Paolino v. Mace Security International, No. 4462-VCL (Del. Ch., revised December 14, 2009), read opinion here.

Short Introduction

This decision provides an excellent analysis of the policy foundations for, and the important distinctions between, advancement and indemnification rights pursuant to DGCL Section 145. After explaining the important distinctions between advancement and indemnification, and the different timing considerations involved in addressing them, the Court stayed the claims for indemnification and after granting advancement rights, directed the parties to proceed summarily in the event that they were not able to agree on the amount of fees subject to advancement.

Brief Background

The factual setting involved the former CEO of a company that was terminated. The CEO initiated arbitration proceedings, claiming that he was wrongfully terminated, that he was defamed and that the company owed him money. Not content with playing defense, the company counterclaimed with various and sundry accusations against their former CEO. The company argued unsuccessfully that the former CEO should not be entitled to advancement of the fees incurred to defend its counterclaim against him, because, the company asserted, the counterclaims were part of the affirmative suit that the former CEO had filed initially.

Overview of Court’s Reasoning

The Court dissected and discarded with surgical precision the fallacies in the arguments by the company. Moreover, in an example of an apparent unintended consequence, the company can be said to have been “hoisted by its own petard” when it argued that one of the reasons the former CEO should not be entitled to advancement is because it was “not humanly possible” to separate the fees that were incurred in connection with the initial complaint he filed, compared to fees incurred to defend against the counterclaim.

After a thorough analysis to support its reasoning, the Court used the company’s material representation to conclude at page 31 that:   “. . . because Mace has represented to me that it is impossible to distinguish between expenses incurred in connection with the Counterclaims and expenses incurred on affirmative claims, I conclude that all of Paolino’s reasonable expenses for the Arbitration must be advanced.” The Court clarified that this was not the same as determining that Paolino had a right to advancement for the offensive claims be asserted, but rather defined the scope of what expenses Paolino could seek under his advancement right for the Counterclaim. The Court emphasized that “Mace has made representations to the Court and those representations have consequences.” The Court provides a very detailed and scholarly analysis of the caselaw that it relies on, and parses that caselaw to support its holding.

For example, the Court explains that 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 a third-party claim, then the covered person is “defending.” The Court underscored the importance of analyzing for “coverage purposes,” each counterclaim as a separate cause of action to determine if it qualifies for advancement. To the contrary, analyzing a counterclaim with an “all-or-nothing” approach is against the public policy that animates Section 145.

Moreover, the Court reasoned that: “Just as it does not make sense to force a corporation to fund all of a covered person’s counterclaims simply because the corporation filed suit first, it does not make sense to relieve a corporation of its advancement obligations for all of the claims it asserts against a covered person, simply because the covered person sued first. To do so would deny the covered person the protection to which he or she is entitled and imposes significant cost, in the form of forfeiting advancement rights for counterclaims” on individuals who sought to enforce their own rights by filing suit.” (See slip op. at 17.)

Distinction between Covered Advancement Claims and Disputes Based Only on an Officer’s Employment Agreement

The Court explained that neither the Delaware decision in Cochran v. Stifel Fin. Corp., 2000 WL 1847676 (Del. Ch. Dec. 13, 2000), aff’d in pertinent part, 909 A.2d 555 (Del. 2002), nor any other cases supported the argument that when an Employment Agreement is at issue “Section 145 goes out the window.” To the contrary, the Court emphasized that instead the Delaware cases demonstrate that “Section 145 will not apply when the parties are litigating a specific and personal contractual obligation that does not involve the exercise of judgment, discretion or decision making authority on behalf of the corporation.” See slip op. at 21-22. See also Reddy v. Electronic Data Systems Corp., 2002 WL 1358761 (Del. Ch. June 18, 2002).

The Court parsed the factual background and legal analysis in the Cochran and Reddy cases and the case of Zaman v. Amedeo Holdings, Inc., 2008 WL 2168397 (Del. Ch. May 23, 2008)  and related cases. The Court explained that in Zaman the Court rejected an argument that advancement was barred for the defense of claims that managers of the New York Palace Hotel had used company credit cards for personal expenses while acting in their managerial capacity. The Court in Zaman rejected the argument that the claims should be characterized as merely a dispute over contractual reimbursement, noting that the claims were “grounded in their alleged misuse of the substantial fiduciary responsibility they were given as key managerial agents.” Id. at *28. Notably, the Court in Zaman observed that if the defendants were ultimately shown “after an adjudication on the merits that the [plaintiffs] were in fact bilking the Palace Hotel and its owners with excessive credit card charges, they will not be entitled to indemnification for any judgments against them.” Id.

The Court highlighted the point that the Cochran case did not establish an exception to advancement rights when Employment Agreements were involved. Rather, Cochran’s holding “that a personal contractual obligation lacked the necessary nexus rested on both the specificity of the contractual obligation and the circularity of the covered person being obligated to make the called-for payment, then obtaining it back through indemnification. Section 145(b) prohibits precisely this circularity in derivative lawsuits by preventing a corporation from indemnifying a covered person for judgments recovered by the corporation.” See slip op. at 28.

The Court further explained that Cochran, Reddy and Zaman are consistent with the overarching test announced by the Delaware Supreme Court for determining whether a covered person has been sued “by reason of” his or her official capacity: “if there is a nexus or causal connection between [a claim] and one’s official capacity, those proceedings are ‘by reason of the fact’ that one was a corporate officer, without regard to one’s motivation for engaging in that conduct” (citing Homestore v. Taffeen, 888 A.2d 204, 215 (Del. 2005)).

In addition, the Court added that the “requisite connection is established ‘if the corporate powers used were necessary for the commission of the alleged misconduct’” (citing Bernstein v. TractManager, Inc., 9538.2d 1103 (Del. Ch. 2007)).