Is your corporation allowed to assume the defense against its own first party claims directed at a current or former officer?

KEEP YOUR DEFENDANTS CLOSE, BUT KEEP YOUR OFFICERS CLOSER

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Can Companies Reduce the Costs of Asymmetric First-Party Advancement by Assuming the Defense?

by CAMDEN B. CHANCELLOR

If the law is an indicator of strength, then tort-feasor defendants should almost never win against stronger plaintiffs, especially when a defendant’s violations appear obvious. Yet business suggests otherwise: costs matter. In cases where defendant officers demand advancement, costs matter even more.

Texas continues to grow its branch of law concerning the obligation of companies to advance the costs of legal defense to company officers. For sustenance, the leaves of “advancement” continue to point toward the all-powerful corporate sun in Delaware.[1] Chancery law continues to shine favorably upon a public policy of encouraging company officers to serve without the fear of unilateral financial prosecution.

Some companies have been left seeking shelter from advancement after company officers were caught intentionally engaging in self-dealing, only to demand that the company foot the bill for the inevitably voluminous and protracted first-party litigation.[2]

Making advancement available to officers, even in first-party cases, is certain to attract the high-dollar actors necessary for market competition. The benefits seem clear. What are the drawbacks?

A desperate defendant may incur desperately large fees. Tex. R. Prof Conduct 1.04 sets forth eight factors which Texas courts consider in determining a “reasonable” attorney fee. So how expensive is too expensive? And how many lawyers is too many? We all know that business litigators charge some of the highest hourly rates in the industry, and their work is complex. It is also common to see at least several lawyers working for one party to a business dispute. I’ve personally encountered as many as eight lawyers representing one natural defendant, with rates as high as $1,200/hour.

Delaware is increasingly firm in its stance that when a defendant’s counselors certify that the fees are reasonable and there is no clear abuse, any dispute as to whether the fees are excessive is reserved until a final indemnification hearing.[3]

If the Delaware example continues to guide advancement, the relevant question may become “how many law firms is too many?” Supposedly, non-meritorious defendants have a disincentive against incurring enormous and unnecessary legal bills because they may be ultimately liable for repaying advanced amounts. In practice, these officer defendants usually belong to that certain group of executives who engage in risky business behaviors. They may be willing to gamble all-in at the roulette table. As this discussion continues, we find that it just might work.

An entangled defendant has an entangled defense. Most companies can handle a little tug at their purse strings, even when company defendants write a blank check for a AAA defense. But can a company handle the cost of advancing fees for several defendants, including sophisticated, third-party competitors?

Many first-party business lawsuits arise from torts committed by multiple parties, including competitors who were willing to take advantage of a conflict of interest or to encourage a would-be-defendant. The causes of action in these cases inevitably lean toward interference and civil conspiracy. Damaged companies are left with no adequate remedy other than to include the co-conspirators in the business torts, and guilty defendants often acted in-concert with interested third parties. Injunctions, disgorgements, and clawbacks of fraudulent transfers all require the joining of these additional defendants.

The result is a group of intertwined and inseparable defendants whose joint defense is dependent upon the same set of facts and circumstances. In these cases, Texas[4] and Delaware[5] have held that a party suing for attorney’s fees may recover the entire amount covering all claims.

The expense of joining sophisticated, third-party entities to individual defendants is not multiplicative - it is exponential.

A judgment never guarantees recovery. Companies are rarely, if ever, able to condition advancement upon an officer’s ability to repay or upon the furnishing of security. Although Delaware has generally frowned upon such provisions as harmful to public policy, they are allowed.[6] The real deterrent to these requirements is that they effectively restrain younger, financially eager executives from accepting employment with a company that may refuse to grant advancement during career-ending events. Therefore, companies usually condition advancement only on the requirement that an indemnified defendant submit an “undertaking” to repay all amounts advanced in the event they are later determined not to be entitled to indemnification.

Undertakings are no better than judgments. For wealthy, guilty defendants, an undertaking is an effective constraint on excessive costs for defense. No officer is excited to satisfy a judgment for advancement amounts which exceeds even the damages sustained by the plaintiff. But the opposite is also true – a defendant facing bankruptcy in the event of a judgment has no incentive to avoid the additional, irrelevant burden of repaying attorney’s fees. Bankruptcy is an inelastic consequence for potential losers.

Plaintiff and defendant resolve are inverse. Litigators often fantasize about representing a large client whose treasury is outweighed only by its managerial commitment to justice. In practice, management’s emotional reaction to tortuous behavior is quickly displaced by the ever-approaching horizon of shifting operations. It is more common, and less expensive, for a business to accept occasional losses than it is for a business to demand infinite accountability. How often have you witnessed your client’s initial ardor at the thrill of announcing justice among its ranks… only for the lawsuit to outlive that manager’s tenure at the company? Members are often sophisticated in business operations yet ignorant of judicial reality.

Business reality is that company members controlling plaintiff litigation usually experience relatively constant compensation. The company may suffer as a whole, but the structure of individual payments has already accounted for an absorption of losses. Constant compensation equals constant incentive. Member returns on time investment in judicial proceedings are rarely as personally profitable as time investment in company operations, or they are otherwise equal. This means that members’ incentive to press for expensive, uncertain litigation decreases over time.

The same is not true for defendants. The process of litigation continues to draw a resisting defendant closer to the time of potential judgment. Like quicksand, the harder a defendant struggles, the more trapped the defendant becomes in grains of adjudication. Defendants’ incentives to escape not only remain aligned, but they increase with each passing legal invoice.

A desperate defendant is prone to escalation.[7] The increasing financial consequences become less and less relevant to the defendant, while the coefficient of reward to the plaintiff continues to decline. Perhaps a flailing defense against first-party lawsuits is the most rational strategy.

Assumption of the Defense as a Carveout Negating Advancement. Often found in company agreements is a small provision stating that the company may be relieved of any obligation to provide advancement to an indemnified defendant by simply taking on the defense directly. These provisions obviously apply to third-party claims against company officers. There remains the question - with no clear precedent - can these provisions be applied to first-party obligations to provide advancement?

Under Delaware law, the duty to defend found in indemnity clauses is impliedly exclusive to third-party claims because first-party claims carry a conflict of interest.[8] However, there is some Delaware precedent recognizing that a duty to defend is distinct from a duty to provide advancement for costs of defense.[9] This distinction authorizes counsel to explore an unsanctioned contractual hypothetical: the indemnitor and indemnitee may expressly agree that an assumption of defense is authorized, and disposes of advancement, during inter se litigation.

If a company may dispose of first-party advancement by simply assuming the defense, the company may therefore control the uncertain costs of an unlimited defense by appointing a limited number of independent counsels to adequately represent the indemnified person with reasonable rates. When first-party conflicts of interest are implicated during an assumption of defense by an insurer, DE allows the insurer to either pay the costs of defense incurred by the insured, or to provide independent counsel.[10] Likewise, Texas should acknowledge that independent counsel with no prior connection to the company may be paid by the company to provide a first-party defense to an officer. This hypothetical is akin to the allowable practice of independent counsel appointment in shareholder derivative litigation.[11] If independent counsel can satisfy the chancellor and vice-chancellors in Delaware, they should be able to satisfy Texas.

[1] See In re Aguilar, 344 S.W.3d 41, 47 (Tex. App.—El Paso 2011)(describing Delaware as "the Mother Court of corporate law.”).

[2] In re Aguilar, 344 S.W.3d 41, 47 (Tex. App.—El Paso 2011)( "Delaware case law is replete with insider trading cases in which executives' expenses are advanced despite allegations of defrauding the corporation or its stockholders of millions of dollars.”).

[3] White v. Curo Tex. Holdings, LLC, No. 12369-VCL, 2017 Del. Ch. LEXIS 39, at *19 (Ch. 2017).

[4] Stewart Title Guar. Co., v. Sterling, 822 S.W.2d 1, 10, 35 Tex. Sup. Ct. J. 206 (Tex. 1991).

[5] Weil v. Vereit Operating P'ship, L.P., No. 2017-0613-JTL, 2018 Del. Ch. LEXIS 48, at *21 (Ch. 2018).

[6] See In re Cent. Banking Sys., No. 12497, 1993 Del. Ch. LEXIS 452, at *9 (Ch. 1993).

[7] See Andrew J.R. Mack, “Why Big Nations Lose Small Wars: The Politics of Asymmetric Conflict,” World Politics, Vol. 27, No. 2 (January 1975), pp. 175–200.

[8] DRR, L.L.C. v. Sears, Roebuck & Co., 949 F. Supp. 1132, 1143 (D. Del. 1996).

[9] Am. Legacy Found., RP v. Nat'l Union Fire Ins. Co., 623 F.3d 135, 145 (3d Cir. 2010).

[10] E.g., Int'l UNDERWRITERS, INC. v. STEVENSON Enters., CIVIL ACTION NO. 80C-SE-82, 1983 Del. Super. LEXIS 649, at *7 (Super. Ct. Oct. 4, 1983).

[11]See ARTICLE: DIRECTOR AND ADVISOR DISINTERESTEDNESS AND INDEPENDENCE UNDER DELAWARE LAW, 23 Del. J. Corp. L. 1157, 1198-1200.