August 3, 2011
Edward M. McNally
Delaware Business Court Insider

How would you like to advance your opponent's legal fees as you fight out your dispute in court? That is bad enough when you are the plaintiff. It is even worse when you have been sued and you find your company paying the plaintiff's attorney fees and expenses to prosecute his or her claims against you. Yet all that can and does happen in suits involving directors and officers in litigation with their former company. How can this happen?

First, some background helps. The American "rule" is that litigants pay their own legal fees, even if they win the case. "Loser pays" is rarely true in the United States in business litigation. Because of that rule, companies have sought to attract good directors and high-level employees by providing them with the employment benefit of indemnification against litigation costs at the end of a trial and advancement of their costs throughout the trial. Indeed, in Delaware and most states, directors have a statutory right to be indemnified in most business litigation. That seems reasonable enough, in the abstract.

But consider what happens when a dispute arises between the company and a former director or officer. Frequently, those former company officials have been given contracts that require they be indemnified against loss in any litigation they win and have their litigation expenses advanced to them throughout the litigation. In those circumstances, the courts have repeatedly upheld the right to have expenses advanced, subject to the company's right to recover those advances later if it wins the litigation. Still, that does not seem so bad. It is just another cost of doing business.

However, the reality may be far more onerous. When the company is paying the lawyer bills without any right to pick the lawyer or even to review his or her statements, there is little restraint on fees. Millions of dollars then are spent, cases settled just to stop the cash drain and rarely is there ever a recovery of expenses advanced to the former official, who is then cash poor. Perhaps even more surprising, there is little the courts can do to control this result.

Companies do object to paying what they see as unreasonable legal expenses. But when their former officials sue to compel payment of those fees, the courts are not able to effectively determine the reasonableness of any bills. After all, it is an abuse of the courts' resources to expect a judge to sit down each month to review a party's legal bills, which often are dozens of pages of minute detail. Solving this problem has proved elusive.

Various remedies have been tried. Courts have appointed special masters to review the legal bills, with the parties sharing the master's fees for his or her services. Under the so-called "Duthie" rules used in the Delaware Court of Chancery, uncontested fees are to be promptly paid, counsel are required to certify their good faith in any dispute, and guidelines are provided as to what may be disputed.

Even those limited remedies to prevent abuses have been undermined, often by the very contracts the company agreed to without much thought. For example, in a decision just last month, the Court of Chancery held that the company must pay all of the fees of the special master because it had promised its former official to advance all of her "expenses" in litigation. Considering that the legal fees in dispute exceeded $5.5 million, paying the special master's fees as well must have felt like the last straw.

What then can be done about this problem? To begin with, companies must recognize that the problem arises out of the indemnification and advancement contracts they sign. No one is forcing them to give overly generous benefits, and no one should expect the courts to change their contracts just because they have become burdensome. Proper contract drafting helps here.

Several examples come to mind and should be acceptable even to the potential new officials the company seeks to retain. These include: limitations on advancement rights when the official is acting as a plaintiff; approval rights on the counsel to be selected; forum choices for any disputes; and fee caps on advancements. Until some of these or more creative terms are used, the problem will remain.

The real problem is not indemnification, but advancement. Delaware law limits the right to be indemnified, even by contract. It is against Delaware law to indemnify a director for wrongful acts, and a contract that attempts to do so is not enforceable. Advancement, on the other hand, is virtually unlimited if the contract is drafted that way. Yet, there is no reason why companies should have to agree to pay unlimited sums to attract talent. To do so is to let some lawyer charge without any restraint. Future articles will show how to avoid that problem.