Indemnification of Directors: Framework and Applications

General Framework

The concept of indemnification of directors is not expressly provided for by the law; therefore, it constitutes an atypical contract.

As known, the legitimacy of atypical contracts is recognized when they, as in the present case, deserve protection, as consistently acknowledged by jurisprudence in this matter.

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Indemnification of Directors

An indemnification agreement, also known as a “manleva” contract, is an agreement by which the potential compensatory consequences of a breach are shifted to another party who guarantees the creditor.

While there are similarities with other typical contracts, there is a distinct resemblance to internal assumption of debt, wherein a third party (the assuming party) takes on the debtor’s position for a specific obligation. In indemnification, it is also an internal agreement, with the creditor remaining external to the relationship between the debtor and the third party.

However, in the indemnification agreement, it is not necessary (unlike in assumption of debt) for the debt to be determined in advance; it can be determinable by reference (it is sufficient for the parties to indicate the facts from which a compensatory obligation may arise, ensuring, however, as will be discussed, that a maximum amount is specified).

The indemnification agreement finds its basis in underlying or connected agreements, such as cases where acquisition procedures of controlling social interests have been initiated or, in any case, extraordinary operations involving the corporate structure to which the directors belong. It frequently occurs that in operations like those mentioned, ancillary agreements are included based on which, in addition to changing the current components of the target company’s governance, it is also established between the seller and the buyer that the same directors will be indemnified against any liability juridicial proceedings.

In the aforementioned cases, indemnification finds peculiar application.

 

Prerequisites for the Validity of Indemnification

In the previous section, certain characteristics of the indemnification contract were outlined. Briefly based on current jurisprudence in this matter, it is necessary to highlight that:

  • It is an agreement that refers (at the very least) to events from which director(s) liability may arise.
  • The events from which the liability obligation may arise must be specified.
  • A maximum amount (cap) for the compensation that can be sought from the directors as a result of a successful liability action against them must be expressly stated. Jurisprudence has applied the provision regarding the maximum guaranteed amount in the context of suretyship (Art. 1938 of the Italian Civil Code), which should be regarded as a general principle.
  • It is an agreement with internal effectiveness between the third party (indemnifier) and the indemnified party (director), as it is an agreement aimed at indemnifying the latter from the consequences of potential liability actions.
  • An indemnification that includes the director’s willful misconduct as a possible cause of compensation may be considered invalid (there is a debate as to whether gross negligence should also be excluded, as seemingly deduced from the general principles of the legal system).

 

Conclusions

In light of the above summary, indemnification can be an effective tool to allow the directors of the target company to be internally guaranteed by the buyer against the risk of being held liable for their management activities. It is essential that the indemnification agreement is clearly identified and regulated in accordance with the limits established by jurisprudence in this matter. Therefore, a case-specific assessment is certainly advisable for the best drafting of such agreement.

 

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