Derivative Plaintiff Entitled to Advancement of Attorneys’ Fees to Defend Counterclaims Brought by Corporation

On May 14, 2014, Justice DeStefano of the Nassau County Commercial Division issued a decision in Schlossberg v. Schwartz, 2014 NY Slip Op. 50760(U), ruling that a corporation's by-laws and New York's Business Corporations Law ("BCL") entitled the plaintiff in a shareholder derivative action to advancement of attorneys' fees and costs incurred in defending counterclaims asserted against him. Schlossberg provides a careful reading of the relevant provisions of the BCL concerning indemnification and advancement of attorneys' fees for corporate officers and directors.

In Schlossberg, the plaintiff, a shareholder, director and former officer of the defendant corporation, filed derivative claims on behalf of the company. In the answer, the company asserted counterclaims against the plaintiff, seeking damages for misappropriation of confidential information, unfair competition, unjust enrichment, conversion, breach of fiduciary duty, breach of the duty of loyalty, violation of BCL § 720 and corporate waste. Claiming that he was entitled to mandatory indemnification under the company's by-laws, the plaintiff filed a motion, pursuant to the BCL and the company's by-laws, seeking permissive advancement of his defense fees and expenses, during the pendency of the lawsuit.

Where a corporation is obligated to indemnify an officer or director but not to advance his litigation expenses, the BCL, although not New York's LLC law, generally permits a court to exercise its discretion and order advancement of "reasonable expenses, including attorneys' fees . . . necessary in connection with [the] defense," BCL § 724(c), subject to the caveat that the officer or director may not retain the advanced funds if a judgment or other final adjudication establishes that his acts were committed in bad faith or were the result of deliberate dishonesty. BCL § 725. In Schlossberg, the company raised two defenses to the motion for advancement: (1) that the indemnification provisions of the by-laws apply but only to third-party claims; and (2) that the indemnification provision did not apply to the counterclaims because they were unrelated to the plaintiff's "mere status as director or officer." Justice DeStefano rejected these arguments and directed the Company to advance $54,477.72 for fees and expenses incurred to date, referring disputes concerning future advancement requests to a special referee.

Sections 722(a) and (c) of the BCL permit a corporation to agree to indemnify directors and officers:

A corporation may indemnify any person made . . . a party to an action or proceeding (other than one by or in the right of the corporation to procure a judgment in its favor), whether civil or criminal, including an action by or in the right of any other corporation of any type or kind . . . . by reason of the fact that he was a director or officer of the corporation.

BCL § 722(a) (emphasis added).

A corporation may indemnify any person made . . . a party to an action by or in the right of the corporation to procure a judgment in its favor by reason of the fact that he, his testator or intestate, is or was a director or officer of the corporation
. . . .

BCL § 722(c) (emphasis added).

Section 8.1 of the company's by-laws provides:

The Corporation shall indemnify any person made, or threatened to be made, a party to any action, suit or proceeding by reason of the fact that he . . . is or was a director or officer of the Corporation, . . . against all judgments, fines, amounts paid in settlement and reasonable expenses, including attorneys' fees, actually and necessarily incurred by him in connection with the defense of such action, . . . to the fullest extent and in the manner set.

The company argued that Section 8.1 of the by-laws only provided indemnification for third-party claims—not claims asserted by the company itself. It compared the language of the by-laws to BCL § 722(c), noting that, unlike the statute, the by-laws did not refer to claims "by or in the right of the corporation." It therefore asked the court to infer that the provision was enacted pursuant to BCL § 722(a), which is limited to third-party claims (i.e., an action "other than one by or in the right of the corporation"). Justice DeStefano disagreed, concluding that the by-law's provision mirrors the language of BCL § 722(a), but omits the parenthetical phrase "other than one by or in the right of the corporation"), leading to the conclusion that it covers both third-party claims and claims by the corporation.

Recent Appellate Division decisions outside the context of director and officer liability, have construed indemnification provisions in commercial contracts narrowly to exclude the award of fees arising from disputes between the parties to the contract, as opposed to third-party claims. See, e.g., Gotham Partners, L.P. v. High River Ltd., 76 A.D.3d 203, 206 (1st Dep’t 2010) ("for an indemnification clause to cover claims between the contracting parties rather than third party claims, its language must unequivocally reflect that intent"). Although the decision does not expressly address that line of cases, Justice DeStefano effectively distinguished such precedent through his reading of the BCL.

With respect to the company's argument that indemnification was not permitted because the counterclaims did not arise "by reason of the fact" that the plaintiff was a director of the company, the Court noted that there was little case law on the meaning of that phrase, but the Delaware Courts had adopted "a broad interpretation . . ., which would include a wide array of claims that might be asserted against a director or officer." Under this interpretation, "if there is a nexus or causal connection between any of the underlying proceedings . . . and one's official corporate capacity, those proceedings are 'by reason of the fact' that one was an officer or director." In a leading case (in which Schlam Stone & Dolan represented certain parties), Ficus Invs., Inc. v. Private Capital Mgt., 61 A.D.3d 1 (1st Dep’t 2009), the First Department, applying Delaware law, noted the public policy advanced by such a broad interpretation—i.e., "to help attract capable individuals into corporate service by easing the burden of litigation related expenses." In light of those principles, Justice DeStefano concluded that "as pleaded," the counterclaims against [the plaintiff] appear to be indemnifiable, and he was therefore entitled to indemnification during the pendency of the action. It is also notable that Justice DeStefano permitted advances here even though they came up in the context of defending a counterclaim as opposed to an action brought by the corporation against the officer or director in the first instance. This is also consistent with Delaware case law.

This decision reflects a continuing trend of the New York Courts following the approach of the Delaware courts in construing the BCL and corporate by-laws broadly to provide officers and directors with indemnification and advancements of defense costs, even though New York law generally construes indemnification provisions narrowly in other commercial contexts.