Thursday, October 10, 2013

Corporate Directors Accused of Bad Faith Conduct Denied Advance Funding of Legal Costs

Most Canadian business corporations statutes, including the Ontario Business Corporations Act and the Canada Business Corporations Act ("CBCA"), contain provisions which permit a director or officer of a corporation to be indemnified by the company "against all costs, charges and expenses, including an amount paid to settle an action or satisfy a judgment" if those costs had been reasonably incurred in proceedings in which the officer or director is involved because of her association with the company.  The legislation also provides that the company may advance money to an individual for her legal costs, but the individual is required to repay the money and the company is not required to indemnify her unless the individual acted honestly and in good faith with a view to the best interests of the company.  Those statutory indemnification provisions are often reproduced in company bylaws.
The law in that area is expanding.  In the case of Cytrynbaum v. Look Communications Inc. [2013] ONCA 455, the Ontario Court of Appeal agreed with the reasons of an application judge which denied an application by former directors and officers of Look Communications Inc. ("Look") for advance funding of their legal costs in defending an action brought against them by Look itself.   
Look is a CBCA company which was engaged in wireless, internet and cable services.   The defendants were either directors or officers of Look or former directors or officers of Look.  Look adopted a share appreciation rights plan "SARs" plan as an incentive to its directors, officers, employees and consultants.  The SARs plan allowed Look to award such individuals share appreciation rights based on the market value of Look's shares.  The SARs could be exercised if Look sold all or substantially all of its assets and entitled the holder to be paid the difference between the market price of the shares on that date and the price on the date the SARs were granted.  The former directors and officers of Look were all granted SARs.  Some were also granted stock options.  
Look's business seriously declined from 2005 to 2008.  In late 2008, Look's board decided to sell Look's assets pursuant to a plan of arrangement under the supervision of a monitor.  In 2009, Look sold its key assets for $80 million to a partnership formed by Rogers and Bell, less $16 million to be paid to Bell to settle certain outstanding litigation.  The sale was approved by Look's shareholders and by the court.
Following the agreement with Rogers and Bell, Look's board accepted the recommendation of certain of Look's management to set aside $11 million for management severance, retention and bonus payments.  The board also accepted management's proposal to authorize payments to terminate the SARs and cancel all stock options on the basis of a share valuation of $0.40 per share contrary to the terms of both of the SARs and option plans that specified the market value was to be used.  At the time, the market price of the shares was approximately $0.20.
Following the sale, Look paid more than $20 million, or 32 per cent of the net sales proceeds to its officers, directors, employees and consultants by way of bonuses and equity cancellation payments.  

Those payments were not disclosed to the shareholders until several months later when a management information circular was issued.  Once disclosed, the payments immediately attracted strong shareholder criticism.  The appellants anticipated that they would be sued and at a board meeting decided to authorize Look to pay $1,550,000 as retainers to three law firms acting for them personally.  Immediately after those retainers were paid, the individuals resigned as directors and officers of Look.  

Look's by-laws provided for indemnity and advance funding, in almost identical wording to the CBCA.  In addition to the by-laws, the defendants relied on indemnification agreements they had entered into with Look which provided indemnity and advancement of costs in broader and more generous terms than the provisions of the CBCA. The former management commenced an application seeking advance payment and indemnity for their legal costs in defending Look's action in accordance with the bylaws and the agreements.  Look refused to make such payments.  
In denying the defendants' application, the first issue considered by the application judge was whether the defendants could seek advance funding of their legal costs when they were defending an action brought by the company itself, as opposed to by a third party.  He found that section 124(4) of the CBCA which provides that a corporation may with the approval of a court indemnify an individual or advance monies in respect of an action "by or on behalf of the corporation" to which the individual is made a party because of the individual's association with the corporation or other entity does not apply only to derivative actions.  He found that the words "by or on behalf of the corporation" clearly and unambiguously included both actions brought by the corporation itself and actions brought on behalf of the corporation.  However, he concluded that directors or officers who have engaged in misconduct towards a corporation ought not to be allowed to use corporate funds to defend themselves.  
Secondly, the application judge held that former management were entitled to the benefit of the presumption of good faith and that it was for Look to lead evidence to rebut that presumption.  Look was required to establish a strong prima facie case that its former management acted mala fides towards the corporation and establish on the evidence that it was likely to succeed at trial.  The application judge found that Look had made out a strong prima facie case that the former management had acted in bad faith by using a share value of $0.40 to fix the equity cancellation payments and that the $0.40 value bore no relation to the market value and was contrary to the terms of the SARs and option plans.  The share price was determined without any consultation with a compensation or valuation expert and resulted in conferring personal benefits of approximately $9 million largely on the defendants at the expense of the corporation.  The application judge rejected the contention that the legal advice the board had received provided the defendants with a defence because the advice extended only to the board's general authority to make compensation awards and not to the decision to use the $0.40 per share valuation.  
Thirdly, the application judge found that the retainer payments to the law firms were made contemporaneously with the defendants' resignations in the face of mounting wave of shareholder complaints and without the support of proper legal advice despite the caution sounded by a lawyer retained by the board who was then excluded from the meeting held to consider the payments.
The former management appealed this decision to the Ontario Court of Appeal.  Mr. Justice Sharpe delivered the judgment of the court and agreed with the application judge.

 Justice Sharpe agreed that the words "by or on behalf of the corporation" unambiguously covered both derivative actions which are brought on behalf of the corporation and actions that are brought by the corporation, such as this one.  In addition, Justice Sharpe held that it was difficult to see any principled rationale for applying one regime for advance costs in derivative actions and another for actions brought by the corporation itself.  The objective underlying the indemnity provisions for directors and officers is to maintain a balance between encouraging responsible behaviour by directors and officers on the one hand and permitting enough leeway to attract strong candidates to foster entrepreneurism on the other hand.

Secondly, Justice Sharpe agreed with the application judge's application of a strong prima facie case standard instead of adopting a standard which would deny advance funding only when the evidence rises to such a level that a court is able to make a final determination of mala fides.  If the matter fell to be determined solely on the wording of the indemnity agreements, advance funding could only be denied on that basis.  However, the issue had to be decided on the basis of the overriding language of the statute which contemplates that the right to advance funding is subject to court approval before trial and that a final determination of the issue of bad faith and indemnity must await trial.
Justice Sharpe held that the application judge did not err in finding that the plaintiff had made out a strong prima facie case of bad faith and was correct in denying advance funding of the defendants legal costs. 



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