When Delaware Companies Are Required to Advance Fees

A recent Delaware Chancery Court case may send Delaware companies scrambling to review their bylaws to determine if they are required to advance fees in more instances than first thought. On June 23, 2008, in an instance of first impression, the court held that a company had to advance fees to its prior outside litigation counsel in subsequent litigation by the company against the law firm, under the company bylaws covering advancement of fees for its “agents.”

Just four days earlier, the court issued two other opinions in advancement of fees cases which also emphasized that the language of a company's advancement of fees provision is essential to defining when a company has to advance fees. The first case held that a company cannot withhold advancement of fees to its former directors under a broadly worded advancement of fees provision, just because the former directors refused to accept settlement proposals in the underlying securities litigation. The second case held that where the company was only obligated to provide advancement of fees for the defense or other defensive disposition of actual or threatened proceedings, the company had no obligation to advance fees to a former board member who had filed a lawsuit against the company following his removal for cause from the board.

Delaware General Corporation Law Section 145 gives a Delaware corporation the power to indemnify and provide advancement of attorneys' fees to its officers, directors, employees or agents. While the advancement authority in Section 145 is permissive, many corporate bylaws or articles of incorporation contain mandatory advancement provisions and, as the three new decisions show, it is the specific wording of the bylaws that often dictates just who is (or is not) covered for advancement of fees.

Outside Litigation Counsel Is Company's Agent to Whom Fees Must Be Advanced

Vice Chancellor Parsons held that Spira Footwear, Inc. had to advance fees to its prior outside litigation counsel in Jackson Walker v. Spira Footwear, Inc., 2008 WL 2487256 (Del. Ch. June 23, 2008). The specific facts of this case, which led to Spira suing Jackson Walker for breach of fiduciary duty after Jackson Walker had represented Spira in prior litigation, are not likely to be often duplicated. The case does open the door, however, for outside litigation counsel, and possibly other consultants or service providers of a company, to seek and be granted advancement of fees where the relationship has soured into litigation. The underlying litigation was among the shareholders of Spira for control of the corporation, and Jackson Walker represented Spira in the litigation at a time when the former majority shareholders controlled the company. Following the conclusion of that litigation, the challenger shareholder acquired control of Spira, fired Jackson Walker as Spira's counsel and filed an action against Jackson Walker on behalf of Spira for breach of fiduciary duties and negligence. In addition to suing Spira in Texas state court to collect on outstanding invoices, Jackson Walker sought advancement of its fees incurred in defense of the lawsuit filed against it by Spira.

Spira's bylaws stated that expenses, including attorneys' fees, incurred in defending a civil or criminal action “shall be paid” by Spira in advance of the final disposition of the action on behalf of “the Director, officer, employee or agent.” The only issue was whether Jackson Walker qualified as an “agent” under Spira's bylaws, and the court held that it did. Relying on a 2003 Delaware Chancery Court opinion that an agent was someone who acted on behalf of a company in relations with third parties, the court held that Jackson Walker, in its role as litigation counsel to Spira, acted on behalf of Spira in relations with third parties and those were the actions for which Spira was suing Jackson Walker. Noting that Section 145 should be broadly interpreted, the court held that Jackson Walker was therefore an “agent” for purposes of advancement of fees.

The court clarified, however, that attorneys would not be considered agents under Section 145 when the attorneys performed only corporate/transactional work or other similar advisory work where they did not interact with third parties on behalf of the company. Importantly, no fees would be advanced under Section 145 for an action by the company against the attorneys for legal malpractice.

Company Cannot Withhold Advancement of Fees Due to Disagreement with Directors' Settlement Posture

Barrett v. American Country Holdings, Inc., 951 A.2d 735 (Del. Ch. June 20, 2008), decided by Vice Chancellor Strine, took American Country Holdings to task for withholding advancement of fees to its former directors. American brought an action against its former directors for securities fraud, and the applicable directors and officers' insurance policy initially covered the former directors' fees. Once the insurance policy limits were exhausted, the former directors brought the subject action for advancement of fees. American refused to advance fees because the directors rejected settlement proposals in the underlying securities litigation, which would require the entry of judgment in favor of the company and assignment of any rights the former directors had against the insurer. Because American told the directors it would not collect on the judgment, American argued that the former directors forfeited their right to advancement by unreasonably refusing settlement. The Delaware Chancery Court soundly rejected American's argument.

American's charter required that the company advance legal expenses to former officers and directors “to the fullest extent permitted by ' Section 145.” The court held that under Section 145, the company was “not free to withhold advancement from the Former Directors as some form of pressure strategy to extract assignments, judgments, breaches of contract, and pledges of cooperation from them.” Therefore, a company must advance fees to its directors, even if it has brought an action against them for securities fraud, and even if it does not like the position the directors are taking in defending the action, under Section 145, unless otherwise limited.

Advancement of Fees for Defense of Action Does Not Extend to Action Filed By Former Board Member Against Company

In Donohue v. Corning, 949 A.2d 574 (Del. Ch. June 20, 2008), Vice Chancellor Strine interpreted Expansion Capital Partners, LLC's advancement of fees provision that Expansion would advance fees “incurred in connection with the defense or disposition of any claim, action, suit, or proceeding, whether civil, criminal, administrative or investigative, in which the Covered Person is involved, as a party or otherwise, or with which the Covered Person may be threatened ',” holding it did not cover advancement of fees for an action filed by a former board member against Expansion.

Donahue, the former managing partner of Expansion, was removed for cause by a vote of the non-managing members on Expansion's board. Donahue then filed litigation against Expansion to determine the control of Expansion, and sought advancement of his fees in the case he initiated. The court rejected Donahue's argument that he was bringing the litigation for the benefit of the investors, noting the issue was not for whose benefit the underlying litigation was brought, but whether the litigation fell under the contractual language of the applicable advancement of fees provision.

Donahue also argued that he was “threatened” to be removed for cause and his lawsuit addresses that threat, but the court determined that a cause of removal is not a “proceeding” as contemplated by the advancement provision. Because “Expansion has nearly unfettered contractual discretion in determining whether to grant advancement, Donohue must establish that he is entitled to advancement under the terms of Expansion's Advancement Provision itself.” In the court's view, the best reading of the advancement provision is that “it only provides advancement to a person covered by that provision who is in a defensive posture, in the sense of responding to an action or other proceeding relating to his official capacity.” The court therefore strictly applied the terms of the relevant advancement provision limiting advancement to defensive proceedings.

Is It Time to Update Your Advancement of Fees
Provision?

While companies could arguably delete a mandatory advancement of fees provision completely, the absence of any mandatory provision could make it hard for the company to recruit capable directors and officers. Instead, all three Delaware Chancery Court decisions emphasize the importance of tailoring and limiting the specific language contained in advancement of fees provisions.

A logical reaction to Jackson Walker might be to delete “agent” altogether from the list of those for whom the company must advance fees, and for some companies that works. There are, however, valid reasons for companies to keep the reference to agent in their bylaws. For example, a company may normally retain consultants who are acting as the company's agent, and for whom the company does intend to advance fees if the consultants are sued for their work at the company. A better solution, therefore, is to clarify the bylaws, to specifically state that “agent” does not include attorneys, auditors, or other service providers.

Jackson Walker provided companies with another option to ensure against advancing fees to their outside litigation counsel, when it commented that “courts should be reluctant to interpret ' 145 and bylaws that implement it as displacing the more specific contractual arrangements that are typically drafted between corporations and outside contractors, such as attorneys, investment bankers, engineers, and information technology providers.” Therefore, as long as the contract between the company and the outside contractor/service provider specifies that the company will not advance fees to those outside contractors, the contracts will trump the company's bylaws. The best time to negotiate this type of language with attorneys or other service providers is at the beginning of the relationship, before the relationship deteriorates to the point that it had in Jackson Walker.

If not already included, Donohue supports including a “defensive” limitation in the fee advancement provision, as a way of ensuring that no covered persons can seek advancement of attorneys' fees from the company for actions they have affirmatively filed against the company. While most directors and officers seeking advancement of fees are defendants, including a defensive limitation on the advancement of fees obligation covers situations such as in Donohue, where there is a corporate control or corporate governance dispute, and should also stop covered persons from using the advancement of fees provision when they file other types of litigation, such as employment disputes.

Finally, Barrett suggests that a company consider whether to include limiting language so that the company does not have an obligation to advance fees to covered persons when the company itself has brought the action against the covered person. With such a limitation, fees would still be advanced in an action filed by a shareholder or other third party, but not in actions filed directly by the company. At the least, companies should understand that a grant of advancement of fees “to the fullest extent permitted by Section 145″ or “to the fullest extent permitted by law” is very broad, and does cover actions by the company against the officer or director, with no exceptions.

Conclusion

Donohue recognized that companies have “nearly unfettered contractual discretion in determining whether to grant advancement.” Delaware companies should ensure they are exercising this discretion to their benefit before a situation arises, rather than being surprised as to when they must advance fees. These cases do not automatically support revised advancement of fees provision. Instead, a company should review its advancement of fees provision to determine whether a revision to the advancement of fees provision could limit the company's obligation to advance fees in the future, rather than blindly copying the broad language from Section 145 or a form advancement of fees provision.

Kimberly S. Greer is Of Counsel in the San Diego offices of Morrison & Foerster LLP. Her practice focuses on defending SEC enforcement actions and shareholder litigation. She may be reached at 858-720-7992 or [email protected].

A recent Delaware Chancery Court case may send Delaware companies scrambling to review their bylaws to determine if they are required to advance fees in more instances than first thought. On June 23, 2008, in an instance of first impression, the court held that a company had to advance fees to its prior outside litigation counsel in subsequent litigation by the company against the law firm, under the company bylaws covering advancement of fees for its “agents.”

Just four days earlier, the court issued two other opinions in advancement of fees cases which also emphasized that the language of a company's advancement of fees provision is essential to defining when a company has to advance fees. The first case held that a company cannot withhold advancement of fees to its former directors under a broadly worded advancement of fees provision, just because the former directors refused to accept settlement proposals in the underlying securities litigation. The second case held that where the company was only obligated to provide advancement of fees for the defense or other defensive disposition of actual or threatened proceedings, the company had no obligation to advance fees to a former board member who had filed a lawsuit against the company following his removal for cause from the board.

Delaware General Corporation Law Section 145 gives a Delaware corporation the power to indemnify and provide advancement of attorneys' fees to its officers, directors, employees or agents. While the advancement authority in Section 145 is permissive, many corporate bylaws or articles of incorporation contain mandatory advancement provisions and, as the three new decisions show, it is the specific wording of the bylaws that often dictates just who is (or is not) covered for advancement of fees.

Outside Litigation Counsel Is Company's Agent to Whom Fees Must Be Advanced

Vice Chancellor Parsons held that Spira Footwear, Inc. had to advance fees to its prior outside litigation counsel in Jackson Walker v. Spira Footwear, Inc., 2008 WL 2487256 (Del. Ch. June 23, 2008). The specific facts of this case, which led to Spira suing Jackson Walker for breach of fiduciary duty after Jackson Walker had represented Spira in prior litigation, are not likely to be often duplicated. The case does open the door, however, for outside litigation counsel, and possibly other consultants or service providers of a company, to seek and be granted advancement of fees where the relationship has soured into litigation. The underlying litigation was among the shareholders of Spira for control of the corporation, and Jackson Walker represented Spira in the litigation at a time when the former majority shareholders controlled the company. Following the conclusion of that litigation, the challenger shareholder acquired control of Spira, fired Jackson Walker as Spira's counsel and filed an action against Jackson Walker on behalf of Spira for breach of fiduciary duties and negligence. In addition to suing Spira in Texas state court to collect on outstanding invoices, Jackson Walker sought advancement of its fees incurred in defense of the lawsuit filed against it by Spira.

Spira's bylaws stated that expenses, including attorneys' fees, incurred in defending a civil or criminal action “shall be paid” by Spira in advance of the final disposition of the action on behalf of “the Director, officer, employee or agent.” The only issue was whether Jackson Walker qualified as an “agent” under Spira's bylaws, and the court held that it did. Relying on a 2003 Delaware Chancery Court opinion that an agent was someone who acted on behalf of a company in relations with third parties, the court held that Jackson Walker, in its role as litigation counsel to Spira, acted on behalf of Spira in relations with third parties and those were the actions for which Spira was suing Jackson Walker. Noting that Section 145 should be broadly interpreted, the court held that Jackson Walker was therefore an “agent” for purposes of advancement of fees.

The court clarified, however, that attorneys would not be considered agents under Section 145 when the attorneys performed only corporate/transactional work or other similar advisory work where they did not interact with third parties on behalf of the company. Importantly, no fees would be advanced under Section 145 for an action by the company against the attorneys for legal malpractice.

Company Cannot Withhold Advancement of Fees Due to Disagreement with Directors' Settlement Posture

Barrett v. American Country Holdings, Inc. , 951 A.2d 735 (Del. Ch. June 20, 2008), decided by Vice Chancellor Strine, took American Country Holdings to task for withholding advancement of fees to its former directors. American brought an action against its former directors for securities fraud, and the applicable directors and officers' insurance policy initially covered the former directors' fees. Once the insurance policy limits were exhausted, the former directors brought the subject action for advancement of fees. American refused to advance fees because the directors rejected settlement proposals in the underlying securities litigation, which would require the entry of judgment in favor of the company and assignment of any rights the former directors had against the insurer. Because American told the directors it would not collect on the judgment, American argued that the former directors forfeited their right to advancement by unreasonably refusing settlement. The Delaware Chancery Court soundly rejected American's argument.

American's charter required that the company advance legal expenses to former officers and directors “to the fullest extent permitted by ' Section 145.” The court held that under Section 145, the company was “not free to withhold advancement from the Former Directors as some form of pressure strategy to extract assignments, judgments, breaches of contract, and pledges of cooperation from them.” Therefore, a company must advance fees to its directors, even if it has brought an action against them for securities fraud, and even if it does not like the position the directors are taking in defending the action, under Section 145, unless otherwise limited.

Advancement of Fees for Defense of Action Does Not Extend to Action Filed By Former Board Member Against Company

In Donohue v. Corning , 949 A.2d 574 (Del. Ch. June 20, 2008), Vice Chancellor Strine interpreted Expansion Capital Partners, LLC's advancement of fees provision that Expansion would advance fees “incurred in connection with the defense or disposition of any claim, action, suit, or proceeding, whether civil, criminal, administrative or investigative, in which the Covered Person is involved, as a party or otherwise, or with which the Covered Person may be threatened ',” holding it did not cover advancement of fees for an action filed by a former board member against Expansion.

Donahue, the former managing partner of Expansion, was removed for cause by a vote of the non-managing members on Expansion's board. Donahue then filed litigation against Expansion to determine the control of Expansion, and sought advancement of his fees in the case he initiated. The court rejected Donahue's argument that he was bringing the litigation for the benefit of the investors, noting the issue was not for whose benefit the underlying litigation was brought, but whether the litigation fell under the contractual language of the applicable advancement of fees provision.

Donahue also argued that he was “threatened” to be removed for cause and his lawsuit addresses that threat, but the court determined that a cause of removal is not a “proceeding” as contemplated by the advancement provision. Because “Expansion has nearly unfettered contractual discretion in determining whether to grant advancement, Donohue must establish that he is entitled to advancement under the terms of Expansion's Advancement Provision itself.” In the court's view, the best reading of the advancement provision is that “it only provides advancement to a person covered by that provision who is in a defensive posture, in the sense of responding to an action or other proceeding relating to his official capacity.” The court therefore strictly applied the terms of the relevant advancement provision limiting advancement to defensive proceedings.

Is It Time to Update Your Advancement of Fees
Provision?

While companies could arguably delete a mandatory advancement of fees provision completely, the absence of any mandatory provision could make it hard for the company to recruit capable directors and officers. Instead, all three Delaware Chancery Court decisions emphasize the importance of tailoring and limiting the specific language contained in advancement of fees provisions.

A logical reaction to Jackson Walker might be to delete “agent” altogether from the list of those for whom the company must advance fees, and for some companies that works. There are, however, valid reasons for companies to keep the reference to agent in their bylaws. For example, a company may normally retain consultants who are acting as the company's agent, and for whom the company does intend to advance fees if the consultants are sued for their work at the company. A better solution, therefore, is to clarify the bylaws, to specifically state that “agent” does not include attorneys, auditors, or other service providers.

Jackson Walker provided companies with another option to ensure against advancing fees to their outside litigation counsel, when it commented that “courts should be reluctant to interpret ' 145 and bylaws that implement it as displacing the more specific contractual arrangements that are typically drafted between corporations and outside contractors, such as attorneys, investment bankers, engineers, and information technology providers.” Therefore, as long as the contract between the company and the outside contractor/service provider specifies that the company will not advance fees to those outside contractors, the contracts will trump the company's bylaws. The best time to negotiate this type of language with attorneys or other service providers is at the beginning of the relationship, before the relationship deteriorates to the point that it had in Jackson Walker.

If not already included, Donohue supports including a “defensive” limitation in the fee advancement provision, as a way of ensuring that no covered persons can seek advancement of attorneys' fees from the company for actions they have affirmatively filed against the company. While most directors and officers seeking advancement of fees are defendants, including a defensive limitation on the advancement of fees obligation covers situations such as in Donohue, where there is a corporate control or corporate governance dispute, and should also stop covered persons from using the advancement of fees provision when they file other types of litigation, such as employment disputes.

Finally, Barrett suggests that a company consider whether to include limiting language so that the company does not have an obligation to advance fees to covered persons when the company itself has brought the action against the covered person. With such a limitation, fees would still be advanced in an action filed by a shareholder or other third party, but not in actions filed directly by the company. At the least, companies should understand that a grant of advancement of fees “to the fullest extent permitted by Section 145″ or “to the fullest extent permitted by law” is very broad, and does cover actions by the company against the officer or director, with no exceptions.

Conclusion

Donohue recognized that companies have “nearly unfettered contractual discretion in determining whether to grant advancement.” Delaware companies should ensure they are exercising this discretion to their benefit before a situation arises, rather than being surprised as to when they must advance fees. These cases do not automatically support revised advancement of fees provision. Instead, a company should review its advancement of fees provision to determine whether a revision to the advancement of fees provision could limit the company's obligation to advance fees in the future, rather than blindly copying the broad language from Section 145 or a form advancement of fees provision.

Kimberly S. Greer is Of Counsel in the San Diego offices of Morrison & Foerster LLP. Her practice focuses on defending SEC enforcement actions and shareholder litigation. She may be reached at 858-720-7992 or [email protected].