The Delaware Court of Chancery recently established a CEO’s right to advancement of expenses to defend against counterclaims asserted by his former corporate employer in an arbitration initiated by the CEO. The court found that the CEO was entitled to advancement of expenses to defend the counterclaims notwithstanding the carve-out in the corporation’s bylaws eliminating the obligation to advance expenses for any proceeding initiated by a potential indemnitee without board approval. Paolino v. Mace Security International, Inc., C.A No. 4462-VCL (Del. Ch. Dec. 8, 2009).

Louis D. Paolino served as Chairman and Chief Executive Officer of Mace Security International, Inc. (the “Company”) from 1999 until his termination by the Company for “cause” in 2008. Following his termination, Paolino sought arbitration claiming wrongful termination and breach of his employment agreement. The Company counterclaimed alleging, among other things, that Paolino had breached his contractual, statutory, fiduciary, and common law duties owed to the Company and its directors and shareholders (the “Counterclaims”). Following unsuccessful requests to the Company for indemnification and advancement of expenses relating to the Counterclaims, Paolino sought relief from the Delaware courts. Notably, Paolino did not seek indemnification or advancement for the claims he initially asserted in the arbitration. The court stayed Paolino’s indemnification claim pending the outcome of the arbitration.

The Company’s bylaws provided its current and former officers and directors with broad and mandatory indemnification and advancement rights. Specifically, the bylaws granted a right to mandatory indemnification “to the fullest extent permitted by Delaware law.”  Using customary language, the bylaws also eliminated the Company’s obligation to indemnify any person “in connection with a proceeding (or part thereof) initiated by such person” unless the proceeding (or part thereof) was authorized by the board. The bylaws also provided mandatory advancement of expenses commensurate with the scope of the indemnification rights thereby requiring advancement of expenses to any covered person “defending” a proceeding in which indemnification could be available. Noting that the bylaws provided indemnification to the fullest extent permitted by the Delaware General Corporation Law (the “DGCL”), the court stated that indemnification would be available under the bylaws not only pursuant to Sections 145(a) and (b) of the DGCL (where a covered person is involved in a proceeding by reason of the fact that he was a director or officer and satisfied the applicable standards of conduct) but also under Section 145(c) of the DGCL (where a covered person is successful on the merits or otherwise in defending a proceeding for which indemnification would be available). Therefore, the court concluded that if Paolino were successful on the merits or otherwise in defending the Counterclaims, then he would be entitled to mandatory indemnification under the bylaws and Section 145(c) which, in turn, meant that he was entitled to the advancement of expenses in defending such Counterclaims.

The Company made several arguments that advancement was not available. The Company first argued that the Counterclaims were part of Paolino’s offensive proceeding and therefore did not qualify for advancements. The Company attempted to rely on Delaware precedent establishing that a covered person could assert counterclaims as part of a defense and still be entitled to advancement and argued that, in light of such precedent, a mirror image rule should apply such that the covered person’s defense of counterclaims asserted in response to a proceeding initiated by the covered person should be considered offensive rather than defensive. The court disagreed noting that “the operative question is not ‘who started the lawsuit?’…but rather has a claim been asserted against the covered person? If a claim has been asserted, whether as an initial claim, counterclaim, or third-party claim, then the covered person is 'defending,'" and therefore entitled to mandatory advancement.

The Company then argued that the carve-out to the bylaws for proceedings initiated by a covered person without board approval precluded Paolino’s claim for advancement because he had instituted the arbitration without board approval. The court again disagreed noting that Paolino was seeking advancement for the Counterclaims which had been initiated by the Company, not Paolino.

Finally, the Company asserted that the Counterclaims arose out of the employment agreement between the Company and Paolino and therefore were personal and contractual in nature in contrast to potentially indemnifiable claims arising out of Paolino’s capacity as CEO and Chairman of the Company. The court rejected these arguments noting that the Counterclaims specifically alleged breach of fiduciary and other duties in Paolino’s capacity as CEO and Chairman and that the mere existence of the employment agreement did not convert those claims into personal contractual ones. The court distinguished Delaware precedent relied upon by the Company noting that in those cases Section 145 was inapplicable only when the parties were litigating a specific and personal contractual claim that did not involve the person’s official capacities.

In determining the scope of the advancement, the court turned one of the Company’s own arguments against it. The Company had argued that it was impossible to separate Paolino’s litigation activities on his affirmative claims from his litigation activities on the Counterclaims because they all arose out of the same set of facts. The court held the Company to its assertions and reasoned therefore that Paolino had a right to advancement for all of his reasonable expenses incurred in connection with the arbitration. The court was careful to note that it did not hold that he had a right to advancement for the offensive claims asserted in the arbitration and limited its ruling to the scope of expenses he could seek under his advancement right for the Counterclaims.

For more information, please contact Vinson & Elkins lawyer Caroline Blitzer. Visit our website to learn more about V&E's Director and Officer Liability or Mergers and Acquisitions practices,  or e-mail one of the V&E Director and Officer Liability practice contacts or Mergers and Acquisitions practice contacts.