Thinking About the Limits of Corporate Officials' Defense Cost Advancement Rights

In addition to indemnification, corporate directors and officers also may have the right under applicable law and corporate by-laws to have their costs of defense advanced before the ultimate right to indemnification has been determined. A question that often arises is whether a corporation may withhold advancement. A recent decision from the Ontario Superior Court of Justice determined that a corporation did not have to advance the costs certain former directors and officers had incurred in defending claims the corporation had filed against them. The decision is clearly significant for directors and officers of companies in Canada, but it also provides an interesting context within which to consider the limits of advancement rights here in the U.S. as well. A copy of the September 28, 2012 decision can be found here.

Background

Look Communications is a technology company organized under the Canadian Business Corporations Act (CBCA). Its business fortunes faltered and its board ultimately approved a sale of its assets through a court-supervised process. Following the sale, the board authorized the payment of bonuses to certain officers and directors and also allowed corporate officials to receive compensation for the cancellation of certain stock option and other equity rights. Altogether the company paid over $20 million in bonus compensation and in compensation for the options and equity rights, representing about 32% of the asset sale proceeds.

After the award of the bonuses and other compensation was disclosed, shareholders filed significant objections. The board authorized the payment of $1.5 million in retainers to law firms acting on behalf of the directors and officers, who then resigned once the retainers had been paid.

In July 2011, after an investigation by Look's new management, Look commenced an action against the former directors and officers alleging that the individuals had breached their fiduciary duties and seeking repayment of the bonuses and equity cancellation payments. The individual defendants, in reliance on the company's by-laws as well as a written indemnification agreement, demanded that the company advance their expenses incurred in defending against the company's lawsuit. The company refused and the individuals filed separate actions seeking judicial declarations of their advancement and indemnification rights.

Under Section 124 of the CBCA, a company may indemnify its directors and officers for legal proceedings in which the individuals become involved as a result of their association with the company, as long as the individual seeking indemnification "acted in good faith and with a view of the best interests of the corporation." Look's by-laws made these permissive indemnification rights mandatory. A separate indemnification agreement required Look to advance legal costs in any proceeding, including one brought by Luck itself, subject only to an obligation to repay if a court determined that the individual was not entitled to indemnification.

The former directors and officers argued in reliance on the by-laws and indemnification agreement that they were entitled to automatic advancement of their defense fees; that they were also entitled to a presumption that they had acted in good faith; and that their ultimate entitlement to indemnification could only be determined after a full evidentiary trial.

Look argued in reliance on Section 124(4) that a corporation is permitted to advance defense fees only "with the approval of the court," which, Look argued, required the court to assess the parties' conduct to determine whether the persons seeking advancement had acted in good faith. Look further argued that the individuals had not acted in good faith and were not entitled to advancement and submitted affidavits and other materials in support of this position.

The Court's Ruling

In his September 28, 2012 opinion, Justice Laurence A. Pattillo noted the court's critical supervisory role in the statutory indemnification scheme, observing that "in my view, requiring the court to scrutinize indemnification and advances in circumstances where a corporation has sued its former directors and officers ensures corporations cannot arbitrarily avoid indemnity and advancement obligations to former directors and officers who have acted in good faith and in the best interests of the corporation, while at the same time ensuring that directors and officers who have not so acted cannot further harm the corporation."

Justice Pattillo further observed that the court's supervisory role still obtained notwithstanding the fact that the parties had a written indemnification agreement that made the rights to advancement automatic. He said that just as a corporation cannot indemnify a director or officer if the statutory requirement of good faith conduct has not been met, "neither ... can they contract to exclude the court's discretion to approve advancement."

Justice Pattillo further concluded that the court approval specified under Section 124(4) requires the consideration of evidence. Because the directors and officers are entitled to a presumption that they acted in good faith, the burden is on the corporation seeking to avoid advancement to establish a "strong prima facie case" that the statutory standard has been met.

Based on the affidavits and other material Look submitted, Judge Pattillo concluded that Look had presented sufficient evidence that all but one of the individuals seeking advancement had acted in bad faith, in their own self interest and not in the best interest of the company, and therefore were not entitled to advancement.

Discussion

This case represents an unusual circumstance where a corporation was able to avoid its obligation to advance defense expenses of its directors and officers. It is, however, a reflection of both the unusual factual circumstances and the particular features of the applicable Canadian statutory provisions. The indemnification provisions in the Delaware Corporations Code (which governs the many U.S. corporations incorporated in Delaware) do not contemplate the same level of judicial supervision that the court exercised here. Indeed, Justice Pattillo specifically declined to consider Delaware case law, notwithstanding the fact that Delaware courts are "well regarded in this area of the law," noting that the Delaware statutory provisions "contain no statutorily imposed conduct requirement."

The outcome is also a reflection of the unusual facts involved. As the Osler law firm noted in its October 11, 2012 memorandum about the decision (here), the facts in this case (at least as found on an interim basis) "appear to have been exceptional" and that in many other cases, courts would be unable to make the kind of determination made here solely on the basis of a "paper record," without live witnesses and credibility determinations.

While the outcome here may be the result of the uncommon factors, what is not uncommon is for these types of advancement disputes to arise, particularly where, as here, the claims have been brought against former management by their successors and the claims is asserted on behalf of the corporation. The successor management often contends that the corporation should not have to fund the defenses of the persons whose conduct they are claiming to have harmed the corporation.

As I noted in a recent post discussing an advancement decision under Ohio law (here), the general pattern and practice is that corporate directors and officers are entitled to have their defense fees advanced, subject only to an undertaking to repay in the event of an ultimate determination that the individual is not entitled to indemnification.

The Ontario court's decision is noteworthy not only because of the critical supervisory role the court played in the determination of the individual's advancement rights, but also because of the court's determination that it was obligated under the statute to play the supervisory role notwithstanding the parties' agreement to make the right of advancement automatic.

For corporations frustrated by their advancement obligations, the level of court supervision exercised here may represent an attractive model. I will say though that there is also something to be said for the rights of corporations and their directors and officers to arrange their indemnification and advancement obligations contractually, at a time when there are no claims pending, and for those arrangements to be respected when the claims do arise. I also note a concern about substantive legal rights being decided on less than a full evidentiary record. Here, because these individual defendants will now not have their defense fees advanced, they may be forced to settle simply to avoid financial ruin, whether or not that outcome is actually warranted by the merits of the dispute.

The Story of the Year?: Two recent guest posts on this site have discussed the question of fiduciary liability insurance coverage for settler liability claims. First, on September 19, 2012, Kim Melvin and John Howell of the Wiley Rein law firm posted a guest post (here) commenting on the New York Court of Appeals decision in Federal Ins. Co. v. IBM (2012), which was followed by an October 11, 2012 commentary by Rhonda Prussack and Larry Fine of AIG (here).

Now in a October 15, 2012 post on his blog, The D&O E&O Monitor (here) , Joe Monteleone has added his observations about the exchange of views in the two guest posts on this site. Among other things, Joe refers to the questions that the New York case has raised as "the story of the year." Joe provides some interesting additional insight on the issues as well.

Homeowners File Latest Libor-Related Antitrust Case: On October 4, 2012, a group of homeowners filed the latest class action lawsuit against the banks that participated in setting the Libor rates. In their complaint, which can be found here, the homeowners, who had adjustable rate mortgages tied to the Libor benchmark, allege that they were harmed by the rate-setting banks' alleged manipulation of the rates. The homeowners assert claims based on the Sherman Act, the New York antitrust laws and RICO. Although there have been numerous antitrust actions previously filed against the Libor rate setting banks, this lawsuit, according to press reports, is the first to be filed on behalf of homeowners.

Read other items of interest from the world of directors & officers liability, with occasional commentary, at the D&O Diary, a blog by Kevin LaCroix.

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