Chancery Court Reexamines the Limits of Indemnification of Corporate Directors, Officers, and Others

By: Susan Apel and Benjamin Kendall

In Dore v. Sweports, Ltd., C.A. No. 10513-VCL (Del. Ch. January 31, 2017), plaintiffs John A. Dore, Michael J. O’Rourke, and Michael C. Moody (together, “Plaintiffs”) sought indemnification under the Delaware General Corporation Law (“DGCL”) and corporate bylaws, for expenses incurred in connection with three legal proceedings that occurred in Illinois, as well as those incurred enforcing their indemnification rights in Delaware.

Background

Defendant Sweports, Ltd. (“Sweports”) is a Delaware corporation with its principal office in Illinois that acts as a holding company for the intellectual property rights for certain cleaning products and holds a majority interest in UMF Corporation (“UMF”). UMF uses Sweports’ intellectual property to manufacture anti-microbial products that are primarily used in the healthcare and hospitality industries. George Clarke (“Clarke”) founded both Sweports and UMF, and effectively controls both through his roles as majority stockholder, chief executive officer, and a director of Sweports.

In July of 2006, Clarke hired the law firm of O’Rourke Katten & Moody LLP (the “Law Firm”) to represent Sweports in connection with its capital raising activities. The Law Firm represented Sweports’ in obtaining a bank loan (the “Bank Loan”) pursuant to which two named partners of the Law Firm, Michael O’Rourke (“O’Rourke”) and Michael Moody (“Moody”), as well as John Dore, Sweports’ Chief Operating Officer (“Dore”) (together, the “Plaintiffs) were included as guarantors of the loan. In consideration for acting as guarantors, each received a 2% equity interest in Sweports and stock options. Shortly thereafter, the Law Firm prepared a written consent that Clarke executed. The written consent added O’Rourke and Dore to the Sweports board of directors, and also amended Sweports’ bylaws to provide for mandatory indemnification rights “to the full extent permitted by the Delaware General Corporation Law” for any person “who at any time is or was a director, officer, employee, or agent.” (the “Amended Bylaws”).

In the following months, O’Rourke and Dore had discussions with a venture capital firm regarding Sweports entering into a joint venture in which Clarke would have no involvement. Clarke became suspicious and objected to, among other things, the joint venture plan. In response, Plaintiffs planned a board meeting to evaluate Clarke’s performance as CEO. Believing that he may be fired, Clarke circulated  documents entitled “Informal Action in Lieu of a Special Meeting of the Directors of Sweports Ltd,” and “Informal Action in Lieu of a Special Meeting of the Shareholders of UMF Corporation” (together, the “Informal Actions”) which (among other things) resolved: to remove Dore and O’Rourke as directors, that the services performed by the Law Firm had “zero” value, to rescind the equity award and options granted to O’Rourke and Moody, and to render “null and void” the Amended Bylaws.  Shortly thereafter, Clarke refused to pay any amounts to the Law Firm and stopped paying the Bank Loan. The guarantors of the Bank Loan, including O’Rourke and Moody, made the payments on the Bank Loan for the next four years.

Illinois State Court Actions

In late 2007, the guarantors of the Bank Loan, including O’Rourke and Moody, brought an Illinois state court action against Sweports (the “Sweports Action”). The Sweports Action sought to recover damages for breach of contract resulting from Sweports’ failure to repay the Bank Loan and the rescission of the Plaintiffs’ equity and options by way of the Informal Actions.  Plaintiffs won their motion for summary judgment on their Bank Loan claim, which was affirmed on appeal. Although the Illinois trial court found Sweports initially liable on the Plaintiffs’ stock claims, this decision was overturned on appeal due to a pleading error.

In response to the Illinois state court action, Sweports filed five sets of counterclaims (the “Sweports Counterclaims”) alleging that Plaintiffs breached their fiduciary duties and that they engaged in fraud. All of the Sweports Counterclaims were ultimately dismissed. Following the dismissal of the Sweports Counterclaims, Clarke caused UMF to assert substantively identical claims against the Plaintiffs in a separate Illinois state action (the “UMF Action”). This action was also dismissed. All of these dismissals were affirmed on appeal.

Bankruptcy

Following the favorable judgments in the Illinois state action, Plaintiffs commenced an involuntary bankruptcy proceeding against Sweports in the U.S. Bankruptcy Court for the Northern District of Illinois (the “Bankruptcy Action”). Ultimately, the bankruptcy judge rejected the reorganization plans of both Sweports and Plaintiffs, and dismissed the case.

Delaware Action

On December 31, 2014, Plaintiffs filed the action in the Delaware Court of Chancery seeking indemnification for expenses incurred in the Sweports Counterclaims and the UMF Action. Following cross-motions for summary judgment, the Court found that the Sweports Counterclaims and the UMF Action named O’Rourke and Dore as defendants by reason of their status as directors and officers of Sweports, that they were successful on the merits of those claims, and that they were entitled to mandatory indemnification under Section 145(c) of the DGCL. The Court denied the summary judgment motion with respect to Moody because he had to rely on the Amended Bylaws provision that extended indemnification to “agents” of Sweport and a question of fact remained as to whether he had acted in good faith in connection with the underlying events.

At the following trial, Sweports did not raise the issue of Moody’s good faith and instead primarily focused on the reasonableness of the legal expenses that the Plaintiffs incurred during the various actions. To the extent permissible by law, the Law Firm represented the Plaintiffs in all the prior actions, and was co-counsel in the Delaware action. The Court’s determination of the reasonableness of the claimed legal expenses was complicated by the fact that Moody and O’Rourke revised the Law Firm’s prior time entries in an attempt to increase the potential recovery in the Delaware action.

Legal Analysis

The Court reviewed DGCL § 145 relating to corporate indemnification. While the mandatory indemnification provision of § 145(c) only covers directors and officers, when a corporation has provided other authorized individuals with mandatory indemnification to the fullest extent of the law, as in this case, then that right extends the mandatory indemnification contemplated by § 145(c) to those individuals. The Court recognized that the first step in assessing an indemnification claim is to determine if the expenses were incurred in connection with a covered proceeding. When a corporation has provided individuals with mandatory indemnification to the fullest extent of the law, it bears the burden of proving that individual is not entitled to indemnification. Second, once a court finds that a proceeding is covered, it must determine whether the plaintiffs’ expenses were “actually and reasonably incurred” in connection with that proceeding. The party seeking indemnification bears the burden of proving that the amount of indemnification sought is reasonable. In light of the above, the Court reviewed the various claims for which the Plaintiffs sought indemnification.

First, the Court agreed that that the Plaintiffs were entitled to indemnification for expenses relating to the Informal Actions, including costs of investigating potential responses to Clarke’s removal of O’Rourke and Dore as directors of Sweports, and his related actions involving the Bank Loan. The Court held that although these actions by Clarke did not expressly threaten litigation, the Informal Actions asserted “an intentional plan to improperly seize control of Sweports.” Read in full context this constituted threatened litigation against the Plaintiffs.

Second, the Court held that Plaintiffs were not entitled to indemnification for expenses incurred prosecuting their Sweports Action claims for breach of contract. “An individual is not entitled to indemnification for 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.” However, the Court held that Plaintiffs were entitled to indemnification for expenses incurred in defending the Sweports Counterclaims and the UMF Action as these named the Plaintiffs as defendants by reason of their status as directors, officers, and agents of Sweports.

Third, the Court held that the Plaintiffs were not entitled to indemnification for costs incurred during the Bankruptcy Action because it was merely a collection vehicle for the judgment obtained on their breach of contract claims, which were personal to Plaintiffs.

Finally, the Court held that, although it would have considered denying enforcement expenses on the grounds of bad faith or unclean hands, if either had been raised, given the steps taken by O’Rourke and Moody to alter time entries, the Plaintiffs were entitled to indemnification for expenses incurred during the Delaware proceeding. When a corporation provides individuals with mandatory indemnification to the fullest extent of the law, the indemnification right includes expenses incurred enforcing the right.

Ultimately, although the Plaintiffs sought indemnification in excess of $1M, the Court only awarded a little less that $250,000 for the actions preceding the Delaware action in light of the pervasive revisions of the Law Firm’s time entries and inconsistent representations made by the Plaintiffs regarding their expenses in prior actions. Because the amount awarded of clearly demonstrable recoverable expenses represented less than 20% of the costs Plaintiffs initially claimed, the Court held that Plaintiffs were only entitled to 20% of the costs they incurred enforcing their indemnification rights through the Delaware proceeding.

Dore v. Sweports, Ltd., C.A. No. 10513-VCL (Del. Ch. January 31, 2017)

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