Court Disallows Executive's Golden Parachute Benefits

The Ontario Court of Appeal has ruled that a former public company executive is disentitled to receive "golden parachute" benefits under an employment agreement with the corporation as a consequence of the breach of his fiduciary duties.

 

In Unique Broadband Systems, Inc. (Re) 2014 ONCA538, the Court of Appeal reversed the decision of trial judge, Justice R. Mesbur in certain fundamental respects. 

 

Unique Broadband Systems, Inc. (“UBS”) is a public company listed on the TSX Venture Exchange.  In 2002, Gerald McGoey was appointed a director and acting CEO of the company and later became CEO on a permanent basis.  McGoey’s relationship with UBS was governed by a management services agreement between UBS and his personal company.  The agreement contained a “golden parachute provision” which granted McGoey enhanced termination benefits in certain circumstances.

 

UBS had in place an incentive-driven share appreciation rights plan (“SAR Plan”) for its directors and senior management.  Upon certain triggering events, a SAR unit holder would be paid an amount equal to the difference between the market trading price of a UBS share and a strike price identified in the SAR Plan. 

 

In 2003, UBS acquired a controlling equity interest in Look Communications Inc. (“Look”), a telecommunications company.   McGoey was also a director and the CEO of Look.  Look’s primary asset was a band of telecommunications spectrum.  In early 2009, Look engaged in the process of selling the spectrum through a court-supervised plan of arrangement.  Ultimately, the spectrum was sold for $80 million.  McGoey expected that the sale would generate a significantly higher price and was very disappointed with the figure offered by the buyer. 

 

UBS’ board of directors resolved to treat the spectrum sale as a “triggering event” pursuant to the SAR Plan.  Prior to the announcement of the sale, UBS’ shares were trading at approximately $0.15 per share.  The board anticipated that the sale would cause the UBS shares to appreciate however, the anticipated share price increase did not materialize and the shares continued to trade at the $0.15 after the announcement. 

 

McGoey engaged in negotiations to sell the balance of Looks’ assets but the transaction did not materialize. 

 

After the sale of the spectrum, the compensation committee of UBS’ board, which consisted of McGoey and two others, began reviewing the SAR Plan.  Each member of the compensation committee had a considerable number of SAR units. 

 

At a meeting of the board, each director disclosed his conflict of interest regarding their SAR unit holdings.  The directors then unanimously resolved to cancel the SAR units and established a SAR cancellation payment pool of $2.31 million based on a fixed unit price of $0.40 per share.  Under this new arrangement, McGoey and others would receive a SAR cancellation award based on the $0.40 per unit figure. 

 

At a subsequent board meeting, McGoey proposed the establishment of a bonus pool of $7 million.  That proposal was not approved.  However, the board did approve establishing a bonus pool of $3.4 million. 

 

Under the SAR cancellation award, McGoey was allocated to receive $600,000 and under the bonus pool he was allocated to receive $1.2 million.

 

Such awards were resisted by UBS’ shareholders.  Faced with this resistance McGoey caused UBS to advance to him $200,000 for the payment of anticipated legal fees. 

 

At a special shareholders meeting McGoey and the other directors were removed and were not re-elected.  McGoey then resigned as CEO and took the position that he was terminated without cause because he was not re-elected to the UBS board.  McGoey brought an action against UBS seeking payment of enhanced severance in the amount of $9.5 million.  He successfully moved for partial summary judgment before Justice Marrocco. 

 

On July 5, 2011, UBS was granted protection under the Companies’ Creditors Arrangement Act (“CCAA”).  McGoey filed a proof of claim in an amount in excess of $10 million which the CCAA monitor disallowed in its entirety.  The court ordered a trial of the issue. 

 

At trial, Justice Mesbur found that McGoey and the other directors had breached their fiduciary duty to UBS in establishing the SAR cancellation awards and the bonus pool as these actions were driven by the board’s own self-interest and were of no benefit to the UBS shareholders.  She set aside the allocations to McGoey pursuant to the SAR cancellation award and the bonus pool.   However, Justice Mesbur found that the breach of fiduciary duty did not qualify as a default under McGoey’s management services agreement with UBS and that he was therefore entitled to the benefit of the golden parachute provisions of the agreement.  Finally, Justice Mesbur found that UBS had no obligation to indemnify McGoey for his legal fees because he had breached his fiduciary duties. 

 

UBS appealed and McGoey cross-appealed.

 

The Court of Appeal held that UBS’ appeal should be allowed and McGoey’s cross-appeal should be dismissed.

 

Justice Hourigan wrote the decision of the Court of Appeal.

 

The Court of Appeal held that Justice Mesbur had reasonably concluded that the board’s actions were driven by self-interest and therefore that McGoey had breached his fiduciary duties to UBS.  The $0.40 share price was unjustified and unrealistic.  The board did not seek any expert advice on an appropriate bonus structure and did not have any comparable or other data regarding executive compensation in the marketplace.

 

The Court of Appeal also found that there was no documentation that stipulated the performance factors or criteria by which McGoey’s performance would be evaluated, and there was no documentation that showed how the bonus pool was quantified.  The breach was not incomplete because McGoey was removed from office before he could be paid.  The court held that it would be a remarkable result if a fiduciary could be allowed to act in a manner contrary to his duty with impunity on the basis that he was prevented by the beneficiaries' vigilance from receiving a personal benefit.

 

The Court of Appeal held that McGoey’s actions were not undertaken with the assistance of independent legal advice.  His actions were not protected by the business judgment rule as he did not satisfy the rules' preconditions of honesty, prudence, good-faith and a reasonable belief that his actions were in the best interests of the company.  Accordingly, because McGoey had breached his fiduciary obligations, UBS was not required to indemnify him for his legal fees.

 

The Court of Appeal disagreed with Justice Mesbur’s interpretation of the management services agreement.  It held that her interpretation had ignored section 134(3) of the Ontario Business Corporations Act (“OBCA”) which provides that no provision in a contract relieves a director or officer from the duty to act in accordance with the OBCA or from his or her liability for a breach thereof.  The Court of Appeal held that Justice Mesbur’s interpretation had led to a commercially absurd result.  Interpreting the provisions of the agreement which defined a "default" which would disentitle McGoey to an enhanced severance payment as including a serious breach of fiduciary duty that was materially injurious to UBS would give effect to the entirety of the words used in the definition in their context.  Such an interpretation was also commercially sensible and was not inconsistent with the OBCA.

Regards,

Blair

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. 

Regards,

Blair