In Baker v. Impact Holdings, Inc., C.A. No. 5144-VCP (Del. Ch., July 30, 2010), read opinion here, the Court of Chancery granted a motion to dismiss an action for advancement for litigation expenses incurred in two prior preemptive and affirmative actions filed by the petitioner, Baker. Baker argued that he was entitled to mandatory advancement because he claimed that he brought the actions “in defense of” allegations made and actions taken by Respondent Impact following what Baker characterized as an investigation into his performance as a director and officer of Impact. See highlights of prior Chancery decision in this case here.
This summary was prepared by Kevin F. Brady of Connolly Bove Lodge & Hutz LLP.
In January 2008, Impact purchased stock in two entities beneficially owned by Baker, and as a result of this sale, Baker became an officer and director of Impact. Impact later took ownership of Impact Confections, Inc. and asked Baker to serve as an officer and director of Confections. Subsequent to the Confections’ acquisition, Impact initiated a financial audit at Confections that allegedly led to an investigation into Baker’s performance as an officer and director of Impact and Confections. Allegedly as a result of that investigation, Impact removed Baker as a director of Impact. After his removal, Baker initiated several actions including an action seeking advancement of his fees and expenses incurred in the other actions.
In a counterclaim filed in one of the actions, Impact alleged that Baker breached his fiduciary duties to Impact and Confections. Importantly for this motion, Impact did not assert any claims against Baker for these alleged breaches. Baker claimed that Impact’s allegations arose as a result of Impact’s internal investigation, and that he filed those actions “to defend against” the effect of the investigation which was “his removal as a director of Impact and the damage to his reputation caused by Impact’s accusations.”
In its analysis, the Court examined Article VIII of Impact’s Certificate of Incorporation which governed indemnification and advancement and mandated advancement as follows:
[Impact] shall indemnify any person who was, is, or is threatened to be made a party to a proceeding (as hereinafter defined) by reason of the fact that he or she (i) is or was a director or officer of [Impact] or (ii) while a director or officer of [Impact], is or was serving at the request of [Impact] as a director, officer… or similar functionary of another foreign or domestic corporation…or other enterprise, to the fullest extent permitted under the Delaware General Corporation Law, as the same exists or may hereafter be amended…Such right shall include the right to be paid by [Impact] expenses (including without limitation attorneys’ fees) actually and reasonably incurred by him in defending any such proceeding in advance of its final disposition to the maximum extent permitted under the Delaware General Corporation Law, [DGCL] as the same exists or may hereafter be amended.
It is also important for this motion that the Court noted that Article VIII broadly defined a “proceeding” as “any threatened, pending, or completed action, suit, or proceeding, whether civil, criminal, administrative, arbitrative, or investigative, any appeal in such an action, suit, or proceeding, [or] any inquiry or investigation that could lead to such an action, suit, or proceeding.”
On October 12, 2009, Baker sent a letter to Impact demanding advancement for fees and expenses incurred in connection with the actions he filed. After Impact refused that demand, Baker filed his petition.
Impact moved to dismiss arguing that, among other things: (i) the petition did not sufficiently show how that investigation (audit of Confection’s financial records) constituted a “proceeding;” and (ii) the actions were not “in defense of” an action, but in fact were affirmatively filed by Baker not to defend against any proceeding, but “to preemptively ameliorate certain negative effects he claims resulted from the Investigation.” Baker responded that: (i) the investigation constituted a “proceeding” under the expansive definition in the Certificate because Impact used information gained during the investigation to support its allegations in the counterclaim that Baker breached his fiduciary duties and as the basis for removing him as a director of Impact; and (ii) he filed the actions to defend himself from the allegations in and results of the purported investigation.
Baker Entitled to Advancement for Affirmative Litigation
DGCL § 145(e) grants a corporation authority to advance expenses, including attorneys’ fees incurred “in defending” a covered proceeding, to a director or officer. Section 145(e) provides only that a corporation “may” pay the defensive expenses of its directors, officers, or employees in advance of the final disposition of a covered proceeding. However, corporations frequently “make the right to advancement of expenses mandatory, through a provision in its certificate or bylaws or…a contract specifically addressing the issue.”
To determine whether a director has such a mandatory right, the Court examined the language of the Certificate finding “unambiguous language” of the advancement provision. As a result, the Court found that even though Baker had alleged facts sufficient to show that Impact’s investigation may fit within the definition of a “proceeding,” he did not bring the actions “in defense of” that investigation.”
The Investigation Was a “Proceeding”
Based upon what Impact alleged in its Counterclaim concerning various actions and omissions by Baker purportedly revealed by the investigation, and, specifically, its characterization of the Investigation, the Court rejected Baker’s contention that Impact conducted an internal investigation specifically into his conduct as a director of Impact or Confections. Rather, the Court found that the investigation referred to in the Counterclaim appeared to be primarily an audit of Confections’ financial records that “happened to lead, as an understandable by-product, to the accusations about which Baker complains.”
However, the Court did not dismiss the claim because of the broad definition of “proceeding” in the Certificate. The Court noted that “the language of that definition seems broad enough to encompass, at its widest point, even a threatened inquiry that could lead to an action, suit, or formal proceeding against Baker. Under this expansive designation, it is conceivable that the financial audit of Confections could constitute an inquiry…that could lead to such an action, suit, or proceeding against Baker, including a possible further investigation specifically into his conduct as a director.” As a result the Court found that Baker had sufficiently alleged the existence of a “proceeding” under the Certificate.
The Actions Were Not Brought “In Defense Of” the Investigation
The advancement provision expressly limited advancement to expenses incurred by a covered person “in defending” a proceeding to which that person “was, is, or is threatened to be made a party.” The Court referenced Citadel Holding v. Roven, 603 A.2d 818, 824 (Del. 1991), where the Delaware Supreme Court found that, “in addition to expenses normally incurred in the context of litigation naming a covered person as a defendant, i.e., attorneys’ fees accrued while defending that litigation, the “in defending” language also applies to: (1) a covered person’s affirmative defenses and (2) compulsory counterclaims directly responding to and negating an affirmative claim against that person…” In this action, however, the Court found that because Impact had not asserted any claims against Baker, he could not reasonably argue that the actions he filed directly relate to and negate claims since no claims were raised.