An important accessory to the indemnification rights of directors and officers is their right to have their defense expenses advanced while the claims against them are pending, before their ultimate right to indemnification has been determined. A frequently recurring issue is the question of when the company may withhold advancement. This issue often arises when new management has asserted claims against former managers they blame for problems at the company.
A recent decision by the Ontario Court of Appeal, applying Ontario and Canadian federal law, affirmed the holding of the lower court that Look Communications, the company involved, did not have to advance the costs certain former directors and officers incurred in defending claims the company had filed against them. Though the decision will be of greatest interest to directors and officers of companies in Canada, it nevertheless provides an interesting perspective on the rights of advancement here in the U.S. as well. A copy of the Ontario Court of Appeal’s July 4, 2013 opinion can be found here.
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 relied on Section 124(4) which provides that a corporation is permitted to advance defense fees only “with the approval of the court.” Look argued that this provision required the court to preliminarily 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.
As discussed here, in a September 28, 2012 decision, Justice Lawrence A. Pattillo of the Ontario Superior Court of Justice held that the individual directors and officers were not entitled to advancement. Among other things, Justice Pattillo held that under Section 124(4) court approval was required for advancement and that approval can be granted only if the officer or director claiming advancement “acted honestly and in good faith with a view to the best interests of the corporations.”
Justice Pattillo concluded that the company had made out a strong prima facie case that the former directors and officers had acted in bad faith by awarding themselves over 30% of the assets sales value, and authorizing the payment of the legal retainer on their own behalf before resigning.
The individuals appealed. On appeal, the individuals urged the appeals court to avoid imposing a merits-based threshold on advancement, arguing that were the court to impose such a threshold directors and officers would be required to litigate the merits of the underlying case in the separate action to determine whether or not they were entitled to advancement.
The July 4 Opinion
In a July 4, 2013 opinion written by Justice Robert J. Sharpe for a unanimous three-judge panel, the Ontario Court of Appeal dismissed the individuals’ appeal and affirmed the lower court’s ruling, holding that the statute “imposes a judicial filter on advance funding and the strong prima facie test for determining whether advancement should be denied is apt.” The Court added that the “test comports with the statutory requirement for court approval but also is sufficiently stringent to ensure that advance funding is ordinarily available to those claiming it unless there is strong evidence of bad faith.”
The individuals had attempted to argue, in reliance on Delaware law, that their defense expenses ought to be advanced without scrutiny of their conduct, subject only to an undertaking to repay if it is later determined based on the outcome of the underlying proceeding that they are not entitled to indemnification. Justice Sharpe wrote:
In my view, apart from demonstrating that it is motivated by a very different underlying policy than adopted by Parliament in Section 124(4), Delaware law does not assist us in resolving the issue on this appeal. Unlike the CBCA, the Delaware General Corporation Law does not require court approval of the advancement of legal expenses. (Citations omitted). By enacting Section 124 (4), Parliament has determined that whatever corporate by-laws or agreements promise, by statute, advancement of legal costs requires court approval and court approval should be withheld if the officer or director has not acted in good faith and in the best interests of the corporation. That represents a fundamentally different policy choice that that prevailing in Delaware, a policy choice that this court must respect.
Justice Sharpe went on to conclude that the individuals’ indemnification agreements did not alter the statutory requirement for judicial supervision. Justice Sharpe agreed that if the agreements’ wording alone controlled, advance funding could only be denied on the basis of a final and conclusive judicial determination. However, the court concluded, the “issue must be decided on the basis of the overriding language of Section 124(4)” which provides that the right of advancement is “subject to court approval before trial.”
The Court of Appeal concluded based on the evidentiary record presented to the court below that the lower court had not erred in concluding that the company had made out a strong prima facie case of bad faith, and properly concluded that the individuals were not entitled to advancement of their costs in defending the claims the company had filed against them.
In the Ontario appellate court’s view, the indemnification provisions in the Canada Business Corporations Act represent “a fundamentally different policy choice than that prevailing in Delaware.” Section 124(4) “imposes a pre-trial good conduct filter,” while under the Delaware statutes “advance costs are awarded without any scrutiny of the conduct.”
Section 124(4) does indeed provide for indemnification under the related statutory provisions “with the approval of the court.” In that respect, the appellate court’s conclusions are unremarkable – they are simply a reflection of the statutory language specifying a requirement for judicial supervision for the implementation of statutory indemnification rights. However, the Ontario Court not only held that the “judicial filter” requirement applied to the individuals’ statutory indemnification rights, but it also held that the requirement for judicial supervision applied to the interpretation of the individuals’ contractual indemnification rights.
It is not at all uncommon for new management to pursue claims against a company’s former management. New managers often blame the former managers for problems besetting the company. One very good reason that well-advised managers will seek to put contractual indemnification agreements in place is so that if the managers are the target of claims after they have left the company, they can claim their rights of indemnification notwithstanding the arrival of new management. The contractual indemnification provides them an extra measure of protection and some level of assurance that their rights will be protected if claims later arise.
The Ontario court’s interpretation of the statutory provision to require judicial supervision not only of statutory indemnification rights but also of contractual indemnification rights at a minimum adds an additional procedural layer for individuals seeking to rely on their indemnity rights to defend themselves. This result is not necessarily compelled by the statutory language, and even the appellate court agreed that if indemnification issue were determined solely on the basis of the language of the agreement, “advance funding could only be denied on the basis of a final and conclusive judicial determination.” However, the Ontario appellate court nevertheless found that the statute’s “overriding language” imposed requirement of preliminary judicial supervision even on the individuals’ contractual rights.
In addition to the additional procedural burdens these requirements put on the individuals seeking indemnification, there is the additional concern of the impact of a “finding of a strong prima facie case of bad faith” on any D&O insurance that may be available to these individuals. There are at least two potential impacts, one having to do with the applicable retention and the other having to do with the possible operation of policy exclusions.
The judicial determination that the individuals are not entitled to advance funding means as a practical indemnification is not available to them. The individuals would then seem to have an argument that the Side A retention is applicable to their claim for policy benefits. In most instances, the Side A retention is zero, meaning that — if coverage is otherwise available under the policy — the individuals would have a basis on which to argue that they are entitled to first dollar coverage under the policy.
Which of course begs the question of whether coverage is otherwise available under the policy. One issue an insurer undoubtedly would explore in these circumstances is whether or not the judicial determination would trigger the preclusive effect of the conduct exclusions. The individuals would argue that even a judicial finding of “a strong prima facie case of bad faith” is not enough to trigger the conduct exclusion, which typically will provide that it applies only after a “final adjudication” The court’s prima facie determination is an interim, interlocutory determination; it is by no means a final adjudication. Moreover, the finding of bad faith arguably represents something other then a determination of criminal, fraudulent or even dishonest conduct. The individuals would appear to have a substantial basis on which to argue that this type of judicial determination would not implicate the typical conduct exclusion wording.
It is worth observing as a final note that though this case represents the rare case where individual directors and officers were denied their rights to advancement of their defense expenses, the outcome is a direct reflection of the specific statutory language involved and of the unusual circumstances presented. But even though the result if the outcome of very jurisdiction-specific and case-specific factors, it nevertheless provides an interesting example from which to consider the rights of individual directors and officers to have their costs of defending claims advanced on their behalf.
Special thanks to loyal reader James Camp for providing me with a copy of the Canadian appellate court’s opinion.