Ambiguous Advancement Provision Favors Former Officer and Director

Farrell Fritz, P.C.

I’ve long been intrigued with the frequency of litigation — especially in Delaware Chancery Court — over advancement of legal fees of a corporate director or officer or LLC manager who’s the target of a lawsuit by the entity with which he or she is or was affiliated.

After all, advancement rights are straightforward, at least in concept:

  • The company’s organizational documents either do or do not require the company to advance a director’s or officer’s or manager’s attorney’s fees during the course of the litigation.
  • If they do, the target of the company’s claims either is or is not within the category of persons entitled to seek advancement.
  • If the target’s status qualifies him or her for advancement, either the claims asserted against the target are or are not the type of claims for which advancement is required, that is, arising “by reason of the fact” that the target is or was a director, officer, or manager.

The frequency of advancement litigation surely is influenced by its high stakes, both dollar-wise and leverage-wise, especially when the company is closely held and the adverse parties are co-owners. From the dissident owner’s perspective, he or she not only could be paying crippling legal fees to defend the claims, but as an equity owner he or she may also be paying indirectly the company’s legal fees, creating great pressure to settle absent advancement. It’s the opposite for the controlling owners: if advancement is required, indirectly they are financing the majority of all legal fees on both sides while incentivizing the dissident owner to litigate to the hilt.

Dodelson v AC Holdco, Inc.

Which brings us to a noteworthy bench ruling last week by Vice Chancellor Sam Glasscock III in Dodelson v AC Holdco, Inc., C.A. No. 2019-00029-SG [Del Ch May 21, 2019], in which he found that the plaintiff was entitled to advancement of her legal fees incurred in defending counterclaims asserted by the company in separate litigation pending in New Jersey state court.

The ruling focuses on a recurrent issue in advancement litigation, namely, whether the advancement provision at issue covers a former officer and director. It also sheds light on the applicable rules of construction when the court finds ambiguity in the provision.

In 2001, plaintiff Saki Dodelson co-founded a company known as Achieve3000 that bills itself the leader in online differentiated reading aptitude instruction. In 2015, defendant AC Holdco, Inc., acquired all of the outstanding capital stock of Achieve3000 and appointed Dodelson President and CEO, positions she held until her resignation in April 2018. She also served on AC Holdco’s Board of Directors until she was removed in June 2018.

In August 2018, Dodelson brought suit against AC Holdco in New Jersey state court primarily seeking enforcement of her alleged stock options. The company filed a half-dozen or so counterclaims against Dodelson for breach of non-compete, non-solicit, non-disclosure, and confidentiality provisions in her employment agreement, and for breach of fiduciary duty and fraud in connection with the employment of her daughter and her alleged misappropriation of credit card rewards points and frequent flyer miles.

In October 2018, Dodelson formally demanded that AC Holdco advance her legal expenses defending the counterclaims pursuant to the advancement provisions in the corporate charter. AC Holdco refused, contending that the charter provisions did not provide advancement to former directors and officers of the company. Dodelson responded by filing suit in Delaware Chancery Court seeking to enforce her alleged right to advancement of her legal expenses defending the counterclaims in the New Jersey action.

The Charter Provisions

The preamble of Article X of AC Holdco’s charter authorizes the company “to provide indemnification of (and advancement of expenses to) directors [and] officers” “to the fullest extent permitted by applicable law.” Article X’s next two sections govern indemnification and advancement, respectively.

Section 1 of Article X mandates indemnification of “any person,” defined as an “Indemnified Person,”

who was or is made or is threatened to be made a party or is otherwise involved in any action, suit or proceeding . . . (a “Proceeding”), by reason of the fact that such person . . . is or was a director or officer of the Corporation . . . against all liability and loss suffered and expenses (including attorneys’ fees) reasonably incurred by such Indemnified Person in such Proceeding. [Italics added.]

Section 2 of Article X mandates advancement of expenses including attorneys’ fees

incurred by a director or officer of the Corporation in defending any Proceeding in advancement of its final disposition, provided, however, of the final disposition of the Proceeding expenses in advance of the final disposition of the Proceeding shall be made only upon receipt of an undertaking by the Indemnified Person to repay all amounts advanced if it should ultimately be determined that the Indemnified Person is not entitled to be indemnified under this Article X or otherwise. [Italics added.]

The difference in the italicized phrases in the above two provisions goes to the heart of the controversy decided by VC Glasscock: was Dodelson entitled to advancement as a former director and officer?

The Decision

The transcript of VC Glasscock’s bench ruling at pages 6-7 summarizes AC Holdco’s argument against advancement based on the use of the phrase “directors or officers” in the Section 2 advancement provision without reference to former directors or officers (“is or was”) as found in the Section 1 indemnification provision. The omission in Section 2, AC Holdco argued, precluded advancement under Chancellor Bouchard’s reasoning in his 2015 ruling in Charney v American Apparel, Inc..

In that case, the court denied advancement to a former director and officer where the advancement provision in the corporation’s charter only referenced officers and directors without any further qualification.

VC Glasscock rejected AC Holdco’s comparison to Charney in which, he commented,

the Charney court, reasonably, in my view, found that the term “director and officer” standing alone implied current officers and current directors.

The provision in question then limited advancement rights to such directors and officers as undertook to repay advanced funds not entitled to indemnification. On that basis, the Court found that the former officer was not entitled to advancement.

VC Glasscock then carefully distinguished AC Holdco’s charter provisions:

The language in AC Holdco’s charter, to my mind, differs materially from the language at issue in Charney. In Charney, a “director or officer” is entitled to advancement when “such director or officer” undertakes to repay. Here advancement is extended to officers and directors when such indemnified persons undertake to repay. Again, “indemnified person” is a defined term. Therefore, I must read that definition into the language of the provision to understand its meaning.

After substituting the full definition of “indemnified person” into Section 2 of Article X, the section reads as follows: “The corporation shall pay the expenses (including attorneys’ fees) incurred by a director or officer of the Corporation in defending any Proceeding in advance of its final disposition, provided, however, that such payment of expenses in advance of the final disposition of the Proceeding shall be made only upon receipt of an undertaking by” — and here I insert the definition — “the person who was or is made or is threatened to be made a party or is otherwise threatened to be made a party by reason of the fact that such person is or was a director or officer of the Corporation.”

“Given this full reading,” VC Glasscock continued:

the advancement provision refers to both current and former directors in the undertaking clause. By contrast, the first clause of this provision refers simply to “directors and officers,” temporally undefined, a term that in this context, as I just explained, has been held to mean current directors and officers.

Notice that the court’s analysis, although suggestive, stops short of explicitly holding that the express terms of Article X of AC Holdco’s charter requires the granting of Dodelson’s advancement claim. Rather, VC Glasscock reaches that conclusion assuming that the dissonance between Section 1 and 2 creates an ambiguity. His explanation invokes the contract interpretation rule, contra proferentem (Latin for “against the offeror”), as well as provision in Section 3 of Article X placing the burden of proof on the company in any suit to enforce advancement rights:

At best for the defendant then, the advancement provision of the charter is ambiguous. The plaintiff’s reading, extending advancement rights to former directors and officers, is, I find, reasonable.

Where one party has drafted a contract, ambiguity is typically resolved against the drafter. Here, that is the defendant. Furthermore, the charter itself states in Section 3 of Article X that after an indemnified person has submitted a claim for advancement, such a person “may file suit to recover the unpaid amount of such claim,” and “In any such action the Corporation shall have the burden of proving the Indemnified Person is not entitled to the requested … advancement … expenses.”

In other words, presumably to encourage individuals to serve as directors and officers, the defendant in its charter authorized the corporation to extend advancement rights to the fullest extent permitted by law, provided for mandatory advancement for directors and officers where such current or former directors and officers undertook to repay, and then voluntarily placed upon the corporation the burden of proof to rebut advancement rights.

In light of the language referred to above, I find that the defendant has not carried that burden here.

Having found that Dodelson’s status as a former director and officer qualified her for advancement, VC Glasscock next addressed whether the counterclaims against her were brought “by reason of” her service as a director or officer. The parties agreed that the counterclaims concerning the hiring of Dodelson’s daughter and her alleged misappropriation of points and frequent flyer miles had the requisite causal nexus.

As to the breach of contract counterclaims, the court found that, “to the extent . . . [they] allege breaches . . . by which Dodelson was made a fiduciary of AC Holdco and refer to misbehavior she was able to engage in because of her position at the company and the access to information received incident to that position as an officer and director, then Dodelson is entitled to advancement.” VC Glasscock then left it to the parties and their counsel to hammer out an allocation protocol to the extent AC Holdco maintains that “some of the alleged wrongdoing” in those counterclaims “lacks a causal nexus to Dodelson’s position with the company.”

The Era of Contractual Indemnification and Advancement

In the realm of the closely held business entity, in Delaware, New York, and most if not all other states where the LLC has displaced the close corporation as the entity of choice, indemnification and advancement increasingly is dependent solely on the presence or absence of such provisions in the operating agreement.

In New York, for instance, the Business Corporation Law authorizes courts to order indemnification and advancement even if no such provisions exist in the corporation’s organizational documents; New York’s LLC Law contains no similar authorization.

The Dodelson case, although it involves the interpretation of charter provisions of a Delaware corporation, nonetheless provides a valuable lesson for drafters of LLC operating agreements.

Hat Tip. My thanks to Kurt Heyman of Wilmington’s Heyman Enerio Gattuso & Hirzel LLP for sending me the decision in Dodelson in which Kurt represented the plaintiff.

[View source.]

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Farrell Fritz, P.C. | Attorney Advertising

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