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Court of Chancery Rejects Limits on Advancement Rights

Authored By Lewis Lazarus This article was originally published in the Delaware Business Court Insider October 1, 2014 {Note the decision discussed in this article was certified to the Delaware Supreme Court on October 6, 2014.} By statute and case law, Delaware has long protected the rights of officers and directors to advancement of fees and expenses incurred defending claims arising out of the officers and directors' service. The public-policy rationale is that in the absence of such protection, qualified individuals would be reluctant to serve in management positions. Corporations whose documents are expansive in providing advancement, however, often are less generous when the time comes to advance company funds to someone the company believes has misused his or her position to the detriment of the company and its stakeholders. While a substantial body of case law has clarified many of the circumstances where directors and officers are entitled to advancement over the company's objections, issues continue to arise that enable the court to provide fresh guidance. The recent case of Pontone v. Milso IndustriesC. A. No. 8842-VCP (Del. Ch. August 22, 2014), sheds light on the nature of claims entitled to advancement, whether a right to third-party advancement vitiates a director or officer's entitlement to advancement from the corporation itself, and the type of counterclaims that are subject to advancement.

Procedural Background

The underlying litigation giving rise to the advancement claims was brought in federal court in Pennsylvania by Scott Pontone's former employers, two Delaware corporations, alleging that Pontone misappropriated confidential and proprietary information of his former employers wrongfully to solicit their employees and customers in breach of contract and common-law duties. Pontone filed certain counterclaims including for defamation and false advertising. On Aug. 23, 2013, Pontone filed his advancement action in the Court of Chancery. The defendants moved to dismiss on the ground that Pontone lacked standing because his new employer was obligated to advance funds and hence he suffered no injury. Pontone moved for summary judgment that he was entitled to advancement from his former employers. The court denied the defendants' motion to dismiss predicated on the new employer's obligation to advance and granted and denied in part Pontone's motion for summary judgment.

Advancement by Reason of Former Corporate Office

The defendants argued that because they did not expressly accuse Pontone of breach of fiduciary duty and he was not serving as an officer and director at the time of the contractual and other breaches they did allege, Pontone was not a defendant in the Pennsylvania action "by reason of" his former corporate office. The court rejected both arguments. First, the court read the defendants as asserting in their complaint in the Pennsylvania action claims for breach of contract, tortious interference with contract, unfair competition, unjust enrichment and trademark infringement that were intertwined with Pontone's role as an officer at his former company. The test is "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 a corporate officer, without regard to one's motivation for engaging in that conduct," quoting Homestore v. Tafeen, 888 A.2d 204, 214 (Del. 2005), or whether "corporate powers were used or necessary for the commission of the alleged misconduct." If so, the fact that the complaint does not allege a breach of fiduciary duty does not mean that the claims do not arise by reason of the defendant's former role as an officer or director. Similarly, the fact that a party is sued at a time when he or she is no longer an officer or director is irrelevant; what counts is whether, as here, the plaintiffs in the underlying action allege misconduct based on information acquired by reason of the defendant's service as an officer or director.

Non-Exclusive Mandatory Advancement Rights From Two Entities

The court found that Pontone was entitled to mandatory advancement from both his former and current employers. As to those fees and expenses that his current employer had already advanced, the court found that Pontone could not seek advancement from his former employer as well (although the court recognized that the current employer could seek contribution at the indemnification stage of the proceeding). However, the court relied upon Schoon v. Troy, 948 A.2d 1157 (Del. Ch. 2008), and DeLucca v. KKAT Management LLC, C.A. No. 1384-N (Del. Ch. Jan. 23, 2006), to hold that the former employer's refusal to advance unpaid and future expenses constituted an injury in fact that gave Pontone standing to pursue advancement from the former employer. The court explained that: "The fact that a third party is willing to honor its contractual commitments to the plaintiff if called upon to do so should not serve as a basis for a defendant to escape its own, independent and commensurate, contractual obligations. In other words, an indemnitee having two essentially co-equal sources of advancement and indemnification should have the right to switch from one to the other in the middle of litigation, if he decides to do so. The indemnitee could not recover twice and presumably would have to stop accepting advancement in the first instance from the first indemnitor." In so holding the court distinguished Levy v. HLI Operating, 924 A.2d 210 (Del. Ch. 2007), first because it was an indemnification case and also because, unlike for the plaintiff in Levy, it was not a foregone conclusion that Pontone would not have any out-of-pocket expenses. This result also avoids the "perverse incentive" of a company with a mandatory advancement obligation delaying payment in the hopes that the defendant would seek payment from another source that would then nullify the advancement obligation of the delaying party.

Advancement of Counterclaims

The test above derives from the seminal case of Citadel Holding v. Roven, 603 A.2d 818 (Del. 1992). When met, a counterclaim is advanceable. The court here determined that a counterclaim for defamation was advanceable while a claim for false advertising was not. The court reasoned that the former was based upon allegations of false statements that "echo[ed] the very charges defendants are advancing in the underlying action" and thus that the defamation counterclaim was compulsory and "a necessary part of the same dispute." Not so for the false advertising claim, which the court found required proof of facts that did not overlap with the affirmative claims in the Pennsylvania action. These then were not advanceable.

Lessons Learned

This case contains lessons for both plaintiffs and defense counsel. First, if a company pursues claims that are based on misuse of information derived from prior service as an officer or director, and its bylaws or other documents provide for mandatory advancement, then the officer or director defendant likely will be successful in seeking advancement for those claims, even if the company does not expressly allege a breach of fiduciary duty. Second, if a company wishes to limit its advancement obligations in circumstances where a third party is also obligated to provide advancement, then it needs to so provide in its bylaws or other documents. Finally, a defendant whose counterclaims are based on factual allegations that do not overlap with the allegations of the underlying action likely will not succeed on a claim for advancement. The Delaware courts remain vigilant in protecting an officer or director's right to advancement and as this case demonstrates, a company that provides for mandatory advancement cannot expect to evade those obligations if it sues based on alleged misconduct resulting from current or prior service. Share
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