One of the most important sources of director protection is corporate  indemnification. But as significant as indemnification is for the protection of directors, the directors’ first line of defense, literally, is their right to advancement of their costs of defense. All too often, these two terms – advancement and indemnification – are used interchangeably, but they are in fact separate and distinct. Of critical importance, directors are entitled to the payment of their attorneys fees in advance of any determination that the directors are entitled to indemnification.


An interesting July 3, 2012 Ohio Supreme Court opinion (here) highlights the critical distinction between advancement and indemnification and examines the circumstances under which directors are entitled to advancement.



Samuel M. Miller (Sam M.) is a 25% shareholder and director of Trumbull Industries, a plumbing supply company. Sam M. is also Trumbull’s Vice President of Sales. Murray Miller (Murray) and Samuel H. Miller (Sam H.) are also Trumbull shareholders and directors. 


In 2002, a dispute arose in which Murray and Sam H. alleged that Sam M. had usurped a corporate opportunity for his personal advantage. In February 2003, Murray and Sam H. filed a complaint against Sam M. (among others) seeking injunctive relief and damages.


In September 2005, Sam M. sent Murray and Sam H. a memo informing them that he had reimbursed himself out of the Trumbull corporate treasury for the costs of defending himself against their complaint, after executing an “undertaking” under Ohio Code Section 1701.13 (E)(5)(a) to repay the amounts if it is determined he is not entitled to indemnification. The undertaking incorporated the specified statutory undertaking language.


In December 2006, both sides sought a judicial declaration regarding Sam M.’s rights to indemnification for his legal fees. Following an almost impossibly complicated procedural odyssey, the indemnification case made its way to the Ohio Supreme Court.


The July 3 Opinion

In a 6-1  majority opinion dated July 3, 2012 and written by Chief Justice Maureen O’Conner, the Ohio Supreme Court overturned the intermediate appellate court’s holding that the trial court had improperly ordered Trumbull to pay Sam M.’s attorneys’ fees and reinstated the trial court’s finding that Trumbull was in contempt for refusing to pay Sam M.’s attorneys’ fees.


In determining Sam M.’s rights, the “Court interpreted Ohio law, but looked to judicial decisions interpreting Delaware law for “insight,” as advancement is a “Delaware specialty.”


At outset, the Court made an important distinction, highlighting the fact that Sam M. sought “advancement,” not “indemnification.” Though the parties and the lower courts had used the terms “interchangeably,” the terms, “though related” are “not the same and should not be used as synonymous.”


Murray and Sam H. (hereafter, the appellees) argued, in reliance on the Ohio statutory provisions specifying when a director is entitled to indemnification, that Sam H. was not entitled to have his attorneys’ fees paid because he was not being sued for any “act or omission” he committed on behalf of the corporation. The appellees also argued that he was not entitled to indemnification of his fees because his acts were not within the protection of the business judgment rule.


The Supreme Court rejected these arguments, based as they were on the statutory standards for the entitlement to indemnification, on the grounds that “the advancement of fees is neither determined by nor dependent on whether a director is entitled to indemnification.” The only issue, the Court said, is “whether Sam M. is entitled to advancement of his expenses,” not whether he will ultimately be entitled to indemnification based on the adjudication of the allegations against him.


The Court said that Trumbull could not avoid its statutory advancement obligation because Sam M.’s conduct, if proven, “would foreclose indemnification due to an alleged breach of his fiduciary duties.” Allowing a corporation to “avoid advancement by asserting that a director breached his fiduciary duty would make the advancement statutory provisions pointless.”


The only prerequisite for advancement is the execution of the statutorily required undertaking to repay, which Sam M. had done. When the director seeking advancement has executed the undertaking, “the corporation is required to advance.”


The Ohio statutes provide, the Court noted, that a corporation may opt-out of these mandatory advancement provisions by adding a provision to its articles of incorporation specifying that the advancement provisions do not apply. However, Trumbull had not adopted an opt-out provision in its articles, and therefore, given that Sam M. had executed the required undertaking, there was no basis for Trumbull to withhold advancement.


Justice Terrence O’Donnell dissented, arguing that Sam M. was not entitled to advancement because the wrongful acts of which he was accused had allegedly been undertaken in his personal capacity or in his capacity as an officer (rather than as a director) of Trumbull. Either way, the acts had not been undertaken in the sole capacity (i.e., as a director) for which he was entitled to advancement under the relevant statutory provisions.



In my factual recitation above, I omitted the lengthy procedural history of the indemnification case. If nothing else, the tortured procedural history shows how contentious these kinds of disputes can become. Indeed, the original claim underlying the indemnification fight is now in its tenth year. The contentiousness in turn illustrates another point, which is the importance of working out the details of advancement and indemnification arrangements when all is calm and skies are clear. It is a terrible time to try to sort these issues out after the storm has hit.


The majority opinion did emphasize that under the relevant statutory provisions, Ohio corporations can amend their articles of incorporation to opt-out of the mandatory advancement provisions. However, I suspect that companies addressing these issues when all is calm are unlikely to include such an opt-out provision in the articles of incorporation. At that point, none of the directors have any way of knowing whether or not they might be the ones that would want to have their defense fees advanced, and so they would be unlikely to adopt such an opt-out provision.


After a dispute has arisen, a corporation or some of its board members may well want to withhold advancement from one or more directors. However, that simply underscores how important it is that the right to advancement is automatic. If it were any other way, after a falling out or during an intra-board dispute, a group of directors could act together to deprive another director of his or her rights and ability to defend themselves.


The automatic operation of the advancement requirement ensures that directors are able to defend themselves, even when (or perhaps particularly when) the allegations against them are serious. From time to time, controversies can arise when corporations are obliged to provide funds for directors’ defense when the directors are the subject of high-profile allegations. For example, as I discussed here, there were questions when BofA funded the defense for former Countrywide CEO Angelo Mozillo. Because the advancement rights are automatic (subject to only to the undertaking requirement), directors cannot be deprived of their defense protection even if they have become involved in controversy or they are the target of intra-corporate vindictiveness.


The advancement right is also very durable. In a July 30, 2008 Delaware Chancery Court opinion (here) in which then-Vice Chancellor Leo Strine held that the Sun-Times Media Group had to continue to advance the defense expenses of four former officers, including Lord Conrad Black, even though: 1) the four had been convicted of various criminal offenses; 2) the four had already been sentenced; 3) the convictions had been upheld on appeal; and 4) the company had already advanced $77 million in defense expenses for the four. Strine held that under Delaware statutory law and the applicable by-law provisions requiring advancement until "final disposition," the obligation to advance expenses continued until the "final, non-appealable conclusion" of the criminal action, which had not yet been reached.


Perhaps the most important aspect of the majority opinion is its insistence on the distinct difference between advancement and indemnification. All too often, observers and commentators, like the parties to this dispute and like the lower courts here, blur the distinction between the two. The two, though related, represent distinct statutory rights available for the protection of directors. Moreover, as the Court here emphasized, if mere allegations which if proven might provide a basis for withholding indemnification from a director were sufficient to deprive the director of his or her right to advancement, the statutory provisions relating to advancement would be meaningless. Advancement is available so that directors can defend themselves, without which the right of indemnification itself might also be rendered meaningless.


It should not be lost here that a critical prerequisite to the right of advancement is the provision of the undertaking to repay. This requirement is not a meaningless procedural step. Directors taking advantage of the right to advancement may in fact be required to repay amounts advanced in the event of a judicial determination establishing they are not entitled to indemnification. In many instances, when the time comes for repayment, the individuals lack resources out of which the might make the repayment. However, from time to time, corporations do successfully assert and establish their right of repayment. 


These issues surrounding the obligation to repay have recently been in the limelight, following the insider trading conviction of Rajat Gupta. Peter Lattman’s June 18, 2012 New York Times article discussing Goldman Sachs’ payment of Gupta’s legal fees and of its rights or repayment for the fees in the wake of Gupta’s conviction can be found here.


A potentially important issue that the majority opinion sidestepped but that the dissenting opinion stressed is the question of whether or not Sam M. was acting in capacity for which he is entitled to advancement when he engaged in the alleged misconduct of which he is accused. The majority opinion essentially said that it did not have to address the question because it had not been properly preserved on appeal. Had the majority addressed the question, the outcome of this appeal could well have been quite different.


For a basic overview of indemnification rights and the relationship of indemnification to D&O insurance, refer to my earlier post on the topic, here. I published the earlier post as part of my series on the “Nuts and Bolts” of D&O insurance; the complete series can be accessed here.


A July 2012 memorandum from the Squire Sanders law firm discussing the Ohio Supreme Court’s opinion can be found here.


Criminal Charges Against Former Officers of Failed Bank: It has been weeks since the FDIC has filed a civil suit against the former directors and officers of a failed bank; as reflected here, the FDIC’s last civil suit was filed in May, and that was the only civil lawsuit the FDIC has filed since April. But the FDIC has not been idle. A grand jury has returned a July 11, 2012 indictment (here) against four former officers of the failed Bank of the Commonwealth, or Norfolk, Virginia, as well as two of the bank’s customers. According to the FBI’s July 12, 2012 press release regarding the indictment (here), the investigation of the bank had been undertaking in collaboration and cooperation with the FDIC’s Office of Inspector General.


The Bank of the Commonwealth failed on September 23, 2011. The indictment alleges that the bank had grown rapidly between 2005 and 2009, largely based on the bank’s reliance on brokered deposits. In 2008, the volume of the bank’s troubled loans soared. The indictment alleges that from 2008 to 2011, the criminal defendants allegedly masked the bank’s true financial condition out of fear that the bank’s declining health would negatively impact investor and customer confidence and affect the bank’s ability to accept and renew brokered deposits.


To hide the bank’s deteriorating loan portfolio and condition, the defendants  allegedly overdrew demand deposit accounts to make loan payments, used funds from related entities—at times without authorization from the borrower—to make loan payments, used change-in-terms agreements to make loans appear current, and extended new loans or additional principal on existing loans to cover payment shortfalls.


The indictment also alleges that bank insiders also provided preferential financing to troubled borrowers to purchase bank-owned properties. These troubled borrowers were already having difficulty making payments on their existing loans; however, the financing allowed the bank to convert a non-earning asset into an earning asset, and the troubled borrowers obtained cash at closing to make payments on their other loans at the bank or for their own personal purposes. The indictment also alleges that troubled borrowers purchased or attempted to purchase property owned by bank insiders These real estate loans were fraudulently funded by the bank.


The bank’s former CEO, Edward Woodard, is charged with conspiracy to commit bank fraud, bank fraud, false entry in a bank record, multiple counts of unlawful participation in a loan, multiple counts of false statement to a financial institution, and multiple counts of misapplication of bank funds. The other defendants are charged with a variety of related charges.


These charges are far from the first criminal charges the enforcement authorities have filed as part of the current wave of bank failures. As discussed here (scroll down), the federal authorities are also pursuing criminal charges against certain former officers of the failed United Commercial Bank. The FDIC has also filed criminal charges against two former officers of Integrity Bank, as discussed here. There undoubtedly have been other criminal charges as well.


It is hard to tell from the outside, but it sure would be interesting to talk to somebody on the inside about when the FDIC upgrades its investigation of the circumstances surrounding a bank’s failure to a criminal investigation. The allegations in the indictment alone do not sound all that dissimilar from the kinds of things that the FDIC and that investors have alleged in connection with many other bank failures that have not involved criminal charges.


In any event, there undoubtedly will be other criminal charges to come in connection with other banks. At the same it is interesting that the pace of the FDIC’s filing of civil litigation in connection with the failed banks clearly has tailed off. Again, it is hard to tell from the outside what is going on, but it sure would be interesting to talk to somebody on the inside.