Why companies may have to pay ex-directors’ legal fees
For a company, suing a former director or officer for theft of trade secrets raises a series of thorny questions. Among these is whether the company has to pay the legal fees of the defendant. The answer may be a surprising one – as a result of competing corporate interests.
Every company wants to be well positioned to protect itself from theft of trade secrets by an officer, director or outside party. But companies must also compete to recruit and retain qualified officers and directors. To do so, they often assure officers and directors that they will not be at risk of personal liability for claims made against them in their corporate capacity, absent proven bad behavior.
A company’s articles of incorporation, other organizational documents or contracts will often seek to offer this assurance by providing that an officer or director is entitled to mandatory advancement of expenses – including attorneys’ fees – if sued for actions (or inactions) taken in his or her capacity as an officer or director, and/or indemnification of judgments, fines, expenses and other liabilities at the conclusion of such a lawsuit.
This relatively typical language may, in certain circumstances, apply even to a lawsuit brought by the very company obligated to advance the expenses.
The following scenario illustrates the dilemma: your organization discovers that one of its former executive officers, before leaving, gave your trade secrets and other proprietary information to a competitor. You sue the former officer for breach of fiduciary duty, breach of the confidentiality agreement he or she signed as a condition of employment and breach of the applicable trade secrets statute.
Before he or she files a response to your lawsuit, the former officer serves you with a written demand to advance his or her attorneys’ fees and other litigation expenses that he or she is about to incur in defending against your lawsuit.
As noted, this right to advancement of fees and expenses is found in many organizational documents or in contracts, and provides certain officers and directors with a right to mandatory advancement and to indemnification ‘to the fullest extent permitted by law’ when defending against any lawsuit arising from their services to the company.
You may think this cannot possibly require your company to fund the defense of the former officer who has done you wrong while you are proving the wrongdoing. As a result, your company denies the request of the former officer. He or she then countersues for advancement of those fees and other costs incurred in defense against the action and for indemnification of the same costs at the close of the case, should he or she prevail.
RECENT CASE AS EXAMPLE
A federal magistrate last year recommended to the trial court, under similar facts, that New Jersey law required advancement of fees and expenses to a former senior executive officer. After terminating the officer, the company sued him for what it alleged were ‘a variety of inappropriate and deceptive practices during his time with the company.’ The former executive then demanded advancement of his fees and other litigation expenses pursuant to the company’s articles of incorporation.
The provision contains the following language, which is not uncommon in such documents, about such situations: ‘During the pendency of any such proceeding, the corporation shall, to the fullest extent permitted by law, promptly advance expenses that are incurred, from time to time, by a director or officer in connection with the proceeding, subject to the receipt by the corporation of an undertaking as required by law.’
This provision, combined with the applicable New Jersey law, distinguishes between indemnification and advancement of fees.
Indemnification – paying a former employee-defendant’s costs and expenses at the end of a lawsuit – is determined based on the applicable limits on indemnification after resolution of the underlying claims. For example, if it were determined that the officer or director illegally misappropriated a trade secret, indemnification would likely be denied.
Advancement of fees and expenses – providing funds before the case ends – occurs before the adjudication of the underlying claims. In the case referenced above, the court cited one commentator who has observed that ‘[a]dvancement depends on the nature, not the merits, of the claims asserted against the corporate official.’
Where advancement is mandatory, the indemnitee may trigger the company’s duty simply by submitting the request for advancement and an unsecured written undertaking to repay the expenses if it is later determined that indemnification is not available. Because the undertaking is unsecured, the company has no guaranty, literally or figuratively, that it will be able to collect on it.
In recommending that the motion by the former executive be granted in the case at issue, the magistrate judge noted that the indemnification and advancement provisions in the company’s articles are mandatory: an officer ‘shall be indemnified’ and the corporation ‘shall… promptly advance expenses.’ Nothing in the articles limited application of those mandatory provisions to lawsuits by third parties.
If you are an officer or director acting on behalf of the organization, it may be troubling to have to indemnify a former officer or director for attorneys’ fees and expenses incurred by that person at the end of a case after suing that person for misconduct. But at least the duty to indemnify is triggered only after an adjudication.
By contrast, advancement of fees and expenses during the case, before your company has had the opportunity to prove the former officer’s or director’s malfeasance, will feel like insult added to the very injury that has prompted your lawsuit. Rulings such as the one in New Jersey may seem surprising, but they are not uncommon.
At a minimum, organizations and their officers and directors should not be taken by surprise on this issue. You should review your articles of incorporation, other governing documents and relevant contracts – and understand how your director and officer insurance policies interrelate with such documents – to understand the full range of protections from personal liability available and the classes of people to whom they apply.
These provisions, including the reasons for them and their benefits, should be balanced against other company interests, such as trade secret protection. Broad provisions for advancement of fees and indemnification may make sense for some organizations, less so for others. Some may benefit from expanding protections to lower-level officers, while others may not. With this in mind, thoughtful analysis and drafting are key.
Doug Mishkin, Chuck Morton and Michael Schiffer are partners, and Sandy Schlesinger is an associate, with Venable