In a judgment released yesterday, the Ontario Court of Appeal has held that directors and officers who are sued by their ex-corporation should be denied advance funding of their legal costs under the indemnity provisions of the Canada Business Corporations Act (“CBCA“) if there is a strong prima facie case that they acted in bad faith.  The decision in Cytrynbaum v. Look Communications Inc., 2013 ONCA 455 imposes a significant new limit upon the availability of advance indemnification, and makes clear that this limit cannot be evaded through by-laws or indemnity agreements.  In addition, Look narrows the circumstances in which directors and officers may establish good faith through reliance on legal advice, and holds that outside directors will not be exonerated from a finding of bad faith merely by virtue of their non-executive position.

Legislative Background

Section 124(2) of the CBCA provides that a corporation may advance funds to its current or former directors and officers to cover the costs of proceedings in which they become involved because of their association with the corporation.  While this provision does not obligate the corporation to pay the advance funds, many corporations – including the one in Look – undertake such an obligation in their by-laws or in indemnity agreements with directors and officers.

Like s. 124(2), s. 124(4) of the CBCA also provides that a corporation may advance funds to its directors and officers to cover the costs, charges and expenses of proceedings.  However, s. 124(4) is concerned with proceedings that are brought “by or on behalf of the corporation”.  For such proceedings, s. 124(4) - in contrast to s. 124(2) – requires court approval before the corporation may pay the advance funds, including that the court satisfy itself the director or officer “acted honestly and in good faith with a view to the best interests of the corporation”.

Because the marginal note to s. 124(4) in the CBCA is entitled “Indemnification in derivative actions”, it has traditionally been thought that the requirement for court approval in this provision only extended to derivative actions against the officer or director (i.e., actions brought on behalf of the corporation by a shareholder, director or officer under s. 239 of the CBCA), and not to actions against the officer or director by the corporation itself.  This understanding of s. 124(4) was affirmed in Jolian Investments Ltd. v. Unique Broadband Systems Inc., 2011 ONSC 3241.

The Facts in Look

The Look appeal arose from an application for advance funding by the former directors and officers of Look, including the appellants, against the corporate respondent.  The application was made in response to a claim which Look had brought against the appellants for their conduct relating to a 2009 sale of Look’s key assets.  When the sale closed, the Look Board authorized the payment of approximately $20 million to its directors, officers and others.  Much of this amount was based upon the appellants’ exercise of share appreciation rights pursuant to an inflated valuation of $0.40 per Look share recommended by management, which was substantially in excess of the market value of $0.20 per share.  While the Board had received a legal opinion prior to authorizing the payments, it spoke in general terms about the Board’s fiduciary duties and the business judgment rule, and did not specifically address the valuation of Look’s shares.

The $20 million payments were not disclosed to shareholders for four months, and immediately attracted strong shareholder criticism.  The appellants then authorized Look to pay approximately $1.5 million to three law firms acting for them personally, and resigned.

Look’s new management and Board commenced an action against the appellants in July, 2011, and the appellants brought an application for advance funding based on the Look by-laws and their indemnity agreements with it.  The application was denied by Pattillo J. on September 28, 2012.  Relying on s. 124(4) of the CBCA, Patillo J. found that court approval was required before Look could be compelled to pay advance funds in an action brought by it, even though the Look action was brought by the corporation itself and not in a derivative capacity.  Further, Pattillo J. found there was a strong prima facie case the appellants had acted in bad faith, so as to disentitle them to advance funding under the CBCA.

The Decision

The Ontario Court of Appeal unanimously upheld Pattillo J.’s judgment.  Sharpe J.A., writing for the court, held that Jolian Investments should not be followed to the extent it held that judicial approval under s. 124(4) of the CBCA is required only where advance funds are sought in the context of derivative actions on behalf the corporation.  Rather, pursuant to s. 124(4), advance funding should be denied in any case involving an action by or on behalf of the corporation, if the court is satisfied there is a strong prima facie case that the director or officer acted in bad faith.

According to Sharpe J.A., the position taken in Jolian placed undue reliance upon the reference to “derivative actions” in the CBCA marginal note, and was inconsistent with the language actually used in the provision, which spoke of actions brought not only “on behalf of” but also “by” the corporation.  Further, Sharpe J.A. found there was no “principled rationale for applying one regime for advance costs in derivative actions and another for actions brought by the corporation itself”.  Sharpe J.A. also dismissed the appellants’ attempt to rely upon Delaware case law, which holds that advance funding should be awarded without any scrutiny of the conduct of the director or officer, since the Delaware General Corporation Law does not require court approval of advance indemnification.  He then observed that, while there were policy arguments in favour of advance funding, there was also an important reason for ”imposing a pre-trial good conduct filter on the right to advancement”, i.e., “the discouragement of bad behaviour by corporate officers and directors”.

In an important development, Sharpe J.A. rejected the appellants’ attempt to circumvent this new requirement for court approval under s. 124(4) based on their indemnity agreement with Look, which obligated Look to pay them advance costs without any requirement for judicial screening:

This court held in Bata Industries Ltd., at p. 329, that s. 136 of the OBCA, the Ontario equivalent to s. 124 of the CBCA, is “a comprehensive code of general application by which the indemnification of officers and directors, and former officers and directors, is regulated.” Like s. 136 of the OBCA, s. 124 “establishes the circumstances under which a corporation may, with and without court approval, indemnify an officer or director, and when a corporation must indemnify an officer or director” and, “[b]y implication … the circumstances under which a corporation cannot indemnify an officer or director.” It follows that the by-laws and indemnity agreements cannot oust s. 124(4). Section 124(4), when read with the other subsections of s. 124, provides that court approval is required for advance funding and that approval can only be granted if the officer or director claiming advancement “acted honestly and in good faith with a view to the best interests of the corporation”. The application judge correctly held that the provision applied in this case to the directors’ and officers’ claims for advance funding. (para. 48)

As for test to be applied in s. 124(4) approval hearings, Sharpe J.A. agreed it only required the corporation to establish a “strong prima facie case” of bad faith, not a “final determination” of it:

In my view, the strong prima facie case test strikes an appropriate balance between those competing considerations. It is a stringent test that gives significant weight to the protection of officers and directors. It ensures that they will ordinarily receive advance funding but leaves open the possibility that advancement will be denied when there is strong evidence of bad faith. (para. 56)

While Sharpe J.A. described this test as a “stringent” one, he nonetheless proceeded to hold that it was met on the facts before the court.  Of particular interest was his conclusion that the appellants were unable to avoid a finding of bad faith in valuing the Look shares at $0.40, simply through their reliance on a generally-worded legal opinion:

The solicitor’s opinion letter to the Board is a carefully worded document that expresses no view as to the valuation of the shares. The solicitor, a partner of a major Toronto law firm, advised the Board in very general terms of its duty to act honestly and in the best interests of the corporation. He referred to the business judgment rule which gives deference to the decisions of the directors provided those decisions fall within a range of reasonable alternatives. He indicated that on restructuring or winding down, it is common for a Board of Directors to authorize special incentive payments to retain key individuals provided that doing so is in the best interests of the corporation. There is nothing, however, in the letter as to the valuation of the Look shares. Indeed, it is not clear to me that the actual valuation, as distinct from the process the Board had to follow, was a matter for legal opinion. There is conflicting evidence from the solicitor and Cytrynbaum as to whether the solicitor knew the valuation the Board proposed to use. If he did know, he studiously avoided expressing any opinion on it and there is no indication that he was asked to do so. At best, the evidence indicates that the Board’s legal advisor advised that the valuation of the shares was a matter of business judgment to be exercised in the best interests of the corporation, and that he said nothing to dissuade the Board from adopting the $0.40 valuation.

In my view, the application judge made no palpable and overriding error of fact and no error of law in concluding that silence by a corporate solicitor on a matter that falls outside the realm of legal expertise and for which his advice was not sought by the Board does not amount to a defence to an allegation of bad faith. (paras. 63-64)

Sharpe J.A. also held that a subsequent legal opinion, which was provided to the appellants after they made their valuation decision, was incapable of shielding them from a finding of bad faith, since “at the highest, the letter reflects the solicitor’s ex post assessment of the decision the Board had already made and does not reflect the advice the Board received before the crucial Board meeting”. (para. 66)

Finally, Sharpe J.A. rejected the contention made by one of the appellants, an outside director who served as Chair of the Look Board’s Compensation and Human Resources Committee, that “the application judge failed to consider his position as an outside director who was not directly involved with legal counsel or the decisions alleged to amount to bad faith”.  According to Sharpe J.A., the appellant could not be exonerated from a finding of bad faith merely because he was an outside director.  He ”personally benefited from the impugned decisions”, and “was expected to exercise independent judgment, engage himself in the Board’s decisions and ensure that management was acting not it its own self-interest but in the interest of Look”. (para. 73)

Significance

The decision in Look is an interesting and important one for Canadian corporate law on a number of different levels.

First, it significantly restricts the entitlement of directors and officers to advance funding of their legal costs when they are the subject of lawsuits by their former corporations. According to Look, such directors and officers will be denied advance funding if the court concludes there is a strong prima facie case that they acted in bad faith. In other words, courts must now “look” to see whether the statutory indemnity requirements – which until now have only been applied to advance funding claims in derivative actions – are satisfied.

It is questionable whether this new regime is truly consistent with the purpose of the indemnity provisions in s. 124 of the CBCA, or represents a rational allocation of risk. In Manitoba Securities Commission v. Crocus Investment Fund, 2007 MBCA 36, a decision not referred to in Look, the Manitoba Court of Appeal said:

Viewed from the corporation’s perspective, a decision to advance defence costs is an interim financing decision. Based on the criteria and safeguards applicable here, the corporation is not necessarily at risk. I agree with the following observations of Chancellor Allen of the Delaware Court of Chancery in Advanced Mining Systems, Inc. v. Fricke, 623 A. 2d 82 (1992) which, while in the context of statutory language closer to the present CBCA than the Act, is nevertheless applicable (at p. 84):

… [T]he decision to extend advancement rights should ultimately give rise to no net liability on the corporation’s part. The corporation maintains the right to be repaid all sums advanced, if the individual is ultimately shown not to be entitled to indemnification. Thus the advancement decision is essentially simply a decision to advance credit. (para. 52)

Second, Look holds that directors and officers may not “contract out of” s. 124(4) by means of a broadly-worded indemnity agreement. Accordingly, Look means that judicial approval will be required for advance funding in all cases where a corporation sues its directors and officers. At the very least, therefore, directors and officers will have to personally fund the costs of such advance funding hearings up front, before they may receive interim indemnity for those and other legal costs, even if there is no evidence that they acted in bad faith. This is likely to discourage persons from acting as directors and officers, contrary to one of the main purposes of s. 124,  i.e., to “permit enough leeway to attract strong candidates to directorships and consequently foster entrepreneurism”: Blair v. Consolidated Enfield Corp., [1995] 4 SCR 5.

Third, the court’s treatment of the appellants’ reliance on legal advice in Look is potentially troubling, regardless of whether that treatment was correct on the facts of Look itself. In Blair, the Supreme Court held that while “mere de facto reliance on legal advice will not guarantee indemnification… reliance that is reasonable and in good faith will establish that a director or officer acted ‘honestly and in good faith with a view to the best interests of the corporation’”. By holding that the legal advice in Look did not adequately address the alleged bad faith, the court’s decision could be taken to require directors and officers to scrutinize the effect of legal opinions even where they have may not have the expertise to do so.

It will be interesting to see whether the appellants in Look seek leave to appeal to the Supreme Court of Canada, and if not, how other courts apply Look in future cases.