Publications

November 13, 2014

Litigation is expensive; in a business divorce, the expense can be crushing for a former director or officer in an adversarial relationship with current management. Many companies provide protection for their officers and directors against that possibility by incorporating indemnification and litigation advances provisions in their bylaws or operating agreements. A recent NYLJ column examined the issues that frequently arise with respect to director and officer liability: When an officer or director is sued by his or her own company for misconduct, under what circumstances must the company indemnify or advance litigation expenses to the defendant where the company's bylaws or operating agreement require payment only when the defendant was sued 'by reason of the fact that [her or she] is or was a director, officer, employee or agent of the corporation.' See Joseph M. McLaughlin, 'Determining Indemnifiable Conduct,' NYLJ, Oct. 14, 2010, at 5. That column explored how Delaware law broadly construes such provisions to maximize the scope of indemnification and advances available to officers and directors in keeping with Delaware's policy of making sure qualified people are willing to serve as officers and directors of Delaware companies.

This column examines how New York's courts have begun following Delaware's lead with respect to advancement and indemnification of officers' and directors' legal expenses but have yet to decide several important issues concerning indemnifying and advancing the legal expenses of officers and directors.

New York Cases

Surprisingly, New York courts have only recently begun addressing the scope of indemnification and advances provisions as they apply to corporate officers and directors. The most significant and first appellate case to address these issues is Ficus v. Private Capital Management, LLC in which the author served as counsel for the corporate officers. In Ficus, a Florida limited liability company sued several of its former officers for breach of fiduciary duty, conversion, and unjust enrichment, alleging that they had misappropriated millions of dollars in funds and assets.

The company argued that a provision in its operating agreement requiring it to advance the litigation expenses of its former officers did not apply because the former CEO had been the subject of multiple preliminary injunctions relating to alleged misconduct on his part. In one of the last opinions written by then-Presiding Justice Jonathan Lippman before he was elevated to Chief Judge, the Appellate Division, First Department, rejected this argument.

The First Department began its discussion by noting the persuasive force of the well developed body of Delaware law governing the entitlement of corporate officers and directors to indemnification and advancement of their litigation expenses because 'Delaware courts have had ample opportunity to address these issues.'¹ Next, the First Department held that contractual provisions requiring advancement of officers' and directors' legal expenses must be construed broadly to ensure that corporate officials receive 'immediate interim relief from the personal out-of-pocket financial burden of paying the significant on-going expenses inevitably involved with investigations and legal proceedings.''²

As for the argument that allegations of misconduct on the part of the former officers deprived them of their mandatory contractual right to advancement of their litigation expenses, the court stated that '[m]ere allegations of theft will not relieve the Company of its obligation to advance expenses, and a request for advancement is not meant to become an adjudication of the merits of the case against the officer.'³ And that court rejected the argument that preliminary rulings can deprive a corporate officer of a right to indemnification or advances: unless the bylaws or operating agreement state otherwise, only a final adjudication can have that effect.

Like Delaware's courts, the First Department reasoned that, because officers' and directors' rights to advancement and indemnification of their expenses were contractual, companies could limit their exposure to these liabilities by drafting their bylaws and operating agreements to limit or eliminate advancement or indemnification provisions. The First Department then remanded the case for further proceedings to determine the reasonable amount of legal expenses that the company had to advance.

Six months after it decided Ficus I, the First Department issued another opinion in the same case, in which it again relied on Delaware case law to reach a result favorable to one of the former officers seeking advancement. On remand from the First Department's initial decision, Justice Bernard J. Fried had confirmed the report of a Special Referee recommending that the company reimburse its former CEO for about $1.5 million in legal expenses. In doing so, Justice Fried had rejected the company's argument that the advances sought by the former CEO should be prorated to reflect the fact that the same law firms had been representing both him and several other former employees of the company who were not entitled to advancement of their legal expenses. Thus, the company argued that if a law firm represents 10 co-defendants in a lawsuit and only one of them is entitled to receive advances of his legal expenses, then he is entitled to advances equal to only 10 percent of the legal expenses billed.

On appeal, the First Department affirmed Justice Fried's rejection of this argument based on testimony provided by the former CEO's counsel that they would have done the same work and billed the former CEO the same amount in fees if they had just been representing him as opposed to him and his co-defendants.⁴ In reaching this result, the First Department relied on Delaware cases rejecting similar arguments made by companies where a former officer or director was entitled to advancement of their legal expenses with respect to some but not all of the claims alleged against them.⁵

Earlier this year, in 546-552 West 146th Street LLC v. Arfa,⁶ the First Department once again found Delaware law persuasive authority in construing the indemnification rights of officers and directors. In Arfa, in which the author served as counsel for the corporate fiduciaries, the First Department had earlier affirmed a dismissal for lack of standing of all claims brought by the plaintiff LLCs against their former managers.⁷ The defendants subsequently sought indemnification for their legal expenses in successfully defending against these claims. Justice Charles E. Ramos denied the motion on the ground that the defendants' right to indemnification was premature because the investors in the plaintiff LLCs had brought their own lawsuit against the defendants alleging the same causes of action and arising out of the same transactions. Because an adjudication of misconduct would defeat the defendants' right to indemnification, Justice Ramos concluded that the defendants' claim for indemnification had to await a determination of the allegations of misconduct in the investors' lawsuit.

The First Department reversed and, relying on Delaware case law, held that a former officer's or director's right to indemnification of the expenses incurred in one action did not depend on the outcome of a subsequent, related action because requiring them to 'wait until all of the related claims against them are resolved would eviscerate the right to indemnification.'⁸

Other Important Issues

Although in Ficus I and Ficus II the First Department held that Delaware law was persuasive authority in construing corporate provisions protecting officers and directors against litigation expenses, New York's courts have either declined to follow Delaware law or declined to decide several important issues with respect to advancement and indemnification of officers' and directors' litigation expenses.

For example, in a subsequent appeal in the Ficus litigation, the First Department held that the former officer was not entitled to preand post-judgment interest on the $1.5 million advances award it had upheld in Ficus II, on the ground that there had been 'no finding in these proceedings' that the company breached its operating agreement by challenging his demand for an advancement of expenses, based on the company's reading of the operating agreement and the issue was before the court solely by virtue of the terms of the Operating Agreement, and not in the context of a breach of contract action in which a judgment had been entered against the company.⁹

In contrast, Delaware's courts routinely award preand postjudgment interest to officers and directors who succeed in obtaining advancement of their legal fees on the ground that 'the prejudgment interest clock might be seen as providing a healthy incentive for responding entities not to deny advancement in cases when they have clearly promised it.'¹⁰

An example of where New York law is unsettled in the area of director and officer indemnification relates to whether officers and directors are entitled to preand post-judgment interest in connection with successful indemnification claims. Whereas Delaware's courts routinely award preand post-judgment interest in connection with successful indemnification claims asserted by officers and directors,¹¹ two New York federal court decisions that have addressed this issue disagreed about whether to award interest in these cases, and the issue remains undecided in New York's state courts.¹²

Another important area relating to indemnification and advances of legal fees where New York and Delaware courts are not in synch involves whether an officer or director should be permitted to recover the legal expenses he or she incurs in successfully litigating his or her right to indemnification or advances (i.e., 'fees on fees'), in the absence of a contractual provision expressly providing for such expenses. In Delaware, fees on fees are routinely awarded.¹³ In contrast, New York's courts have rejected awarding fees on fees with respect to directors and officers of business corporations.

In Baker v. Health Management Systems Inc., 98 N.Y.2d 80, 745 N.Y.S.2d 741 (2002), a closely divided Court of Appeals held that fees on fees could not be awarded in successful indemnification claims brought by officers and directors in the absence of express contractual provisions authorizing those awards. In reaching this result, the majority decision relied on Section 722(a) of the Business Corporation Law, which provides in relevant part that a corporation may indemnify 'attorneys fees actually and necessarily incurred' as a result of the underlying litigation. According to the majority: 'In limiting recovery to only those expenses that are 'actually and necessarily incurred as a result of such action or proceeding,' section 722(a) quite clearly in our view requires a reasonably substantial nexus between the expenditures and the underlying suit. In actuality, the attorneys' fees arising in connection with this motion were caused by [the corporation's] refusal to indemnify [the former officer] following his dismissal from the underlying litigation. It stretches language beyond the outer limits of meaning to claim that those fees on fees were necessarily incurred by reason of the joinder of [the former officer] in the securities fraud suits.'¹⁴

In the aftermath of the Court of Appeals' narrowly divided decision in Baker, New York's courts have not yet decided whether fees on fees can be recovered in indemnification litigation involving limited liability companies, given that the 'actually and necessarily incurred' language on which Baker turned does not appear in Section 420 of New York's Limited Liability Company Law, which permits LLCs to indemnify their officers and managers. Finally, the question of whether fees on fees are recoverable in advances litigation remains an open one in New York given that the operating agreement in the Ficus litigation expressly provided for the recovery of fees on fees incurred in vindicating the advances rights provided for in that agreement.

In sum, while New York's courts have recently expressed a willingness to follow Delaware law in defining some of the contours of officers' and directors' rights to indemnification and advances of their litigation expenses, there are many instances in which New York and Delaware courts have parted ways or in which New York's courts have yet to provide a definitive answer.