The statute’s subjective good faith requirement provides the board with broad discretion to indemnify, or to refuse to indemnify, a director who fails to prevail, or who has not yet prevailed.
Can litigation defense costs be advanced before the director prevails?
Yes. While a final decision on the director’s mandatory right to indemnity cannot be made until the claim concludes, a board can but is not required to agree to advance legal expenses to defend the claim. To do so, the director provides the association with an “undertaking” to repay the association if it ultimately turns out the director was not entitled to indemnity. An undertaking could be a bond or other financial instrument. In California, a promise from the director that they will repay the association for expenses advanced if they are ultimately denied indemnity might be acceptable. Each situation must be separately analyzed.
What if there is insurance?
There is an exception to the rule limiting indemnification until the conclusion of the claims, and this concerns insurance. Generally, an insurer must immediately defend directors and prior directors when they are sued, regardless of whether the association has a duty to indemnify, even over the board’s objection. Such defense and indemnity rights depend on timely reporting and other insurance conditions. But even this protection has a wrinkle: if the insurance policy has a “self-insured retention” (“SIR”) (basically like a deductible) that must be paid before the insurer’s obligation to pay defense costs “kicks in,” the director may yet be faced with having to pay this retention “up front” before insurance is triggered. The director likely will ask the association to advance this cost. If the association itself has also been sued, the “SIR” may be satisfied by the association’s payment for itself.
What is the manager’s role?
Management should recommend that the board obtain the broadest possible liability coverage with the smallest SIR. Having an insurance broker explain defense and indemnity coverages to the board is advisable. To maximize insurance coverage, claims against directors must be reported timely. Management should involve counsel quickly to assist in communicating with the director(s) that are the target of a claim. Management should work with counsel to draft the notices, assist in the indemnity voting process, and communicate with the director concerning their indemnity requests.
