October 22, 2015

DELAWARE INSIDER: “Mandatory” But Not Guaranteed: Delaware Court of Chancery Narrows the Broad Scope of Corporations’ Mandatory Advancement Provisions

Michael S. Swoyer

Section 145(a) and (b) of the Delaware General Corporation Law (DGCL) grant Delaware corporations the power to indemnify current and former directors, officers, and employees (the“Corporate Officials”) for costs incurred in proceedings that arise “by reason of the fact” that the person is or was a Corporate Official. Section 145(e) also allows, but does not require, corporations to advance the costs and expenses incurred in covered proceedings. Advancement will be made mandatory only by “a clearly worded by-law or contract making it [so].” Thompson v. The Williams Companies, Inc., 2007 WL 3326007, at *3 (Del. Ch. Jul. 31, 2007). Thus, mandatory advancement provisions are found in many certificates of incorporation, bylaws, and indemnification agreements. Where an unambiguous mandatory advancement provision exists, Delaware courts rarely strike down an advancement request due to failure to meet the “by reason of” requirement.

In two recent decisions, however, the Court of Chancery denied advancement claims made by Corporate Officials pursuant to mandatory advancement provisions because the claims did not arise “by reason of” the officials’ corporate authority or position. These decisions, Lieberman v. Electrolytic Ozone Inc. and Charney v. American Apparel, Inc., clarify the broadly-applied “by reason of” standard set forth in Section 145 and serve as a reminder that Delaware courts will not order advancement in every claim that relates to an official’s corporate position. This article will discuss the “by reason of” standard, examine the Court of Chancery’s decisions in Lieberman and Charney, and provide several key takeaways.

Section 145’s “By Reason Of” Requirement

The Delaware Supreme Court has explained the “by reason of” requirement as follows: “[I]f there is a nexus or causal connection between any of the underlying proceedings contemplated by section 145(e) and one’s official corporate capacity, those proceedings are ‘by reason of the fact’ that one was a corporate officer.” Homestore, Inc. v. Tafeen, 888 A.2d 204, 214 (Del. 2005). A causal connection exists if the official’s corporate powers “were used or necessary for the commission of the alleged misconduct.” Bernstein v. TractManager, Inc., 953 A.2d 1003, 1011 (Del. Ch. 2007). A causal connection does not exist if “the parties are litigating a specific and personal contractual obligation that does not involve the exercise of judgment, discretion, or decision-making authority on behalf of the corporation.” Paolino v. Mace Sec. Int’l, Inc., 985 A.2d 392, 403 (Del. Ch. 2009).

The Lieberman Decision

In Lieberman, two former executive officers (the “Officers”) of Electrolytic Ozone, Inc. (EOI), brought suit for advancement of legal expenses after EOI claimed the Officers had violated several contractual agreements entered into in connection with their employment. Generally, these claims included breach of contract for failing to return EOI property and information and comply with post-termination obligations. EOI’s corporate documents provided for advancement and indemnification to the fullest extent permitted under Delaware law. The Officers had also entered into separate indemnity agreements with EOI, which provided for mandatory indemnification and advancement in any legal proceeding brought “by reason of the fact” that the officer is or was an officer.

In addressing the Officers’ advancement claim, the court discussed the broad scope of the “by reason of” standard, but emphasized that advancement would be denied if the underlying claims were based on personal contractual obligations and the Corporate Official “did not need make use of any entrusted corporate powers in order to engage in the conduct that gave rise to the specific claims. . . .” Applying this standard to the claim before it, the court found that the underlying claims against the Officers did not exist “by reason of the fact” that they were EOI officials. The court observed that the Officers were no longer employed by EOI at the time of the alleged contractual violations, and the claims were “not dependent on any alleged on-the-job misconduct.” Thus, the court denied the Officers’ request for advancement.

The court also determined that the Officers were not entitled to indemnification for costs incurred seeking advancement from the court. Although the Officers’ indemnity agreements required indemnification for all good faith actions seeking advancement, the court found that Delaware corporations lacked the contractual power to compensate a party for costs incurred in an unsuccessful advancement claim.

The Charney Decision

The Standstill Agreement

In June 2014, Dov Charney, the founder and CEO of American Apparel, Inc. (the “Company”) was suspended from his position as CEO. Three weeks after he was suspended, Charney entered into a standstill agreement with the Company, which, among other things, obligated him to refrain from “acting to replace directors and from disparaging the company.” Under the terms of the standstill agreement, Charney was no longer permitted to serve as CEO, or as any other officer or employee of the Company. Charney signed the agreement in his personal capacity, without reference to any corporate affiliation.

In December 2014, Charney was formally terminated as CEO. In May 2015, the Company sued Charney for breaching the terms of the standstill agreement. In response, Charney made a demand on the Company for advancement of the legal costs incurred in connection with the standstill proceeding. The Company denied the request. Charney then filed suit in the Court of Chancery, alleging that he was entitled to advancement of all costs related to his defense pursuant to the terms of the Company’s certificate of incorporation and a separate indemnity agreement he had entered with the Company.

Advancement under the Company’s Certificate of Incorporation

The Company’s certificate of incorporation contained a mandatory indemnification and advancement provision that stated, in pertinent part:

The [Company], to the full extent permitted by Section 145 of the [DGCL] . . . , shall indemnify all persons whom it may indemnify pursuant thereto. Expenses (including attorneys’ fees) incurred by an officer or director in defending any . . . proceeding for which such officer or director may be entitled to indemnification hereunder shall be paid by the Corporation in advance of the final disposition . . . proceeding upon receipt of an undertaking by or on behalf of such director or officer to repay such amount if it shall ultimately be determined that he is not entitled to be indemnified by the Corporation as authorized hereby.

Charney argued that this provision made clear that the Company’s “advancement obligations are defined by and flow from its indemnification obligations” such that he was entitled to advancement as long as the Company could legally indemnify him for such costs. The Court of Chancery disagreed. Reiterating that advancement will only be mandated when the plain language of the contract “explicitly” requires it, the court found that the provision provided mandatory advancement only to those who were Corporate Officials at the time suit was filed against them. In so doing, the court observed that the first sentence of the provision, mandating indemnification, explicitly included both current and former Corporate Officials by mandating indemnification to the fullest extent permitted under Section 145, but the second sentence, mandating advancement, included only current officials. The court concluded that because the section of the provision addressing advancement lacked any reference to “former” Corporate Officials, only current Corporate Officials were entitled to advancement under the Company’s certificate of incorporation.

Advancement under the Indemnity Agreement

Charney next argued that he was entitled to advancement under the indemnity agreement, which provided that Charney was indemnified and entitled, upon request, to advancement for all expenses incurred in any proceedings that resulted from an “indemnifiable event.” The term “indemnifiable event” was defined by the Agreement as: “any event or occurrence . . . related to the fact that [Charney] is or was a director and/or officer . . . of the Company, . . . or by reason of anything done or not done by [Charney] in any such capacity.”

Although “related to the fact” was not defined in the indemnity agreement, Charney claimed that this language was broader than the “by reason of the fact” standard and encompassed a “but for” standard. He contended that he was entitled to advancement for the standstill proceeding because some of his alleged violations occurred before he was terminated as CEO and the substance of his alleged breaches was related to his role as a director and officer of the Company. Charney also alleged that “[b]ut for [his] former corporate service and his desire to regain the positions wrongfully taken from him, he never would have entered into the standstill agreement and could not have been accused of breaching it.”

The court, examining Court of Chancery precedent that used the phrase “related to the fact” interchangeably with “by reason of the fact,” rejected Charney’s overly broad “but for” standard. The court determined that requiring advancement merely because a former fiduciary would not have entered into the contract but for his role in the company would lead to absurd results. The court also found that to construe “related to the fact” more broadly than “by reason of the fact” would render the indemnification terms of the provision invalid under DGCL Section 145(a) and (b), which require satisfaction of the “by reason of the fact” standard. Thus, the court found that any broader standard for indemnification would be considered ultra vires, and held “related to the fact” to be the equivalent of “by reason of the fact.”

Applying the “by reason of” standard to Charney’s claim, the court found that he was not entitled to advancement because none of the alleged violations, which all took place after Charney was suspended as CEO and had resigned as director, were “causally connected to the use or misuse of Charney’s corporate power as a director or officer of [the Company].” First, the court addressed Charney’s claim that his entering into the standstill agreement was a result of his role as a Corporate Official. The court observed that Charney had entered into the standstill agreement in a personal capacity, at a time when he had no authority to bind the Company or execute contracts on its behalf. Accordingly, the court concluded that “Charney’s status within the Company may have formed part of the narrative leading to execution of the Standstill Agreement, but it did not create a causal nexus with the transaction itself.”

Next, the court rejected Charney’s argument that all of the contractual violations alleged were made possible only by his use of relationships he built as CEO and knowledge he gained as a director and officer of the Company. Charney’s attempt to use his reputation and social status as former CEO of the Company as a tool of persuasion to aid him in breaching the standstill agreement was not the type of “corporate power” that satisfied the causal connection required to meet the “by reason of” standard.

Finally, the court addressed Charney’s claim that some of the alleged violations of the standstill agreement occurred before he was formally terminated as CEO and thus satisfied the requisite standard of causality. In rejecting this claim, the court stated: “Although claims challenging actions taken when one holds the title of a corporate official typically satisfy the ‘causal connection’ standard, that condition is not dispositive. . . . The alleged breaches of the Standstill Agreement that these discussions may have caused were outside of and unrelated to Charney’s corporate powers, to the extent he still retained any such powers.” Accordingly, the court denied advancement.

Finally, the court rejected Charney’s claim that he was entitled to indemnification under the indemnity agreement for costs incurred in seeking advancement. As in Lieberman, the court held that regardless of what an indemnity agreement provides, indemnification will not be awarded to an unsuccessful claimant in a Section 145 action.

Takeaways

Satisfaction of Section 145’s “By Reason Of” Standard Is No Longer a Certainty

Lieberman and Charney, decided within two weeks of one another, provide warning that satisfaction of the “by reason of” standard should no longer be taken for granted in the Court of Chancery. One fact stressed throughout the court’s opinions was that much of the Corporate Officials’ alleged misconduct occurred post-employment. The decisions highlight the importance of this factor and the effect it will have in advancement proceedings. Stated simply, a Corporate Official seeking advancement for conduct that is arguably related to his or her former role as fiduciary, but which took place post-employment, must satisfy a higher burden under Section 145.

Section 145’s “By Reason Of” Standard Cannot Be Contractually Expanded

The court’s decision in Charney makes clear that an indemnification provision that purports to create a broader standard than “by reason of” is invalid under the DGCL. As the Charney court explained, a more expansive standard would exceed the corporation’s authority to indemnify and render the indemnification provision ultra vires.

While the court did not expressly address whether such a standard would be held invalid if it applied solely to advancement, its ruling as to indemnification is dispositive. Unlike indemnification, a corporation’s right to advance funds is not constrained by the “by reason of” standard. But Section 145(e) does require that any Corporate Official seeking advancement undertake to repay the funds advanced if it is “determined that such person is not entitled to be indemnified by the corporation.” Thus, while a provision mandating advancement for claims not meeting the “by reason of” standard may be legally valid, it would also be futile, as any monies advanced to the Corporate Official based on those claims would be promptly returned to the corporation. It follows that practitioners should not attempt to broaden the scope of the “by reason of” requirement for Corporate Officials in an indemnification or advancement provision. Those officials seeking broader protections would be better served in the alternate entity domain, as Delaware allows both limited liability companies and partnerships to indemnify and hold harmless any person “from and against any and all claims and demands whatsoever.”

Practitioners Must “Explicitly” Identify Who Is Covered in an Advancement Provision

Delaware courts have refused to recognize claims for advancement not granted in specific language clearly suggesting such a right. Corporate Officials who want to ensure they will be entitled to advancement both during their corporate service and after their corporate role has ended must do so “explicitly” within the mandatory advancement provision. The Charney decision also reaffirms that claims for advancement and indemnification are separate and distinct legal actions, and that a contractual obligation to indemnify both current and former Corporate Officials does not necessarily create an obligation to provide advancement to both current and former Corporate Officials. The express terms of the advancement provision must provide for that right. The Charney decision shows that this rule applies even if the terms of advancement are accompanied in the same provision by terms granting indemnification “to the fullest extent permitted by Delaware law.”

An Agreement Mandating Indemnification in Every Section 145 Action Is Invalid

Both decisions make clear that a contractual provision mandating indemnification for fees and expenses incurred by a Corporate Official in an unsuccessful Section 145 action is invalid under Delaware law. This is true even when the provision conditions indemnification on a finding that the losing claims were brought in good faith. This decision sounds in Delaware precedent and public policy, and requires Corporate Officials to carefully consider the merit of their advancement or indemnification claim before filing suit. 

Conclusion

Satisfaction of the “by reason of” requirement set forth in Section 145 should not be considered a foregone conclusion, especially when the underlying claim involves actions taken after the Official has been relieved of his or her corporate duties and is alleged to have violated a contract entered into in his or her individual, rather than corporate, capacity. While these two decisions denying advancement may be a rarity, they remind Corporate Officials of the importance of a well-drafted advancement provision, and that satisfaction of the “by reason of” requirement is not guaranteed merely because the claim has some relation to the fiduciary’s current or former role in the corporation.   

Michael S. Swoyer

Michael S. Swoyer is an associate with the Delaware Counsel Group, LLP. The author would like to thank former Delaware Supreme Court Justice Henry duPont Ridgely for his helpful comments and suggestions in drafting this article.