Advance! Amend! Retreat!
November 04, 2019
The title of this post describes not an army maneuver, but the outcome of a recent lawsuit in Delaware Chancery Court for advancement of litigation expenses in which:
- A company sued its ex-CEO in New Jersey federal court for pre-termination breach of fiduciary duty and post-termination breach of the non-compete and non-solicitation clauses of his employment agreement, in the process allegedly using purloined confidential information.
- The ex-CEO sued in Delaware Chancery Court for contractual indemnification and advancement of his defense costs in the federal court action.
- Chancery Court ordered advancement.
- The company amended its federal court complaint by removing all allegations of post-termination misuse of confidential information, following which it moved in Chancery Court to modify the advancement order.
- Chancery Court modified its prior order to eliminate advancement for the post-termination contract breach claim.
Vice Chancellor Glasscock’s ruling last week in Carr v Global Payments Inc. underscores important lessons both for both public and private companies about the interpretive interplay between statutory and contractual provisions governing rights to officer and director indemnity and advancement, the breadth of advancement doctrine, the need for company counsel to analyze closely the impact of proposed pleadings on advancement rights, and, most importantly, the company’s need to anticipate and choose between the benefits of bringing claims that trigger advancement rights versus the strategic and financial costs of advancement.
Robert Carr is the founder and former chairman and CEO of Heartland Payment Systems, Inc., a Delaware corporation that designs and markets payment processing systems. Carr left the company upon its merger with Global Payments Inc. in 2015.
Subsequently, the SEC sued Carr for pre-merger insider trading. Heartland then sued Carr in New Jersey federal court. Its complaint alleged claims for pre-merger breach of fiduciary duty based on the alleged insider trading and a breach of contract claim for starting a new company post-merger that offered competing products and services in violation of his employment agreement’s non-compete and non-solicitation clauses. The contract claim also alleged Carr’s use of purloined confidential information obtained while he was an officer and director of Heartland.
Section 5.9 of Heartland’s merger agreement included provisions for indemnification and advancement for officers and directors of Heartland both for pre- and post-merger acts. Post-merger, section 5.9(b) provides for indemnity and advancement “to the fullest extent permitted under applicable Law” for any litigation “to the extent such Litigation arises out of or pertains to the fact that an Indemnitee is or was an officer or director of the Company.”
Take note of Section 5.9’s use of the phrase, “pertains to the fact that” instead of the phrase, “by reason of the fact that” found in most state statutes enabling corporate indemnification and advancement including Delaware General Corporation Law § 145; the different verbiage became a central issue in the subsequent advancement litigation.
Carr brought suit in Delaware Chancery Court after Heartland refused his demand for advancement of legal expenses in the New Jersey case. In late 2018, VC Glasscock issued an advancement order covering both of Heartland’s contract and fiduciary breach claims.
In May 2019, Heartland filed an amended complaint in the New Jersey case in which it deleted all allegations of Carr’s post-merger wrongful use of company information obtained pre-merger while Carr was Heartland’s chairman and CEO.
Soon afterward, Heartland moved in Chancery Court to modify its prior order to eliminate advancement for the contract breach claim now pleaded as arising solely from Carr’s conduct after he was no longer an officer and director of Heartland.
Chancery Court Agrees with Heartland
VC Glasscock launches his 26-page opinion on a doubtful note, stating that Heartland’s motion “engages my skepticism” and explaining,
This Court, having found — over [Heartland’s] protests — a right to advancement, ought to be wary of artful attempts at pleading around such a right. I found this case difficult, for that reason, at least. Nonetheless, in light of the facts and instructive case law, [Heartland’s] motion must be granted.
VC Glasscock’s legal analysis centers on two issues. First, does Section 5.9’s substitution of the phrase, “pertains to the fact that,” for the statutory phrase, “by reason of the fact that,” provide a different and, as Carr argued, broader standard that covers Heartland’s contract claim even as amended? Second, if it doesn’t, is Heartland’s amended complaint a true abandonment of that part of the contract claim triggering advancement, or did Heartland “simply attempt[ ] artfully to pursue the same claims in cosmetically-redacted form”?
The court answers the first question “no.” Given Carr’s acknowledgement that “pertains to” is the equivalent of “related to,” VC Glasscock reasons, Carr’s argument for a broader reading than the statutory standard is refuted by Chancellor Bouchard’s construction of “related to” as the equivalent of “by reason of” in his 2015 ruling denying advancement in Charney v American Apparel, Inc. VC Glasscock explains the logic applied in Charney:
1) Section 145(f) permits corporations and their employees to contract for indemnification and advancement, but 2) the scope of indemnification so permitted is delimited by Sections 145 (a) and (b), including the requirement that such indemnity be limited to claims “by reason of the fact” of the employment, such that 3) construing “related to” more broadly than “by reason of the fact” would create an indemnification right that was ultra vires and invalid, and 4) it is not reasonable to suppose that the drafters meant to create an invalid provision, therefore 5) the language should be construed as no more broad than the statutory limitation to avoid such invalidity with respect to the indemnification provision, and 6) principals of consistency required a construction of the language regarding advancement in the same way as the identical indemnification provision. The Court recognized that canons of construction favored giving different constructions to differing language — that is, crediting that a drafter had some intent for choosing “related to” rather than “by reason of”; the Court concluded that the reasoning laid out above trumped this consideration, however.
VC Glasscock concludes that “the Charney rationale controls” and therefore Carr’s argument for a broader reading of Section 5.9 is negated by DGCL § 145.
Next, VC Glasscock concludes that Heartland’s amended complaint in the New Jersey action erases Carr’s previously-found right to advancement, reasoning as follows:
- The “by reason of the fact” test requires a causal nexus between the litigation and Carr’s official corporate capacity. “Unless the claim has some nexus to the service of the employee in pursuit of her delegated corporate powers, the litigation does not arise by reason of the fact of her service.”
- Post-termination actions for breach of contract may warrant advancement if they involve confidential information learned pre-termination. On the other hand, “if the claim merely alleges post-employment breach of a non-compete agreement, and it does not allege that the party used confidential information previously learned to facilitate the breach, then the breach does not arise ‘by reason of’ the party’s position.”
- Heartland’s amended complaint “effectively erases all mention of confidentiality from the breach of contract claim” and therefore “does not warrant advancement because as alleged, Carr breached the contract after his termination” and did not use confidential information obtained by reason of the fact of his position with Heartland in doing so.
As a final check on his ruling, and observing that “the Court must be vigilant in review for artful pleading, and ensure that cosmetic changes to pleadings do not defeat vested contract rights,” VC Glasscock satisfies himself, not only does the amended pleading “eschew” any claim alleging misuse of confidential information, but that Heartland will not again reverse course by bringing misuse allegations into the case at a later stage. To that end he accepts Heartland’s counsel’s representation “to forego pursuit of such a claim now or later, in a manner which raises a judicial estoppel against such an action in the future.”
Always Consider Advancement Rights Before Pulling the Trigger
Litigants and their counsel must give careful consideration before bringing claims or counterclaims against co-owners that may trigger indemnification and advancement rights under statute, by-laws, certificate of incorporation, articles of organization, or any agreement among shareholders, members, or partners.
In all cases, and more so when company owners are few in number and/or the company’s finances are tight, advancement by the company of the defending party’s legal expenses can have a dramatic impact on the course and duration of the litigation and the climate for settlement. The impact can have even greater intensity — financially and psychologically — when the claims are brought derivatively, i.e., the derivative plaintiffs are paying full freight for their own attorney and also are indirectly subsidizing their opponents’ attorney’s fees to the extent of the plaintiffs’ pro rata profit interest in the company.
I have been involved as counsel in cases involving closely held companies where claims or counterclaims against my client have been dropped after a court orders advancement. I have also been involved in cases where otherwise viable claims or counterclaims were not asserted to avoid triggering advancement rights.
There’s no single answer to the question whether to risk advancement when bringing claims against present or former officers, directors, and other management personnel covered by statutory or contractual indemnification and advancement provisions. Each case requires its own cost-benefit analysis taking into account the direct financial impact on the company of advancement expenses, the indirect financial impact on the owners, the value and likelihood of recovery on the claims or counterclaims to be asserted, the impact on how the case will be litigated and its duration, the impact on potential mediation and settlement, and other financial and non-financial consequences.