As more executives are being removed for misconduct issues in recent years, and sometimes resorting to the courts to dispute the conditions of their removal, boards are being confronted with the impact of common indemnification provisions that cover legal fees for executives — even if they’ve been fired.
For example, days after The Hertz Corporation sued former CEO Mark Frissora and other executives looking to claw back compensation, the individuals filed legal actions of their own seeking to have their former company pay their bills to defend themselves.
The company argued that it shouldn’t have to advance the fees despite having a policy to do so because, if Hertz prevails in the underlying clawback litigation, it could have trouble recouping advanced sums from the former executives.
The circumstances highlight both the tendency for companies to provide broad legal fee advancement provisions to executives and directors and a decision that corporate insiders may later regret when disputing with a former executive accused of misconduct, attorneys say. But the Hertz advancement dispute additionally highlights novel circumstances that boards should pay attention to, says Arthur Kohn, partner at law firm Cleary Gottlieb.
Kohn says most disputes about advancement of legal fees arise when a third party brings an action against an executive or director. But in the clawback context, the company and the board have brought a claim against a director or officer, perhaps making an assumption that fee advancement should not be required, he adds.
The court in Hertz quashed such an assumption last year, Kohn points out. It ruled that Hertz would have to advance the fees as promised in its bylaws.
“It seems to me that it should be possible, if a company so desires, to tell … officers that we’ve adopted this clawback policy [and] when we seek to implement it, we are not going to advance legal fees,” Kohn says. “As far as I know, although the argument seems somewhat intuitively attractive, no company has done this,” he says.
According to Shearman & Sterling’s annual corporate governance and executive compensation survey for 2019, 88 of the largest 100 U.S. companies disclose clawback policies related to financial misconduct. Some 40 of the largest 100 companies have disclosed policies that do not require financial fraud to implement a clawback but include other triggering events such as a failure of risk management or termination for cause or misconduct.
Meanwhile, according to search firm Challenger, Gray & Christmas, 2019 was a record year for CEO turnover, with 1,640 CEOs being replaced. That’s compared to 1,452 in 2018. Much of that increase was due to allegations of CEO misconduct, according to the firm.
That increase may give some boards pause over continuing to promise to cover execs’ legal costs, but indemnification and advancement provisions remain popular.
Companies have long accepted the tradeoffs associated with broad indemnification and advancement provisions: that at the expense of taxing litigation centered on these protections and soaring legal bills, companies can attract directors and officers who have come to expect sweeping coverage. And even when the calculation does result in protracted litigation, Kohn says, directors are unlikely to make changes to corporate documents offering the provisions.
“You can find folks who wonder about whether it’s the right way to go” to offer broad protections, and who express “regret about the breadth of their promise to executives,” Kohn says. Directors, for example, may look with frustration at an executive who put a company under the microscope with allegations of misconduct, he says, and then added to that annoyance is the requirement to pay legal fees.
“They may say, ‘Why did we do this?’ But they generally don’t change.”
‘Lopsided Dynamic’
Rights providing the advancement of legal fees, found in corporate documents such as articles of incorporation or bylaws, allow directors and officers to collect fees in advance of a final resolution in a particular matter. These provisions go hand in hand with indemnification, which gives directors and officers reimbursement rights related to a final disposition, so long as insiders are not deemed to have acted in bad faith.
For a number of reasons, advancement issues create more of a headache for companies than indemnification, says Francis Pileggi, vice chair of the commercial litigation group of Eckert Seamans Cherin & Mellott. For one, he points out, it is often incredibly difficult for a company to recover advanced fees because a director or officer who is convicted of a crime, for instance, may not be able to come up with the funds. And this defense — that companies are likely to face challenges in recouping legal fees — is one that courts are not persuaded by, according to Pileggi.
From the director’s or officer’s perspective, Pileggi says, “advancement is more important than indemnification, because indemnification rights are not triggered until years later, and that could be several million dollars later.” On the flip side, from the company’s vantage point, Pileggi notes that in his experience, “most companies don’t realize the large exposure they have until it’s too late.”
In keeping with previous reporting by Agenda, legal disputes about fee advancement continue to plague companies with regularity. Indeed, as of Jan. 14, 2020, more than 30 complaints were filed in Delaware’s Chancery Court in the previous 12 months that related to advancement of fees, according to an Agenda review of court filings.
The Hertz dispute arose when former CEO Frissora was accused by the company in court filings of creating an “intimidating” and “demeaning” work environment, as Agenda reported, leading the company to seek to claw back his and other former executives’ compensation. Four days after Hertz filed its complaint in federal court in New Jersey, the executives hit back with suits of their own in Delaware court looking to secure corporate funding for their disputes.
In May of last year, vice chancellor Kathaleen McCormick determined that Frissora and his former colleagues were entitled to legal fees. “Hertz rightly notes that Delaware’s procedural process governing advancement presents a lopsided dynamic favoring advancement claimants,” McCormick wrote in a court filing. “In my view, this dynamic is consistent with Delaware policy — it should be easier to turn the ‘advancement spigot’ on than to turn it off.”
Beyond Delaware, courts similarly allow for enforcement of companies’ obligations to pay legal fees in a variety of circumstances. Take an ongoing case in federal court in New York, for instance, where ousted Barnes & Noble CEO Demos Parneros sued the company for breach of contract and defamation following his July 2018 termination. Following B&N’s response suit against Parneros, the former chief executive argued in court filings that he was entitled to advancement of 50% of legal fees per his contract with the company and its bylaws.
The parties disputed through court filings whether claims in Parneros’s original complaint and in the company’s subsequent countersuit were intertwined enough to fall within the scope of Parneros’s advancement rights. Also at issue was whether the claims related to Parneros’ role as a corporate officer.
“Plaintiff’s demand for advancement of 50% of his total fees and expenses for this lawsuit is clearly excessive and would provide Plaintiff with an unjustified windfall,” B&N argued in a court document. “Plaintiff is asking Barnes & Noble to subsidize his defense of direct claims asserted by the Company for his own misconduct — a result that was not contemplated by the indemnification statutes, which were enacted to protect directors and officers from the costs of defending third party and derivative claims, not to immunize them from the consequences of their misdeeds towards the company itself.”
Ultimately, the court determined in May of last year that B&N was indeed on the hook for half of Parneros’s legal fees and expenses due to the broad rights offered in the bookseller’s bylaws.
Despite numerous court battles over these provisions, which often go in the officer’s or director’s favor, there is only incremental movement by companies away from nearly absolute protections. A relatively common caveat to advancement without question is that directors or officers execute an undertaking to repay the company if they are deemed not entitled to indemnification.
Less prevalent is a grant of authority to the board to make the call on advancement, such as at biopharmaceutical giants Amgen and Gilead Sciences, where directors may decide whether advancement should be made to corporate officers.
A main reason that the broad provisions remain popular, according to attorneys, is that, up against a desire to attract talent, the court battles and sometimes swallowing bills are seen as a price worth paying. “Companies really need [broad provisions] to attract and retain the talent that they want,” Cleary Gottlieb’s Kohn explains.
Self-interest is also at play, says Kevin LaCroix, attorney and executive vice president of RT ProExec, a division of wholesale insurance brokerage R-T Specialty. “You have to picture the environment when indemnification and advancement rights are set,” he suggests. People sitting at the table at that point all have an interest in those provisions being as broad as possible because “they don’t know which person in the room is going to need that advancement and indemnification.”
“I’ve been brought in to look at these provisions, and the conversation is never about how to make them more narrow.”
LaCroix finds it reasonable that well-advised and seasoned directors and officers expect no less than broad protections. “It’s a very unusual thing in our legal system,” he says. “You take a job, you’re paid for that job, but you can go to jail. You can be personally liable for conduct in that job.”
Company executives and directors need these rights because they can be accused of the worst kinds of misconduct, LaCroix says, and the tendency for the accused is that “they want to defend themselves to the last breath.”
