What to Watch for in Proxy Season 2023: Officer Exculpation

Recent amendments to the Delaware General Corporation Law (“DGCL”) have led public companies to propose new protections for their corporate officers, thereby forcing shareholders to consider whether they should give up their right to sue those officers for claims of negligence and breaches of their fiduciary duty of care.

Companies incorporated in Delaware, with the approval of shareholders, now have the ability to adopt “officer exculpation” provisions in their certificates of incorporation to provide certain officers with liability protection previously available only to corporate directors. The Delaware law on exculpation was originally designed to only apply to directors, as their role is so different from that of officers, and it made sense to protect directors from liability so they could properly serve shareholders. Although the roles of directors and officers have not changed since the law was initially crafted, the amended law now makes those same liability protections available to officers.

The amendments were prompted in part by the prevalence of litigation directed at companies, particularly in the context of mergers and acquisitions. Difficulties hiring executives and frivolous litigation, along with insurance and other cost issues, are a few of the reasons why companies may seek to adopt officer exculpation provisions.

The amendment does not fully protect corporate officers from liability. Officers will only be protected from liability from claims brought against them on behalf of shareholders. Officers will still be liable for derivative claims brought on behalf of the company, but derivative claims are typically at the direction of the board. As such, while exculpation provisions will still not fully protect officers from liability, they will protect officers from direct liability from shareholders. By approving an amendment to adopt exculpation provisions, shareholders will effectively be giving up this important right to sue corporate officers for claims of negligence and breaches of their fiduciary duty of care.

What Officer Exculpation Means for Proxy Season 2023

Since the rules were amended in August 2022, we have already identified 19 companies in our research coverage – 10 in 2022 and nine in 2023 – that have proposed to adopt officer exculpation provisions. As such, we expect numerous companies to propose similar provisions for shareholder approval at annual meetings in the 2023 proxy season. We will be evaluating these proposals on a case-by-case basis to determine whether boards have provided a robust and justifiable rationale for why shareholders should support adoption of these provisions and give up their right to hold corporate officers accountable.

Shareholders will need to consider the value to companies of adopting such provisions against their own rights as owners. In addition, in assessing the extension to officers of liability protections that were originally crafted specifically for directors, it is worth considering their differing roles and responsibilities.

What terms do investors need to understand, and in what specific circumstances will officers be exculpated from personal liability? This post/report provides background on the topic, an overview of key considerations for investors and public companies, and an explanation of Glass Lewis’ approach.

Amendment to the DGCL

In August 2022, the Delaware General Assembly amended Section 102(b)(7) of the DGCL, thereby granting corporations incorporated in Delaware the ability to amend their certificates of incorporation to adopt officer exculpation provisions that eliminate or limit the personal monetary liability of certain corporate officers for breaches of their fiduciary duty of care. Under Section 102(b)(7), a corporation must affirmatively elect to include an exculpation provision in its certificate of incorporation. Prior to the change in law, Delaware corporations were only permitted to adopt exculpation provisions that applied to their directors.

Who is Now Covered?

Per the amendment, Delaware corporations are authorized to provide for the exculpation of the president, chief executive officer, chief operating officer, chief financial officer, chief legal officer, controller, treasurer or chief accounting officer, or otherwise the “named executive officers” identified in the corporation’s SEC filings, in addition to certain individuals who have agreed to be identified as officers of the corporation.

What is Covered?

• Corporate exculpation provisions under the DGCL apply to claims for breaches of the duty of care, but not to breaches of the duty of loyalty.
• Exculpation provisions also do not apply to acts or omissions not in good faith or that involve intentional misconduct, knowing violations of the law, or transactions involving the receipt of any improper personal benefits.
• Exculpation provisions apply against claims brought on behalf of shareholders. However, they do not apply to derivative actions brought on behalf of the company (typically at the direction of the board).

Key Terms to Understand

Fiduciary Duty of Care and Duty of Loyalty

All corporate officers and directors owe fiduciary duties to the corporations and shareholders that they serve. The fiduciary duty of loyalty dictates that corporate officers and directors must act in the best interests of the corporation and shareholders, and not in their own self-interest. The fiduciary duty of care dictates that corporate officers and directors must act in good faith and with reasonable care and diligence in the decisions and actions they make.

Corporate exculpation provisions under the DGCL apply only to claims for breaches of the duty of care, and not to breaches of the duty of loyalty.

The Role of Officers and Directors

Directors are generally responsible for oversight of the corporation and ensuring the long-term best interests of shareholders are met, while officers are generally responsible for the day-to-day management and operations of the business. The board of directors delegates authority to manage the corporation to the officers. Given this distinction and corporate officers’ direct involvement in managing the business, directors should be able to rely upon officers to implement proper controls and communicate potential concerns to the board of directors. As discussed below, should the officers fail in performing this duty, the right to bring a suit against those officers should ultimately rest with the shareholders of the company.

Derivative Litigation

Officer exculpation provisions specify that officers may not be exculpated from claims brought against them by, or on behalf of, the corporation (i.e., derivative actions). However, in practice this does little to preserve shareholders’ right to file suit. While shareholders are technically able to launch derivative actions, they must generally either first make a demand on the board to pursue the claim or demonstrate that such demand would have been futile. To demonstrate demand futility, shareholders must show that a majority of directors benefitted from the challenged act or face personal liability from the claim, or otherwise had their independence compromised. Therefore, unless shareholders can make the substantial showing required to establish demand futility, the board will retain the ultimate authority to pursue derivative claims for breaches of the duty of care against officers.

What Would Officers Be Protected From?

Under officer exculpation provisions, corporate officers would be protected from personal monetary liability from lawsuits by shareholders that claim those officers breached their fiduciary duty of care by acting negligently or recklessly while performing their duties. Examples of this include officers preparing potentially misleading proxy statement disclosures to gain shareholder approval of a merger. Disclosure claims related to incomplete or misleading climate disclosures could also be something officers would be protected from. Other examples of negligence by corporate officers might include failure to implement proper policies, controls and procedures to ensure appropriate management of business risks and/or communication of any misconduct.

Corporate Adoption of Officer Exculpation Provisions

At present, three avenues exist for companies incorporated in Delaware to adopt officer exculpation provisions in their certificate of incorporation. In most cases, companies seeking to adopt officer exculpation provisions must propose an amendment to their certificate of incorporation for shareholder approval; since the August 2022 amendment, some 19 companies have already put such proposals on their annual meeting ballots. However, controlled companies can adopt officer exculpation provisions without shareholder approval. Companies entering public markets through an IPO, spin-off or direct listing can also include officer exculpation provisions as part of their new certificate of incorporation.

Glass Lewis’ View

We generally believe that some protection from liability may be reasonable to protect directors against certain suits so that these directors feel comfortable taking measured risks that may benefit shareholders. However, given the differences in the role of directors and officers, we have adopted a more cautious stance when providing recommendations on the adoption of such provisions for officers.

We believe that the officers of public companies are well-compensated for the risk of litigation they take on and identify this factor as an important contrast between the roles of corporate officers and their director counterparts. Shareholders should be reluctant to relinquish their rights to pursue claims for breaches of duty of care against corporate officers without some clear demonstration of the benefit to the company and its shareholders of adopting such provisions.

We will evaluate proposals to adopt officer exculpation provisions closely, on a case-by-case basis. We will generally recommend voting against proposals eliminating personal monetary liability for breaches of the duty of care for corporate officers, unless a compelling rationale is provided by the board, and the provisions are reasonable, meaning that they do not go beyond the fullest extent permitted by law.

Looking Ahead

Despite our concerns, we remain committed to a case-by-case evaluation of all proposed amendments that intend to exculpate the officers of Delaware companies. In determining our vote recommendation, we benefit from transparent disclosure wherever possible. For example, where companies can demonstrate that the proposal is intended to address some material disadvantage, such as officer retention or persistent and frivolous litigation, we may adopt a more favorable view of officer liability limitations.

We will continue to monitor further developments regarding officer exculpation and liability limitation as more companies pursue adoption of such provisions. Thus far, we have identified 19 companies in our research coverage that have proposed such provisions. In the upcoming proxy season, we expect that numerous Delaware-incorporated companies will propose these provisions — although as they generally require an amendment to the certificate which must be approved by shareholders, it remains to be seen how many companies will do so and win majority shareholder support.  We expect continued engagement and discussion with companies and shareholders close to this issue will further our ability to assist shareholders in weighing the benefits and drawbacks of any given exculpatory amendment.