By Edward McNally and Patricia Winston

Delaware Business Court Insider

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March 14, 2017

There is perhaps one single obligation that most aggravates corporate boards of directors: Paying your opponent's legal fees when you are convinced he has done you wrong. How then is that not just possible, but a regular occurrence?

Delaware law permits a corporation to agree to pay an officer or director's litigation expenses "in advance of the final disposition of such action, suit or proceedings." Persons considering serving on the boards of directors of a publicly traded corporation almost always insist that such "advancement rights" be provided to them, by contract or corporate bylaw. Thus, if their corporation later claims that the director acted improperly, such as by obtaining an unauthorized benefit or by deliberately neglecting her duties, that director will ask the corporation to pay for her defense.

Over the last few years, corporations have tried to avoid that obligation in many ways. For example, corporations have claimed they were fraudulently duped into hiring the defendant and therefore the advancement contract should be rescinded. More frequently, corporations have argued that the defendant's actions leading to filing suit did not "arise out the defendant's actions" as a director or officer (the commonly used qualifier in advancement contracts that must be met before fees are advanced). None of those defenses generally works, however.

Moreover, apart from the irritant of having to pay an allegedly "bad actor's" fees, the right to advancement often involves real money. The recent decision in  Del. Ch. C. A. 12369-VCL (Feb. 21), involved an advancement claim for $5,121,651.73 and other decisions have involved similar large amounts. Under those circumstances, it is no surprise that corporations and other legal entities have sometimes resisted the advancement claims of their former directors or officers.

Once the advancement claim is denied, the claimant has the right to file suit in the Delaware Court of Chancery to compel payment, 8 Del. C. Section 145(k). Typically, that court will treat such a suit "summarily," meaning the litigation will be given priority on the court's docket and scheduled for as prompt a hearing as circumstances permit. The Court of Chancery will then first determine if advancement is required. If so, then the parties will often be required to follow the procedures set out in  (Del. Ch. 2012) (the Fitracks procedures).

Briefly, the Fitracks procedures require that senior Delaware counsel for the parties review invoices for fees and expenses, meet to resolve any disputes and then no more frequently than quarterly, submit any still disputed amounts to the Chancery Court for its decision. In the meantime, the party who is required to pay advancement must pay at least 50 percent of the amount sought. Most significantly, the Court of Chancery's review is very limited with respect to what claims will be denied advancement. The Curo decision sets out in detail the limits of that review. Generally, only "grossly" overstated claims will be denied.

There are good reasons for limiting the Court of Chancery's scope of review in advancement cases. To begin with, advancements are subject to the claimant's providing "an undertaking to repay such amount if it shall ultimately be determined that such person is not entitled to be indemnified by the corporation," 8 Del. C. Section 145(e). That determination occurs after the litigation is resolved, such as by judgment or settlement. Hence, the corporation has some safeguard to get its money back if the claimant is judged not to be entitled to keep it. Moreover, as the Curo court reminded, it would be inappropriate to seek a granular review of the advancement claim while the underlying litigation continues for months or years. Accordingly, the court typically adopts the Fitracks procedures requiring the parties to first use their own efforts to avoid unnecessary waste of the court's limited resources. In fact, as Curo also points out, a party who inappropriately resists a claim despite using the Fitracks procedures may be required to pay the claimant's attorney fees incurred in pursuing the advancement claim.

Given the summary nature of advancement proceedings and the often lack of any effective client restraint on lawyers who are being paid by someone other than the actual client, there is a natural concern that the claims for fees are inflated. Moreover, even if the claimant has agreed to repay the fees if she loses, it is often doubtful that an individual has the unencumbered assets to do so, particularly if millions of dollars are involved.

This then finally brings us to the question of what can be done to avoid the perils of advancement obligations to former directors or officers. To some degree, those obligations can be insured against. A typical director and officer liability policy will reimburse a corporation that pays the legal bills of current or former directors or officers. For this reason, actual advancement cases are not all that common, compared to the number of suits filed against boards of directors.

Unfortunately, insurance does not always solve the problem. A typical D&O policy will exclude coverage for potentially collusive litigation, such as by denying insurance payments for "insured versus insured" suits. Thus, if the corporation is the plaintiff suing a former director, both the corporation and the director are considered an "insured" and there is no insurance coverage. This exclusion is not all that easy to avoid. Even stockholder derivative suits may be subject to the insured versus insured exclusion if the suit has been instigated by a director or by the corporation having a stockholder file the claim in her name.

Nonetheless, there are some potential ways to limit the perils of advancement. While the right to advancement will almost always be provided just as a matter of common practice, the right is essentially contractual. Hence, it may be subject to limitations set out in a contract or bylaw. Insurance companies have the same concerns as corporations providing advancement rights in terms of excessive fees unrestrained by the real client's oversight. To at least try to limit that exposure, insurers often retain the right to select counsel (with whom they have pre-existing reduced fee agreements) or to consent to settlements. While the designated counsel must be independent of the nonclient party paying his fees, it might be expected that the promise of future referrals will dim his ardor for fees. At least the counsel designated should be chosen on the basis of their experience and expertise and not a lawyer learning the substantive law at someone else's expense.

There have been few proposals on how to limit advancement claims. That may well be because that is no easy task given the strong demand for unlimited advancement rights. But if insurance companies can negotiate cost controls with their clients, perhaps corporations can also do so with their prospective and often highly paid directors.

https://www.law.com/delbizcourt/almID/1202781272761/The-Perils-of-Advancement