Delaware entities generally provide broad advancement and indemnification rights to encourage directors and officers to serve. Absent such protection, managers bear the costs of defense for claims against them arising out of acts they perform in carrying out their company duties. Qualified officers and directors likely would be reluctant to serve or too risk-averse if every official act they performed were subject to litigation that the manager had to pay personally to defend.
At the same time, companies generally regret broad advancement and indemnification rights when such protection inures to the benefit of a manager whose acts of disloyalty, fraud or bad faith allegedly injured the company. The Delaware courts understand the reluctance of companies in these situations to advance funds but at the same time have been consistent in requiring Delaware entities to honor such obligations so as to enforce the underlying policy: encouraging people to serve without fear of personal monetary liability for acts performed by reason of their position or in the course of performance of their duties. The recent case of Fillip v. Centerstone Linen Services, C.A. No. 8712-ML (December 3, 2013), well illustrates the tension, the court's enforcement of unambiguous advancement provisions to the benefit of people who are accused of acting disloyally, and the consequences of opposing a manager's request for advancement when the court finds the opposition lacks merit.
Plaintiff Karl Fillip in 1999 had co-founded Alliance Laundry and Textile Services to provide health care linen services. In 2008, Centerstone Linen Services acquired Alliance and Fillip acquired a 10.47 percent equity interest in Centerstone in exchange for a $1 million promissory note. Fillip also became a manager on Centerstone's six-member board and served as its CEO pursuant to an employment agreement. In 2012, Fillip resigned as Centerstone's CEO and contended he did so for good reason under his employment agreement, such that he was entitled to substantial severance. The company disagreed and refused to pay the severance.
Fillip filed suit in Georgia to obtain his severance. The parties engaged in settlement talks. They executed a term sheet to settle their differences. Centerstone thereafter contended that it had discovered facts that Fillip manipulated Centerstone's revenue for his personal benefit. It refused to honor the settlement on the ground that Fillip fraudulently induced it to settle. Fillip moved to enforce the settlement agreement, but the Georgia court denied his motion.
Centerstone then answered the complaint and asserted counterclaims. Centerstone contended that Fillip manipulated its revenues and EBITDA to obtain larger bonuses for himself, modified the repayment terms of the promissory note, and covertly attempted to sell the company. Centerstone alleged that by these actions Fillip violated his fiduciary duties and breached his employment agreement.
Fillip Seeks Advancement
Upon the filing of the original counterclaims, Fillip sought advancement pursuant to Article 3.7 of the company's LLC agreement. That article provides in Section 3.7:
"The company shall indemnify, defend and hold harmless each manager and officer for all costs, losses, liabilities and damages whatsoever paid or incurred by such manager or officer in the performance of his duties in such capacity, including, without limitation, reasonable attorney's fees, expert witness and court costs, to the fullest extent provided or permitted by the [Delaware Limited Liability Company] Act or other applicable laws. Further, in the event fraud or bad-faith claims are asserted against such manager or officer, the company shall nonetheless bear all of the aforesaid expenses subject to the obligation of such manager or officer to repay all such expenses if they are finally determined to have committed such fraud or bad-faith acts."
Centerstone then amended the original counterclaims. The factual allegations did not substantially change. It withdrew its breach of fiduciary duty claim without prejudice. Centerstone asserted in its amended counterclaims that Fillip caused his annual bonus from 2008 to 2012 to be substantially overstated (Count I), that Fillip modified the terms of his promissory note without authorization (Count II), and that it was entitled to a declaratory judgment that the LLC agreement prohibited Fillip from soliciting customers and employees form Centerstone or competing with it (Count III). It also asserted affirmative defenses that Fillip's claims were barred by the doctrine of unclean hands and Fillip's breaches of the employment agreement.
In amending its original counterclaims, Centerstone was candid that it was withdrawing the fiduciary duty claims to avoid advancing Fillip's legal fees. It asserted that, since the factual issues remained substantially the same, it would investigate those claims with the benefit of discovery and then seek summary judgment without having to pay Fillip's legal expenses. Centerstone later stated it would withdraw the fiduciary duty claim with prejudice, but the parties disputed how that dismissal could be accomplished.
Right to Advancement Upheld
The court interpreted Section 3.7 as extending mandatory advancement rights to "any manager or officer of Centerstone who incurs costs or expenses by reason of his position as a manager or officer of the company." The court rejected Centerstone's argument that the word "defend" did not create any rights additional to indemnification. The court relied in part on the Delaware Supreme Court's recent decision in Winshall v. Viacom International, 76 A.2d 808 (Del. 2013), that when parties "intend to create separate duties to indemnify and to defend, they employ an 'indemnify and defend against claims' clause or similar language to that effect," and thus a duty to indemnify does not create a separate duty to defend. The court read Winshall to suggest that "a contract's reference to a duty to defend means something other than an indemnity obligation and creates a duty to 'pay for the outlays of defense on a current basis.'"
The court also rejected Centerstone's argument that to read the second sentence in Section 3.7 as simply reinforcing the right established in the first sentence would render the second sentence superfluous, a result disfavored by Delaware courts. The court found instead the use of the words "further," "nonetheless" and "aforesaid" demonstrated that the two sentences were interwoven. The court concluded the second sentence clarified that the advancement right in the first sentence applied even when the company alleges fraud or bad faith and thus removed any doubt on the point.
Finally, the court rejected the company's argument that the advancement right is limited by the language referring to costs incurred "in the performance of his duties in such capacity." The court read that phrase in conjunction with the language providing that the company shall indemnify and defend "to the fullest extent provided or permitted by the [LLC] Act." That act enables parties to provide for indemnification and advancement for "any and all claims and demands whatsoever." The court rejected Centerstone's ipse dixit that "in the performance of his duties in such capacity" reflected an intention to be narrower than the language in Section 145 of the Delaware General Corporation Law allowing advancement for defending claims in an action "by reason of the fact" that the person was an officer or director. As such, if corporate powers were used or necessary for the commission of the acts constituting the alleged misconduct, then an appropriate nexus exists between the underlying proceeding and the defendant's official capacity and the defendant is entitled to advancement.
Applying the foregoing principles, the court found that even though styled as breach of contract claims, Centerstone's claims were premised on Fillip's having used his position as CEO to engage in conduct alleged to violate the employment agreement and promissory note. The court read Count I to be "based on allegations that Fillip took improper actions in his official capacity as CEO that resulted in overpayment of his compensation." Similarly, the court read Count II to allege that Fillip used his position as CEO to modify the terms of the promissory note without Centerstone's knowledge or consent. Because plaintiff conceded that it was uncertain whether he was entitled to advancement without additional discovery, the court deferred that issue to a later day if the parties were unable to resolve it themselves. The label Centerstone applied to its claims in the underlying action thus was not dispositive; instead, the court focused on Centerstone's having pleaded that Fillip acted as CEO to accomplish the alleged wrongs.
The court similarly concluded that Fillip was entitled to advancement for costs incurred in connection with Centerstone's affirmative defenses and the dismissed counterclaims. As to the latter, the court noted that even when it dismissed its fiduciary duty claims, Centerstone did so without prejudice and asserted its intent to later assert them depending on what it learned in discovery. The court found that the affirmative defenses—that Fillip was not entitled to relief because he breached the employment agreement and the promissory note and that his claims for relief are barred by the doctrine of unclean hands—were based on his conduct as an officer. Further, the court rejected the argument that advancement applied only to "claims" and not affirmative defenses asserted against a claimant, relying on the text of Section 3.7 and the policy underlying advancement.
Fees and Prejudgment Interest Awarded
Having found that Fillip was 90 percent successful, the court awarded him 90 percent in "fees on fees" for his expenses in the advancement action itself. It also awarded prejudgment interest that began to run 10 days after Centerstone unequivocally refused to honor Fillip's advancement request or to identify where Fillip should send his invoices.
While this case, decided by Master in Chancery Abigail LeGrow, remains subject to review by a member of the court, it well illustrates the principles a Delaware court applies in assessing claims for advancement. A party that in the underlying action asserts claims of breach of fiduciary duty that can only arise from the defendant's actions in his or her official capacity will have a hard time denying that a claimant is entitled to advancement, particularly where the relevant documents provide for advancement to the fullest extent of Delaware law. Attempting to avoid that result by withdrawing the count for fiduciary duty without substantially changing the factual allegations and while still asserting injury based on conduct arising from an officer's conduct in his or her official capacity likely will also fail. Companies should carefully assess whether attempting to avoid the unpleasant result of having to advance funds to a person the company believes has acted wrongfully is worth the litigation expense, particularly where, as here, a successful claimant will also be entitled to fees on fees and prejudgment interest.