And these very same justices in Citizens United, also asserted that based on precedent, they were permitted to tackle a question not brought before them by the parties.  However, the cases the majority cited in support of this right (Lebron v. Amtrak, 513 U.S. 374 (1995) and its predecessor, U.S. v. Williams, 504 U.S. 36 (1991)) were not perfectly on point. The Court claimed Lebron stood for the proposition that “our practice permits review of an issue not [pressed] below so long as it has been passed upon.”  Yet in Citizens, this was an issue not brought up by either the petitioner or respondent. And, in fact, the petitioner only wanted the court to rule that the federal law was invalid as applied.  In Lebron, the petitioner had actually raised a new issue as late as its merits brief and wanted the Court to address it.  In contrast, the petitioner in Citizens did not want the issue addressed.

One has to wonder why it is that the five justices felt comfortable relying on the Lebron case in a sua sponte striking down of a federal law in Citizens. However, in Mr. Jackson’s case, they refused to do so? Notably, Mr. Jackson's Respondent's brief cited Lebron for the proposition that "once a federal claim is proprely presented, a party can make any argument in support of that claim; parties are not limited to the precise arguments they made below."  Additionally, even using the Lebron precedent for the proposition cited by the Citizen's majority, should have resulted in it not being "too late" for Mr. Jackson. This is because the 9^th Circuit decision in Rent-a-Center revealed that the question had been passed upon by the district court. The 9^th Circuit wrote that: “The court found that the Agreement to Arbitrate ‘clearly and unmistakably provides the arbitrator with the exclusive authority to decide whether the Agreement to Arbitrate is enforceable.’” This is a clear reference to the delegation provision.

But why confuse this majority with the facts or the law. The distortions of the Prima Paint arbitration case precedent coupled with this claim that it was too late to bring up the delegation provision, ignoring both Citizens and Lebron,  invite the question of what motivates this majority. Is it just that it doesn’t like distasteful  things like peas or powerless people and will build arguments to suit its palate – rather, its political preferences?

Distortion of Precedent:
The majority claimed that their decision was supported by Prima Paint Corp. v. Flood & Conklin Mfg. Co., 388 U.S. 395 (1967). However, that more than 40-year-old decision, involved a consulting agreement between two businesses in which there was an arbitration provision. In contrast, the entire four-page agreement Mr. Jackson signed was a stand-alone arbitration agreement.  And, the agreement in the Prima case was between two businesses, presumably with more balanced power than an employee would have on his first day of work, handed a boiler plate agreement that he is required to sign as a condition of employment.

Childish Reasoning:
The majority’s reasoning resembles a child arguing that there are two ways to ask him to finish his vegetables. One way is to specifically say, “Please finish your peas.” A second way is to say, “Please finish your meal."  When the parent asked the second way and does not mention the peas specifically, the child insists there is no need to eat them.  And, that is not even the worst of it. The opinion is even more juvenile than that.  Eventually, Mr. Jackson did indeed challenge the delegation provision. In other words, on appeal to the Supreme Court, his lawyer asked in the right way. However, the majority decided it was too late for him to raise the claim.



District Court:
The case began in 2007, when Antonio Jackson filed a lawsuit against Rent-a-Center, West, Inc. , claiming racially-based employment discrimination and retaliation.  Prior to any trial on the merits of his discrimination claims, Rent-a-Center filed a motion to dismiss. The corporation argued that because back in 2003, when he was hired, Mr. Jackson signed an arbitration agreement, he was not entitled to pursue his case in court.  The 2003 arbitration agreement directed all disputes, including employment discrimination claims to an arbitrator. In addition, the agreement contained what’s known as a “delegation provision,” which stated that if there was a dispute over whether the agreement was unenforceable, the parties would go to an arbitrator, not to court to settle that question.

Hoping to avoid arbitration, Mr. Jackson opposed the motion to dismiss, arguing that the arbitration agreement was unconscionable and unenforceable under Nevada law.  For example, the agreement was very one-sided, with claims important to an employee (such as discrimination claims) sent to arbitration, but claims important to Rent-a-Center (trade secret disputes) not bound by the arbitration agreement and permitted to go to court. And, Nevada law routinely invalidates one-sided contracts. The district court granted Rent-a-Center’s motion to dismiss.

9^th Circuit Court of Appeals:
On appeal, the 9^th Circuit sided, in part, with Mr. Jackson, vacating the lower court's order mandating arbitration. And, the 9th Circuit remanded the case to the the district court for it (not an arbitrator) to decide whether the arbitration agreement was unconscionable and thus whether Mr. Jackson could have “meaningfully assent[ed]”  to its terms.  The decision applied the Federal Arbitration Act (the “FAA”). While the FAA establishes clear support for arbitration agreements, it has historically been interpreted to allow a judge to decide gateway questions such as an agreement’s validity. Under Section 2 of the FAA, aribration clauses are to enforced as written "save upon grounds that exist at law or in equity for the revocation of any contract."

Supreme Court:
In the majority opinion, written by Justice Scalia and joined by Roberts, Kennedy, Thomas and Alito, the Court had to split hairs in order to force Mr. Jackson into arbitration. The five justices “reasoned”  that there are two distinct ways to ask a court to invalidate an arbitration agreement under the FAA. One way, “challenges specifically the validity of the agreement to arbitrate.” The second way “challenges the contract as a whole, either on a ground that directly affects the entire agreement ( e.g. , the agreement was fraudulently induced), or on the ground that the illegality of one of the contract’s provisions renders the whole contract invalid.”  They claimed that prior precedent dictated that the right way to ask is the first way.  

Our other recommendation was free Internet.  To get the Internet for free at Starbucks, you had to have a card registered with the Company and then you got only two hours.  Otherwise, you had to pay.  Given the free nature of the Internet in many places, not the least of which is the case in other coffee shops (in Denver, Caribou, for example, offers the Internet for free), it certainly discouraged some laptop lumbering coffee drinkers from heading to Starbucks.

Well, it turns out that the Company is planning to provide for free Internet (apparently without the need for a loyalty card) in a majority of its outlets.  The catalyst?  Not other coffee shops but McDonalds, which is now offering free Internet at many of its 11,000 outlets.  It is an overdue step that will benefit shareholders and coffee drinkers. 

Yet this principle is nowhere written into federal law.  Most federal district courts (unlike the US court of appeals) have a system for ensuring random assignment of cases.  This prevents parties in most cases from judge shopping, although there have been occasional efforts to game the system.  This might occur, for example, where multiple actions are filed in a case arising out of the same facts and then consolidated in a courtroom of a judge viewed as the most favorable.  See United States v. Pearson, 203 F.3d 1243, 1264 (10th Cir. 2000)("Fourth, the practice, if undertaken on a broad scale, arguably threatens the independence of the judiciary. If a judge receives case assignments not through some neutral system, but rather because of prosecutors' opinion that he or she is more favorably disposed to the government's arguments than another judge in the same district, then a judge's caseload might be based in part on prosecutors' evaluations of judicial performance.").  

There have been some high profile instances of alleged non-random assignment of cases.  For example, back in 2000, Judge Norma Holloway Johnson, then the Chief Federal Judge of the U.S. District Court (U.S.D.C.) in Washington, D.C., and a Carter appointee, was accused of going ''off the wheel'' to assign a politically senstive case involving Webster Hubbell in a non-random fashion.  As the NYT described:

• The issue stems from complaints by Republican members of Congress that Judge Johnson bypassed the usual computer-operated system that randomly assigns cases to trial judges under her for a handful of cases. Those cases involved Webster L. Hubbell, an Arkansas friend of the Clintons and former senior Justice Department official and Charlie Yah Lin Trie, a fund-raiser for the president. Judge Johnson assigned those and some other criminal cases involving associates of Mr. Clinton to four judges he named to the bench.

All of this brings us back to the Bank of America.  According to the WSJ, counsel for BofA sent a letter, dated April 22, to Judge Chin at the US District Court for the Southern District about the disposition of 15 shareholder actions against the Bank on his docket, with at least one apparently involving the acquisition of Merrill Lynch.  Judge Chin is moving to the Second Circuit so the cases will be reassigned to someone else in the Southern District. 

The Bank apparently sought to prevent automatic assignment of the cases to Judge Rakoff, who handled the case brought against BofA by the SEC.  It did so by addressing a letter to Judge Chin.  As the Journal described:

• the bank asked for the cases to be reassigned "by lot," or "such other process determined by the Assignment Committee."  It would be "incongruous" for the matter to transferred "outside the random assignment process" to Judge Rakoff given his work on the SEC case, said the letter.  

The concern likely arose out of the practice in some courts of assigning cases to judges with prior experience in the matter.  It is a form of judicial efficiency.

So what happened?  The case was not assigned to Judge Rakoff and not assigned randomly.  Again, according to the WSJ:

• In the end, random assignment wasn't used. Rather, Loretta Preska, chief judge of the U.S. district court, decided to give the cases to U.S. District Judge Kevin Castel, she said in an interview. The decision was hers to make, versus random assignment, because the matter involves several cases transferred from different districts, she said.

There is no reason to believe that the case was assigned on anything but a neutral basis.  Moreover, the letter sent by BofA apparently had no role in the decision.  According to the WSJ:  "The April 22 letter to Judge Chin, she added, didn't influence her decision. "I don't recall seeing it; I don't recall hearing of it," she said."

Nonetheless, the result is unfortunate.  The case deserved to be assigned in the usual fashion for cases in the Southern District.  If it meant sending it to Judge Rakoff because of his prior experience, so be it.  If it meant random assignment (with Judge Rakoff having an equal likelihood of receiving the case), that also would have been appropriate.  Cases ought to be assigned on an objective and standard basis, even where the chief judge has the authority to do otherwise. 

The panel began with a discussion of the changes forthcoming in SEC examinations of broker dealers.  Mr. di Florio mentioned that the Commission will attempt to target their exams and do more of their own due diligence before prior to investigation.  This approach moves away from “form exams” as they exist today.  This narrower focus will allow Commission staff to focus on integrity in the markets and prevention of fraud.

The panelists moved on to discuss the themes of current regulatory reform efforts. When discussing Senator Dodd’s bill, the major themes discussed were: (1) creation of a counsel for financial stability; (2) ending the notion of “too big to fail”; (3) restricting banks from proprietary trading; (4) hedge fund regulation; (5) OTC derivative reporting requirements; and (6) regulation of financial professionals.  This final category is of personal interest to me, as someone with prior broker-dealer experience, so I will provide more detail on that discussion.

The panel’s discussion of financial professional regulation focused on the idea of treating brokers as fiduciaries.  One new proposal calls for an explicit duty on the part of the registered representative, with the violation of such duty imposing criminal penalties.  The difficulty with such a proposal is defining its scope. Questions must be addressed, such as, (1) how would such a plan impact customer initiated transactions?; (2) how long would the duty exist after a broker recommended purchase?; (3) how much further would such a duty extend expectation to “know one’s client”?; and (4) what impact would this have on the recommendation and sale of proprietary products by registered representatives? Clearly, according to the panel, there is need of further discussions to flesh out, in much more detail, the overall impact of imposing such an explicit duty.  

Thank you again to the panel for their thoughts and to the CBA for including The Race to the Bottom in this year’s Conference. 

The term financial derivative refers to a (1) contractual arrangement between two or more parties (2) that specifies the terms of a future transaction, (3) which ultimately derives value from an underlying asset or metric (“underlying”).  As with all trades, a financial derivative requires both a buyer (i.e., long position) and a seller (i.e., short position).  Generally, one party’s loss results in an equal gain to the counterparty, and vice versa.  Notably, derivative products can lead to highly leveraged balance sheets and financial markets because investors do not have to own the derivative’s underlying asset.  Thus, not surprisingly, many types of these securities exist, both bespoke (i.e., privately negotiated) and standardized.  They can exist both on regulated exchanges (e.g., equity options markets) and in over-the-counter markets (e.g., credit default swaps).  Basic financial derivatives include the forward, the option, and the swap. 

A forward is a financial instrument that obligates the seller to deliver an underlying asset to the buyer on a specified date at a predetermined price.  For example, assume S agrees to sell 100 barrels of oil to B one month from today at $90 per barrel.  If on the future date, the market price of oil is $95 per barrel, S must nonetheless sell 100 barrels of oil to B at $90 per barrel.  This results in a loss of $5 per barrel to S (because otherwise S could have sold the same 1,000 barrels of oil on the open market for $95 per barrel) and a $5 per barrel gain to B (because otherwise B would have to purchase the same 1,000 barrels of oil on the open market for $95 per barrel).  Commonly, however, these transactions are cash settled, so buyers and sellers do not actually deliver the underlying asset.  Rather, they exchange cash payments equal to their respective gains and losses.  This instrument is commonly employed for, among other reasons, speculation on commodity prices, or to hedge against devaluing inventories.   

Next, an option gives a buyer the right, but not an obligation, to purchase an underlying asset from the seller on a specified future date at a predetermined price (commonly referred to as the strike price).  The seller is required to deliver the underlying asset only if the buyer exercises the option.  Buyers pay the seller a premium for the option; the seller keeps the premium regardless of whether the buyer exercises, and thus, benefits from the option.  To illustrate, assume the same facts as above except now B has an option to purchase oil from S.  If one month from today the market price of oil is $95 per barrel, B will exercise the option requiring S to sell 1,000 barrels of oil to B at $90 per barrel.  The same financial gain and losses as above result to S and B, respectively, less the premium.  Different from the future contract, however, if the market price of oil is $85 on the future date, B is not obligated to purchase the oil from S.  B would let the option expire, purchase the oil on the open market at the lower price of $85 per barrel, and S would keep its premium.  Market participants use options to both speculate and hedge.

Finally, a swap is a contract under which one party receives a series of variable payments, determined by reference to an underlying metric, in exchange for making a series of fixed payments.  Thus, each party gains or losses depending on whether the fixed payments exceed the variable payments or vice versa.  For example, assume F makes payments under a variable interests rate note (i.e., the interest rate under the note may increase from time to time).  F would like to ensure the note’s interest rate does not increase.  As such, F agrees to make a series of fixed payments to V in exchange for V’s promise to pay F any amount above the current interest rate of the note, should the rate increase.  If the note’s interest rate never increases, V profits from F’s fixed payments.  On the other hand, if the interest rate increases, V must pay F, likely resulting in losses to V.  Thus, swaps also provide parties with hedging or speculative abilities.  Commonly, institutions use swaps to manage interest rate risk, or to speculate in a similar manner. 

The proxy update stated that disclosures are, in large part, becoming more sophisticated and more streamlined according to the panel.  That said, many companies still have not filed proxies, so time will tell if this trend will continue.  Further, the panel noted that disclosure is less organized the first year after rule changes as companies try to interpret what is expected by new regulations.  Specifically, the panel discussed: 1) Equity award disclosure in summary compensation tables in light of constant “staff interpretations”; 2) issues concerning target compensation v. realized compensation; 3) the timing discrepancy concerning equity and option awards and when to account for them; and 4) conflicts of interest regarding compensation consultants who consult on work other than compensation plans.

The panel then discussed a current overview of pending legislative changes that will impact the executive compensation area.  The panel listed and discussed the 11 sections of Senator Dodd’s Reform bill that will effect executive compensation and corporate governance.  Although may of these requirements already exist in one way or another, the panel found a few to be in need of further development.  Those pending requirements are: Executive Compensation: 1) “Say on Pay” requiring an advisory vote on compensation packages; 2) Independence of the compensation committee and advisors to it; 3) a link between compensation and performance (specifically a historical link between Total Shareholder Return (“TSR”) and executive pay); 4) Disclosure of the ratio of CEO pay to that of the median employee; 5) Mandatory clawback provisions for exchange listed companies; 6) Disclosure of executives/directors hedging actions; 7) “Excessive Compensation” by bank holding companies; 8) Prohibition on brokers from discretionary voting of proxies; Corporate Governance: 1) Majority voting in uncontested director elections; 2) SEC may prescribe proxy access rules; and 3) Leadership structure discussion as to why the CEO and Chairman positions are or are not combined.



The panel discussed the uptick in shareholder activism as the economy recovers from the past two years.  So far this proxy season there have been 766 shareholder proposals, already outpacing last year.  Further, the 61 proxy contests this year outdid both 2008 and 2009.  “Vote No” campaigns are up as well, but without as much publicity as in the last two years.

Also of interest, the panelists discussed the continued struggle to get retail shareholders to exercise their voting powers.  Although the SEC is considering some methods to increase access and awareness for retail shareholders, such methods like E-delivery of proxy materials seems to do little good.  One presenter noted that his firm still uses paper delivery of proxy materials because the firm only saw a 7% response from E-delivery.  One attendee of the conference, an attorney for Prudential, offered a creative and seemingly effective method to spur voting.  In order to entice retail shareholders to vote (only 5% voted last proxy season), Prudential offered shareholders the “gift” of a tree planted in their name or an eco-friendly bag if the shareholder voted.  No where did the company ask the shareholder to vote for or against management’s slate and the gift was of nominal value.  Apparently the company has seen a big uptick in shareholder participation in the proxy voting process and even an increase in shareholders providing comments on directorial performance.  The panel noted that France is considering similar strategies of offering “rewards” for voting participation by retail shareholders.   

One important point came from the Delaware Supreme Court’s decision in Gantler v. Stephes, which affirmed the long held notion that officers owe the same duties of care and loyalty as directors.  This case highlighted the issue that an officer may inherently have a conflict whenever he or she is an actor in a merger because selling the company affects the officer’s employment, and therefore the officer has a financial interest in the transaction.  In this context, the officer’s conflict does not necessarily breach the duty of loyalty, but it may subject the officer to a heightened standard above the normal business judgment in the face of litigation.  This standard, called entire fairness, will require the officer to prove fair dealing and fair price.  Evidence of fair dealing may include how the deal was initiated, structured, negotiated, disclosed to directors, and how approvals were obtained.  In order to supply this information, as the panel noted, the company should make a habit of documenting the process and reasoning of decisions.  

Another reason for extensive process and documentation of decisions came from Trados.  This case involved a merger that resulted in the preferred stock of the target receiving $52 million of the consideration while the common stock received no value.  Since the board owned a substantial amount of the preferred stock and because the common stock received nothing, the court applied the entire fairness standard to the decision to sell.  The panel noted that these types of sales may not be that uncommon in distressed markets.  In advising a company in this situation, the panel suggested heightened process and documentation of the decision making process (including other options explored) in order to prove that the deal meets the entire fairness standard.

An area of particular concern was the drafting of fraud carve outs.  The panel strongly recommended that seller companies include provisions that state the acquisition agreement represents the exclusive agreement of the parties and does not include any statements not represented within the four corners of the document.  However, these same acquisition agreements often include carve outs for statements of fraud.  The loose definition of “fraud” by courts can cause problems because the term may include reckless statements, omissions when faced with a duty to speak, and even equitable fraud.  Mr. West and the other panelists emphasized the point that if the buyer insists upon a fraud carve out, that fraud be defined and limited to intentional misstatements (ie. lying).  Further, because these transactions often involve numerous agents of both the bidder and seller, defining “knowledge persons” will limit the actors that the fraud carve out applies to, thereby limiting future liability.  Courts, especially within Delaware, pay great deference to sophisticated parties and clear intentions contained within the document.  The panel noted taking these extra precautionary steps gives the seller further security in the case of a buyer’s remorse.  

Long  Journey
The plaintiffs sued Harris Associates L.P. (“Harris Associates”) back in August of  2004, claiming that Harris Associates breached its fiduciary duty under the Investment Company Act,  to fund shareholders by charging excessive fees. The district court prevented a trial from occurring when, in 2007, it granted Harris Associate’s motion for summary judgment.

In May of 2008, the 7^th Circuit affirmed this decision, but introduced a new legal standard, rejecting the long-followed approach articulated by the 2^nd Circuit in Gartenberg v. Merrill Lynch Asset Mgmt. Opting for a market-based, disclosure-oriented test, Judge Easterbrook determined that “[a] fiduciary must make full disclosure and play no tricks but is not subject to a cap on compensation.” Short of “pulling the wool over the eyes” of the fund board members, the board’s approval of the fee “is conclusive.” In other words, evidence of lower fees paid to institutional clients was not considered.

In a memorable dissent to a denial of en banc rehearing, Judge Posner along with four others on the 7^th Circuit questioned Easterbrook’s departure from the Gartenberg standard and  insisted that “there is no doubt that the captive funds are indeed captive . . . [and noted that Harris had a practice of ] “charging its captive funds . . . more than twice what it charges independent” clients. For additional background, see Jones v. Harris Associates: Let 8,000 Lawsuits Bloom, Part 1 and Part 2.

Today’s Decision: “Gartenberg-Plus Ruling”

Professor William Birdthistle has deemed the unanimous decision, a  “Gartenberg-Plus Ruling.” This is an apt description. In the majority opinion, Alito first affirms the basic principles in Gartenberg. 

“[W]e conclude that Gartenberg was correct in its basic formulation of what §36(b) requires: to face liability under §36(b), an investment adviser must charge a fee that is so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arm’s length bargaining.” (Page 9)

 Next, however, unlike the 2^nd Circuit in Gartenberg, the Supreme Court asserted that “comparisons between the fees that an adviser charges a captive mutual fund and the fees that it charges its independent clients” are relevant.

 “Petitioners contend that such a comparison is appropriate. . .  but respondent disagrees. . . . Since the Act requires consideration of all relevant factors . . . we do not think that there can be any categorical rule regarding the comparisons of the fees charged different types of clients. . . . . Instead, courts may give such comparisons the weight that they merit in light of the similarities and differences between the services that the clients in question require.”

 The Court  reiterated that reviewing courts need to give deference to the conclusions made by a mutual fund board of trustees during its annual review of management fees. However, the Court noted that a reviewing court should weigh that deference in relationship to the actual circumstance, including whether the trustees were “fully informed” and their “care and consciousness” in performing the review. A “court’s evaluation of an investment adviser’s fiduciary duty must take into account both procedure and substance.” 

 The Court explicitly rejected Easterbrook’s new test, writing, “By focusing almost entirely on the element of disclosure, the Seventh Circuit panel erred.” It also rejected his market-based approach in an industry where arm’s length bargaining is absent. 

 “By the same token, courts should not rely too heavily on comparisons with fees charged to mutual funds by other advisers. These comparisons are problematic because these fees, like those challenged, may not be the product of negotiations conducted at arm’s length. See 537 F. 3d, at 731–732 (opinion dissenting from denial of rehearing enbanc); Gartenberg, supra, at 929 (“Competition between money market funds for shareholder business does not support an inference that competition must therefore also exist between [investment advisers] for fund business. The former may be vigorous even though the latter is virtually non-existent”).” (Pages 14-15)

Paolino, the Chairman and Chief Executive Officer of Mace from 1999 until May 20, 2008 was terminated by the company.  Upon dismissal, he filed a demand for arbitration, and claimed that he was terminated in retaliation for insisting that the Board publicly disclose certain material facts and events affecting Mace’s business, which the Board refused to do. 

Mace filed counterclaims.  Mace argued that Paolino refused to follow the Board’s direction, refused to properly inform and/or seek Board approval for Paolino’s actions, refused to comply with Mace’s corporate governance principles and bylaws, refused to reduce corporate overhead and expense as directed by the Board, and inappropriately interfered with the Board’s investigation of matters.  Mace alleged that Paolino’s actions constituted willful misconduct, which according to the terms of an employment agreement, negated any severance payment Mace may have owed to Paolino.

Paolino sought indemnification and advancement of fees and expenses incurred in defending against counterclaims. Mace moved to dismiss the complaint alleging that Paolino was not entitled to advancements because Paolino was not defending against the counterclaims, a carve-out in the provision barred recovery, and the counterclaims did not arise out of Paolino’s role as a director or officer of Mace.

The court stayed the action to the extent it sought indemnification pending final disposition of the arbitration, but continued Paolino’s action to enforce the mandatory advancement right granted to him under Mace’s Bylaws.  Under Section 145(e) of Delaware’s General Corporation Law, corporations may pay expenses incurred by directors and officers in defending any civil, criminal, administrative or investigative action, suit or proceeding “in advance of the final disposition of such action.”  Pursuant to this authority, Mace adopted Bylaws that entitled current and former directors and officers of Mace to broad and mandatory indemnification and advancement rights.  As the Bylaws provided:  

• §6.01—Each person who was or is made a party…in any action, suit or proceeding, whether civil, criminal, administrative or investigative, by reason of the fact that he or she…is or was a director or officer of the Corporation…shall be indemnified and held harmless by the Corporation to the fullest extent authorized by the Delaware General Corporation Law…provided, however, that except as provided in paragraph (b) hereof, the Corporation shall indemnify any such person seeking indemnification in connection with a proceeding (or part thereof) initiated by such person only if such proceeding (or part thereof) was authorized by the Board of Directors of the Corporation.
• §6.02—The right to indemnification conferred by Article 6 shall include the right to be paid by the Corporation the expenses incurred in defending any such proceeding in advance of its final disposition, including without limitation, attorney’s fees, expert's fees and all costs of litigation.

Because Paolino was defending against the counterclaims, he was entitled to advances under the Bylaws. 

Mace argued, however, that Delaware precedents did not require the advancement of expenses.  Mace alleged that where a covered person initiated a proceeding and a corporation asserted counterclaims defensively, those claims were not defensive.  Mace further argued that the counterclaims were part of the covered person’s offensive proceeding and did not qualify for advancements. 

The Vice Chancellor held that Mace’s argument contradicted the core public policies underlying Section 145.  The Section was intended (a) to allow corporate officials to resist unjustified lawsuits so that the corporation will bear the expenses of litigation in the event the Plaintiffs are successful; and (b) to encourage capable candidates to serve as corporate officers and directors because the corporation will absorb the cost of defending their honesty and integrity.  The court held that the procedural posture of the claim wasn't important, only whether the office or director was placed in a posture of having to defend.  

• For purposes of determining whether someone is “defending” a proceeding, the operative question is not “who started the lawsuit?” as Mace suggests, but rather “has a claim been asserted against the covered person?” If a claim has been asserted, whether as an initial claim, counterclaim, or third party claim, then the covered person is “defending.”

The court also stated that the carve-out within the Bylaw did not bar Paolino from receiving advancements.  Mace argued that the carve-out in Section 6.01 foreclosed advancement because Paulino initiated the proceeding.  The carve-out provided that payments would not be made where the officer or director "initiated" the proceeding unless "authorized by the Board of Directors of the Corporation.”  Furthermore, Section 6.02 provided that “the right to indemnification conferred by Article 6 shall include the right to be paid by the Corporation the expenses incurred in defending any such proceeding in advance of its final disposition.”  The court held that Paolino was not seeking advancements or indemnification in connection with a proceeding initiated by him.  Rather, the counterclaims were part of the proceeding that Mace initiated because the counterclaims were a separate cause of action for purposes of Section 145 analysis. 

Lastly, the court stated that the employment agreement between Paolino and Mace did not alter his right to recover.  Mace argued that Paolino was not entitled to recover because the counterclaims did not arise “by reason of the fact” that Paulino was CEO and Chairman of Mace, but rather out of his employment agreement.  Plaintiff needed only to show the existence of a "nexus or casual connection between a claim and [the officer's] official capacity."  The court concluded that the counterclaims broadly asserted that Paolino breached his fiduciary obligations and contractual, statutory, and common law duties owed to Mace.  Thus, the counterclaims implicated his duties as an officer and director. 

Additionally, the requisite connection was established “if the corporate powers were used or necessary for the commission of the alleged misconduct.”  Under this test, a claim against a director or officer for matters that related to a corporation would fall within Section 145, even if the individual was a party to an employment agreement.  The court further stated that in order for the corporation to avoid advancements, the claim must involve a specific and limited contractual obligation without any nexus or casual connection to official duties.

The primary materials for this post are available on the DU Corporate Governance website.

Plaintiff James River Group, Inc. (“JRG”) was a Delaware corporation and defendant Michael Kehoe was its sole director.  Plaintiff James River Insurance Company (“JRIC”) was incorporated in Ohio.  All defendants, Kinsale Management, Inc. and Kinsale Capital Group (“Kinsale”), William Kenney, Brian Haney, Ann Marie Marson, Edward Desch (“James River Individual Defendants”), Greg Share, and Michael Kehoe, were on JRIC’s board of directors, and all defendants sought advancement from JRIC.

Plaintiffs JRG and JRIC filed suit against defendants alleging misappropriation of trade secrets, breach of contract, and breach of fiduciary duty.  Plaintiffs claimed that defendants used their positions to form the knowledge and expertise to start a competing company. Defendants subsequently moved for an order requiring JRG and JRIC to advance all fees and expenses, including attorneys’ fees, incurred by defendants in connection with this litigation.

A corporation can make the right to advancement of expenses mandatory through either its certificate of incorporation or through its bylaws.  When this is the case, the recipient’s right is enforced as a contract.  A director’s right to advancement is not dependent upon the likelihood that he will ultimately be entitled to indemnification.  The two notions are distinct.  The right to advancement also does not depend on the likelihood of repayment if the litigant loses.

Section 145 of the Delaware Code provides that indemnification is available for actions brought against officers and directors, even if the defendant does not ultimately prevail.  Additionally, the statute provides that a corporation may "advance" fees and expenses in advance upon receipt of an undertaking by such director or officer to repay the corporation if the director or officer is ultimately not entitled to indemnification.  Advancement and indemnification rights, however, may only extend to legal proceedings incurred “by reason of the fact” of the director’s position as a director, and not resulting from activities that a director pursues in his personal capacity.  There needs to be a nexus or causal connection between the underlying proceedings and one’s official corporate capacity in order for those proceedings to be “by reason of the fact.”

 The JRG bylaws include mandatory advancement and indemnification provisions that state

[E]xpenses incurred by a present or former director, officer, employee, or agent… shall be paid by the corporation in advance of the final disposition of such action… upon receipt of an undertaking by or on behalf of the director or officer to repay the amount if it shall ultimately be determined that [the director or officer] is not entitled to be indemnified by the corporation.

The court found that nexus existed between the claims against Kehoe and his corporate capacity, thereby entitling him to the advancement of expenses.  The claim asserted that he used his “entrusted corporate powers” to misappropriate JRG’s trade secrets and form a competing company.  If Kehoe had any liability, it would rise directly out of his former position as a director of JRG, and thus would satisfy the requisite nexus between the proceedings and his official corporate capacity. 

With respect to advancement from JRIC, the issue turned on Ohio law.  Section 1701.13 of the Ohio Code contained language slightly different from Delaware.  Like the Delaware Code, the Ohio Code provides that a corporation may indemnify its management.  The Ohio Statute also states that “expenses incurred by a director in defending an action or proceeding shall be paid by the corporation as they are incurred, in advance of the final disposition of the action.”  As the court noted:

• One could interpret it, as the Defendants urge, to command a result that corporations must always advance fees and expenses any time a corporate officer or director is sued for acts with a nexus to his official capacity. Alternatively, one could view the right to advancement . . . as devolving from a decision . . . to indemnify, as the Plaintiffs argue. It is undisputed that JRIC did not provide advancement or indemnification rights to its officers in its bylaws.

The District Court held that the latter view was correct.  Reading the statute as a whole, the court concluded that the plain meaning of the statute indicated that the advancement provision devolved from the decision made under the indemnification provision.  Ohio corporations were not, therefore, always required to advance fees to its director-litigants, but rather only when the corporation had chosen to make indemnification available. 

Because JRIC did not opt in to the indemnification and advancement provisions under the Ohio Code, the defendants were not entitled to advancement for fees and expenses incurred while litigating the claims brought by JRIC.

The court held JRG must advance Kehoe’s expenses for its claims against him under the Delaware Code, but JRIC was not required to advance expenses to the defendants under the Ohio Code.

The primary materials in this case can be found at the DU Corporate Governance Web Site.