The Delaware Chancery Court’s recent decision in Charney v. American Apparel, Inc., (here) highlights some potential pitfalls that may exist in many standard Delaware indemnification and advancement provisions for directors and officers. In American Apparel, the company’s founder and former CEO and Chairman, Dov Charney, sued to recover advancement of legal expenses he was incurring in another litigation filed by the company. In that other case, the company was suing Charney for breach of a Standstill Agreement the parties had entered into the previous year while Charney was still at the company. The court held that Charney was not entitled to advancement under the company’s charter and his indemnification agreement because the suit over the Standstill Agreement was not “related to the fact” that Charney was a director or officer.

In June 2014, Charney was suspended as CEO by the board of directors, pending an investigation into alleged misconduct by Charney.  In July 2014, Charney and the company entered into the Standstill Agreement, under which Charney was prohibited from taking certain actions, including seeking removal of members of the board and making disparaging comments about the company to third parties.  The Standstill Agreement also governed  the terms by which Charney might return to the company, depending on the outcome of the investigation.  In December 2014,  following the investigation, Charney was terminated for cause based on his misconduct prior to June 2014.

Following his termination, Charney allegedly engaged in a variety of hostile actions that the company believed violated the Standstill Agreement.  On May 15, 2015, the company filed its lawsuit over these alleged violations, claiming that Charney was attempting a potential takeover, had expressed anti-board sentiments at employee meetings, made negative statements to third parties, and submitted a declaration in opposition to the board in an unrelated legal proceeding.  Charney made a prompt demand on the company for advancement of his legal fees incurred in the Standstill Agreement case under his indemnification agreement and company’s by-laws. The Company rejected Charney’s demand on May 26, 2015.

Charney filed his suit for advancement of fees on June 4, 2015. Charney argued that the company’s advancement obligations are defined by and flow from its indemnification obligations such that he is entitled to advancement expenses incurred in the Standstill Proceeding under Delaware law. The court disagreed and held that while rights to advancement and indemnification are related, they are “discrete and independent.” As such, Delaware courts have refused to recognize claims for advancement absent specific language that permits it under the applicable circumstances. Similarly, the court rejected Charney’s argument that he was entitled to advancement under the company’s charter. The court held that under the charter, only current officers and directors of the company are entitled to advancement. Finally, the court rejected Charney’s argument that his fees were incurred “as a result of” his position as a director and/or officer of the company. The court held that while Charney’s position exacerbated the magnitude of his actions, there was no causal connection and all  of his actions could have been undertaken whether or not he served as a director or officer. Moreover, each of the alleged actions the company was challenging occurred after he had been terminated an officer or director.

Practice Takeaways

  • Review the language of the company’s indemnification obligations under the by-laws, charter or in separate agreements with its officers and directors. While most standard indemnification provisions cover both former and current officers and directors, the advancement obligations may not apply to former officers and directors.
  • Pay particular attention to the triggering language of the indemnification obligations. If it is limited to claims brought “by reason of the fact” that one is an officer or director (the language used in section 145 of the Delaware Gen Corp. law), there may be no coverage for contract disputes, like the one here in American Apparel, which may arise out of one’s role as a director but may not “arise by reason of the fact” of that role.
  • Recognize that generally there will not be indemnification or advancement coverage for claims that do not have a causal connection to the claimant’s actions or inactions as an officer or director, or which do not relate to his or her exercise of judgment, discretion, or decision-making authority on behalf of the corporation.