Much to the chagrin of corporate lawyers, there are still some companies that do not have provisions in their articles of incorporation, bylaws or operating agreements that provide for advancement of litigation expenses to directors and officers. The recent case of White v. Kern, No. 7872-VCG (Del. Ch. Jan. 24, 2014) (Transcript) illustrates that courts may prohibit the advancement of expenses to defendant directors and officers in the absence of these provisions.

White v. Kern involved a plaintiff shareholder-director of a Delaware corporation bringing a breach of fiduciary duty claim and a self‑dealing claim against the other two remaining shareholder-directors. It was undisputed that the corporation’s bylaws did not contain a provision for the advancement of litigation expenses.

Following the initiation of the plaintiff shareholder‑director’s suit, the two defendant shareholder‑directors, as controllers of a majority of the shares and board, voted to amend the bylaws to permit advancement of litigation expenses. The court held that the two shareholder‑directors had a conflict of interest in voting to approve the amended bylaw due to the pendency of the lawsuit against them. Because of the conflict of interest, the court determined that the decision of the shareholder-directors to amend the bylaws must be reviewed under the higher entire fairness standard.

When there is no pending litigation against a director or officer of a corporation, the decision to amend the bylaws to add an advancement provision is reviewed under the business judgment rule and can be rationalized that it is in the best interest of the corporation because it is a protection that is necessary to recruit or retain directors and officers of the corporation.

However, when a lawsuit is pending against a director or officer of a corporation, the decision to amend the bylaws to add an advancement provision will be reviewed under the entire fairness standard and it will be difficult to rationalize the action as in the best interest of the corporation because that director or officer already has been recruited to the company. Further, if advancement of expenses is not required under the existing organizational documents, a decision to advance expenses results in the corporation bearing additional risk that a director or officer may not have the means to reimburse the corporation should their defense be unsuccessful. That additional risk may not be in the best interest of the corporation.

In White v. Kern, the court held that the amendment to the bylaws to add the advancement provision did not satisfy its entire fairness review and was accordingly void. In addition, the court ordered that the defendant shareholder‑directors repay to the corporation any expenses advanced up to that point.

Takeaways

Companies should review their articles, bylaws and/or operating agreements to ensure that they include not only indemnification provisions, but also provisions mandating or permitting the advancement of litigation expenses. A typical structure is mandatory advancement of expenses for directors and officers, and permissive advancement of expenses for other employees. Failure to include an advancement provision could result in advancement being unavailable from the corporation to directors, officers or other employees should they be sued. Absent advancement from the corporation, many directors, officer or other employees will experience a great financial burden in fronting the funds necessary to pay for a vigorous defense, even if those amounts are later reimbursed by the corporation following a successful defense.