Indemnification of Director Despite Judgment of Wrongdoing

Posted by Jay McDaniel on February 02, 2011

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Most corporations include broad indemnification provisions in their by-laws that are intended to protect directors and officers from the costs of lawsuits claiming wrongdoing. Those corporate provisions, however, as well as the statutory provisions that permit indemnification have an important caveat, an officer or director cannot be indemnified against intentional wrongdoing.

What happens when the officer or director loses a civil case, however, and a judgment is entered finding wrongdoing?  According to a recent decision in New Jersey that finding of wrongdoing does not automatically deprive the officer or director a right to indemnification, nor does it require him or her to repay the costs incurred in the defense or payment of any judgment.

 

Advancement of Defense Costs

Corporations typically advance the costs of attorneys’ fees to officers and directors that have been sued and, indeed, they are often required to do so by provisions in the by-laws that provide for indemnification unless there is an express finding of intentional wrong.  In Commerce Bancorp, Inc. v. InterArch, Inc., 2010 N.J. (App.Div. Dec. 16, 2010) (Opinion here), the corporation sought to recover those fees. Although the decision is based on a surgical parsing of statutory language, you can’t help but note the court’s pique with the plaintiff. The events underlying the lawsuit occurred more than a decade ago and the plaintiff had approved the indemnity payments, only to change its mind years later with a change in corporate politics.

In any event, when interpreting a statute, the placement of punctuation can mean a great deal. The specific issue on appeal was a lower court’s ruling that an applicable provision of the New Jersey Business Corporation Act barred a corporation from permissively indemnifying its agents under specific factual circumstances, based on its reading of the statute, and the placement of a period in particular. The appellate division, however, disagreed with the interpretation and said that there was no basis in law or equity to support plaintiff’s suit to recoup indemnification payments it knowingly and voluntarily made the defendants.   

The disagreement between the trial and appellate court centered on the statutory interpretation of N.J.S.A. 14A:3-5(2)(a)/(b), mainly because the lower court read a provision as pertaining to only one subsection, where in reality the provision applies to both.

 

Construction Led to Derivative Litigation

In the dispute, Commerce hired HVAC construction company DiMaria to perform work on a newly constructed office building. Commerce also hired the Defendants, Interarch, to do interior design on the project. Interarch is owned by the wife of Commerce’s founder and chairperson. Commerce terminated DiMaria from the job, but an arbitration hearing on its breach of contract claim resulted in it being awarded damages, which Commerce paid.  

DiMaria then sued Interarch for tortious interference with its construction contract with Commerce and won damages of over $800,000. After a lengthy investigation by outside counsel, Commerce was advised to indemnify Interach to the tune of $1.3 million. Six years later, after a corporate shakeup at Commerce, the bank re-visited the indemnification of Interarch and brought the underlying suit for restitution, asserting that defendants acted in bad faith and outside the scope of agency.  

The trial court granted summary judgment in favor of Commerce, reasoning that the applicable statute barred Commerce from originally indemnifying Interarch because the agent for Interarch did not act in good faith and in the best interest of Commerce.

 

 

Statutory Interpretation of NJ Business Corporations Act

The trial court based its interpretation on the language of N.J.S.A. 14A:3-5(2)(a)/(b) and the so called “anti-presumption” provision which states that “[t]he termination of any proceeding by judgment, order, settlement, conviction . . . shall not of itself create a presumption that such corporate agent did not meet the applicable standards of conduct set forth in paragraphs 14A:3-5(2)(a) and 14A:3-5(2)(b).” The trial court read this provision as only applicable to criminal proceedings based on the way the provision was structured.  

On appeal, the Court engaged in an interesting grammatical interpretation of the statute by parsing the structure of the language in order to properly unearth what the legislative intent was. The relevant statutory section in context reads:

(2) Any corporation organized for any purpose under any general or special law of this State shall have the power to indemnify a corporate agent against his expenses and liabilities in connection with any proceeding involving the corporate agent by reason of his being or having been such a corporate agent, other than a proceeding by or in the right of the corporation, if

(a) such corporate agent acted in good faith and in a manner he reasonably believed to be in or not opposed to the best interests of the corporation; and

(b) with respect to any criminal proceeding, such corporate agent had no reasonable cause to believe his conduct was unlawful. The termination of any proceeding by judgment, order, settlement, conviction or upon a plea of nolo contendere or its equivalent, shall not of itself create a presumption that such corporate agent did not meet the applicable standards of conduct set forth in paragraphs 14A:3-5(2)(a) and 14A:3-5(2)(b). (emphasis added).

 

The trial court viewed the “anti-presumption” provision, underlined above, as only pertaining to criminal proceedings, and therefore found the original suit against Interarch for tortious interference with DiMaria’s contract as creating a presumption that Interarch did not act in good faith, or with Commerce’s best interest in mind. This resulted in a favorable ruling for Commerce, allowing for their suit for restitution to proceed. 

The Appellate Division disagreed with this analysis, finding that the second sentence, although in close structural proximity and connected with clause (b), is actually a modification of the first sentence and specifically and expressly references both clauses.

The result: that the “anti-presumption” provision applies to both clauses (both civil and criminal).  This effectively meant that the judgment against Interarch shall not of itself raise any presumption of bad faith, and the mere fact that now some six years later there may exist “a different legal gloss on a known and undisputed state of facts possibly suggesting an erroneous conclusion as to its legal effect does not alter the equities of the situation, excuse the delay, or itself justify a belated cause of action for recoupment.”

 

Derivative Claim in Dispute Between Owners May Require Independent Counsel

Posted by Jay McDaniel on December 20, 2010

Disputes between the owners of a business often involve derivative claims; specifically that one of the parties has breached his or her duty to the business or done something to damage the business.  In the closely held business the interests of the owners are more likely to be the same as the business.  Nonetheless, a derivative claim raises the thorny question of whether the entity must now engage independent counsel to represent the business itself.  

 

The Role of Independent Counsel in Derivative Actions

The role of independent counsel in a derivative action is to avoid potential conflicts of interest between the controlling owners and the business entity, whether it is a corporation, a limited liability company or a limited partnership. (Claims by a partner in a general partnership are similar, but do not fall under the concept of a derivative action.)  A derivative action is a claim that belongs to the business entity, but which the controlling owners refuse to pursue.  

A derivative action must be brought by an owner (shareholder, member or limited partner) who was an owner at the time that the cause of action arose and at the time that the claim is brought.  The statute requires that the minority owner first make demand (demand that the majority pursue the claim) unless to do so would be futile.  In a closely held business, in which the majority owners would have to vote to sue themselves, futility is usually presumed.

 

Derivative Claims in Closely Held Businesses

Derivative actions provide for an award of attorneys fees, and we invariably include a derivative claim when representing a minority owner in which there are claims of conduct detrimental to the business entity.  Typical derivative claims include conduct that depleted corporate assets, breaches of the duty of care or loyalty, basic self dealing, excessive compensation, or misappropriating a business opportunity that belongs to the business.

The defendants in such a derivative action are the other owners, officers, directors, members or general partner, and the corporation is named as a nominal plaintiff.  The potential for the conflict of interest is that the majority owners cannot be expected to act on behalf of the corporation in a way that is detrimental to their interest – particularly when they are also defendants.  In addition, there is also the likelihood that the majority owners will contend that the minority owner is liable to the business for some wrongdoing.

Independent counsel, when appointed to represent the corporation, will advise the business (the controlling and minority owners) on the issues in which the interests of the corporation are at stake: e.g., compromise of claims, indemnification of officers and directors, disclosure of sensitive records.

 

Disqualification of the Majority’s Attorney

When an attorney attempts to represent both the controlling owners of a business and the business itself, opposing counsel should file a motion to disqualify as a result of the actual or potential conflict of interest.  The commentary on Rule 1.13 of the Annotated Model Rules of Professional Conduct proves instructive:    

Most derivative actions are a normal incident of an organization's affairs, to be defended by the organization's lawyer like any other suit. However, if the claim involved serious charges of wrongdoing by those in control of the organization, a conflict may arise between the lawyer's duty to the organization and the lawyer's relationship with the board. In those circumstances, Rule 1.7 governs who should represent the directors and the organization.  (Emphasis added).

In many cases, there will not be a sufficient uninterested number of owners to waive any potential conflict of interest, or to consider such controversial conduct as approval of permissive indemnification, much less to determine whether there is merit in the derivative claim.  The duty owed to the corporation to preserve misappropriated funds, or correct an interested transaction, may well be compromised through the representation of the alleged wrongdoers.  

As a general rule, in the absence of a benefit to the corporation from suit, or an injurious threat to the company, a defendant in a derivative action may not use corporate funds for the payment of attorney’s fees.  See Hollander v. Breeze Corporations, 26 A.2d 507 (N.J. Court of Chancery 1941).  If, when the derivative action threatens the health of the corporation, corporate funds may used to pay the defense. Most would agree that a plaintiff should not have to pay for a defendant’s defense.  The same concept applies here.

 

Derivative Action May be Indistinguishable from Oppression Claims

            Defense counsel, in an attempt to fight opposing counsel’s motion to disqualify for a conflict of interest, may posit some useful arguments.  First, defendant may attempt to prove that the interests of the corporate officer(s) and the corporation are aligned or identical, thereby nullifying a conflict of interest argument.  Often in closely held corporations, the lines separating the corporate entity from the corporate officers are blurred, so an injury to one may be viewed as an injury to all.  To be successful, the defendant must be sure that the alleged misconduct does not rise to the level of serious wrongdoing (See Rule 1.13). 

A second response to a motion to disqualify is to convert the action from derivative to direct, thereby altering the position of the parties which can potentially ameliorate conflicts of interest.

A court has discretion to find a conversion appropriate, and in doing so will circumvent many of the restrictions and defenses applicable to only derivative actions.   Generally courts convert derivative to direct actions in order to permit a plaintiff to pursue a claim that would be barred by the technical requirements of the derivative statute; however, we have seen it argued successfully that the court should convert the derivative action to recognize the reality that the business has no interests distinct from its owners.

New Jersey does not unilaterally treat all closely held derivative actions as direct as some jurisdictions do.  See Brown v. Brown, 323 N.J. Super. 30 (App. Div. 1999).  A court reserves the discretion to deem an action direct even if brought derivatively, in recognition of the realities of the overall circumstances and difficulties differentiating the injury to the corporation, as opposed to the injury to the officer(s).  (The concept of a corporate injury that is distinct from any injury to the shareholders approaches the fictional in the case of a firm with only a handful of shareholders)(Comment (e) to § 7.01. American Law Institute's Principals of Corporate Governance: Analysis and Recommendations (1992)).  

A potential problem to this argument is that despite a conversion to a direct action, conflicts of interest may still exist which would require independent representation if officers in a closely held corporation have differing interests with respect to the particular suit.

Alessandro Bianchi, an associate of the McDaniel Law Firm, PC, assisted in the preparation of this post.

 

 

Owners of Parent Corporations Should Have Remedies Against Officers of Subsidiary Businesses

Posted by Jay McDaniel on September 30, 2010

Businesses often create additional new businesses, whether as joint ventures or subsidiaries. The flexibility and favorable tax treatment given to the limited liability company have made it fairly common that an LLC has other business entities as its owners.  For the individual owner, however, this situation can present problems.  The requirement that the members act at the company level often means less individual control and less ability to address acts of wrongdoing in the subsidiary or joint venture.

The individual owner’s recourse is the double derivative action, a complicated device in which the individual owner. asserts the rights of the parent to assert a claim as an owner of the subsidiary. It’s confusing, but the principle is generally well accepted.

 

An Example

An example that came up recently in our practice recently may help illustrate.  Two corporations formed a joint venture, each owning 50 percent.  The two corporations, lets call them A Corp. and B Corp., were each owned by two partners, 50 percent each. There were four individuals each with a 25 percent interest.  However, the members could only act at the entity level, meaning that A Corp. had one vote and B Corp. had one vote.  And, because both corporations needed the approval of both of its shareholders, the result was that all decisions had to be unanimous.

In addition, as is common, the principals were all appointed managers and had jobs in the business.The managers were elected and could be removed by a vote of the members.  So when one of the managers became a problem, that manager could not be removed by a vote of the members because the problem manager could block the affirmative vote of one of the parent entities.  

Consider the alternative as well.  If one of the individual owners has a real grievance at the level of the subsidiary or joint venture – mismanagement of the joint venture or exclusion from management, for example – there is no easy way to address the grievance if the majority is in disagreement.  The individual member is not an owner of the subsidiary.

 

Nature of Derivative Litigation

We hear most often about derivative suits in the context of large public corporations, but the same principles apply to the closely held corporation and they are commonly asserted in litigation among the owners.  A derivative suit is a claim brought by one of the owners of a business (shareholder or LLC member) that asserts a right owned by the business itself.

For example, when the president of a corporation wastes money using the corporate jet for personal vacations, an individual shareholder may sue derivatively on behalf of the corporation. The recovery, if any, belongs to the corporation and the shareholder benefits only indirectly to the extent that the business recovers.  But derivative actions are intended to prevent and deter wrongdoing by corporate insiders and the successful plaintiff in a derivative action can recover costs and legal fees.

 

Double Derivatives

In the double derivative, the individual seeks to enforce a right owned by the subsidiary (which the plaintiff does not own directly).  A recent case in the Delaware Supreme Court (Opinion here in Lambrecht v. Oneal.pdf) provides a good example.  In that case, Merrill Lynch was purchased by Bank of America for sto ck and all of ML’s stockholders received Bank of America stock for their ML shares.  ML became a subsidiary of Bank of America.  One of the former ML shareholders, now a Bank of America shareholder, brought a derivative claim alleging that the former ML management had damaged the corporation by, among other thins, paying huge bonuses to executives.

The plaintiff brought a claim that alleged that:

1)      ML had a claim against its former management.

2)      Bank of America, as a shareholder of ML, had a right to assert that claim derivatively against the managers.

3)      Plaintiff as a shareholder of Bank of America had the right to assert Bank of America’s claim derivatively against the managers because both Bank of America and ML had failed to sue themselves.

Put another way, the plaintiff sought to assert Bank of America’s right to stand in the shoes of Merrill Lynch and sue the allegedly liable managers.  The defendants attempt to dismiss the claim by arguing that the plaintiff did not have standing failed.

In the close corporation, individuals may have similar structural problems.  They are affected as individuals, but the structure of the business presents an obstacle.  Double derivatives are often their only real remedy.