Board Bad Faith

The recent decision by the Ontario Superior Court in Cytrynbaum et al. v. Look et al  raises serious questions about the extent to which directors and officers (D&Os) and their insurers can rely on the terms of indemnification bylaws and agreements. An appeal of the decision is currently scheduled for late May 2013, and brokers advising D&Os should be watching the result.

First, a bit of background on indemnification under s. 124 of the Canada Business Corporations Act (CBCA). Those rules permit (but do not require) corporate indemnification of past and present D&Os for many types of proceedings, including civil, criminal and administrative actions. They require, however, that the individual have “acted honestly and in good faith with a view to the best interests of the corporation” and “had reasonable grounds to believe that their conduct was lawful.” They permit (but again, do not require) advancement of costs during litigation, which must be repaid if the director did not meet the “good faith” requirement, but they require indemnification of the individual’s costs if she is successful on the merits and met the “good faith” requirement. Court approval is required in some instances, generally thought to be limited to derivative actions.

That said, many corporate bylaws and private indemnification agreements take what the CBCA permits and make it mandatory. This can be an important incentive when choosing to serve as a corporate director and potentially significant factor in underwriting D&O insurance.  The value of the assurances they provide is called into question in the Look matter.

Shareholders vs. Directors

Look was a communications company traded on the TSX. Nearing insolvency, a monitor was appointed under the CBCA and sold key assets for $60 million. Subsequently, Look’s D&Os set aside a bonus pool and option redemption plan that had the result of reducing those proceeds by $20 million. The most significant beneficiaries of the bonus pool and the option redemption plan were the D&Os themselves. The shareholders learned of this in an information management circular and a revolt ensued. The D&Os eventually resigned and the company brought a claim against them alleging breach of fiduciary duty and seeking repayments.

Importantly, Look’s bylaws were more generous than the CBCA provision on indemnification. They stipulated that both indemnification and advancement of costs were mandatory, subject to repayment if necessary. The individual directors’ agreements with Look were even broader. They specified that indemnification and advancement of costs are required even when the claim is brought by the corporation, and they provided that costs must be advanced within ten days of notification to the company.

When Look refused to advance costs to the directors, they brought a court application. However, far from enforcing the agreement or bylaws, the court dug into the issue and dismissed the application. It confirmed many significant things:

Directors may have agreed to sit on boards facing particularly thorny issues on the basis of robust indemnification provisions. They may now want to give additional pause before agreeing to do so.

• It found that s. 124(4) CBCA, bearing the headnote “Indemnification in derivative actions,” in fact applies to all claims brought by corporations, not just derivative claims. In consequence, the court had a supervisory role.

• It found that it was required to make investigation as a result of its supervisory role and that it could not simply apply the terms of the bylaws and agreements, which were clear that indemnification was mandatory. In fact, it found that it could override them.

• It rejected a submission that D&O indemnification and advancement of costs is analogous to an insurer’s duty to defend, with the attending evidentiary rules and burden of proof. It found that the applicable test was more stringent (i.e. less beneficial to D&Os).

• Although it recognized that D&O good faith is presumed, it found that the presumption can be overcome by evidence.

• The company’s burden of proof was described as “a strong prima facie case that the [D&Os] acted mala fides [i.e. in bad faith] towards the corporation.”

The court then went on to examine the facts in the case, including the board approval of valuations of equity options for an amount that greatly exceeded market value, to conclude that there was sufficient evidence to support the “strong prima facie case” requirement. Interestingly, the D&Os also asserted that they relied on Look’s corporate counsel, and that this showed that they met the good faith requirement and “had reasonable grounds to believe that their conduct was lawful.” The court found that this reliance was unproven, at least with respect to certain aspects of the board’s decision such as the valuation of the equity options for an amount greater than market value. It dismissed the application.

Consequences?

First, there is nothing that D&Os can do to palliate the situation. They cannot exact agreement terms to get around this case. Any amendment to the agreement would be unenforceable.

Second, this decision may well affect D&O decision-making. Directors may have agreed to sit on boards facing particularly thorny issues on the basis of robust indemnification provisions. They may now want to give additional pause before agreeing to do so.

Third, it is common practice for D&O carriers to request copy of indemnification bylaws and agreements as part of the underwriting process. D&O carriers may have given underwriting weight to the robustness of indemnification wordings in the past and may well choose to no longer do so.

Fourth, D&O carriers will likely want to reflect on whether such claims might fall under Side A (rather than Side B) coverage in similar circumstances, particularly if their wordings contains exceptions to the insured vs. insured exclusion. They may also give consideration to how differences between Side A and Side B, such as retentions, will be affected.

Fifth, we can expect further disputes on evidentiary and burden of proof issues. How much of an investigation into alleged bad faith conduct is sufficient at a preliminary stage? How can the court ensure that it has sufficiently balanced evidence? What exactly is “a strong prima facie case,” and how strong does it have to be? How do potential defences, such as reliance on a professional, which must be proven by the D&O, play into the company’s burden of proof? There is ample room for disagreement on these points.

So, what is D&O indemnification really worth? Watch this space.

Trevor McCann is a partner with the Clyde & Co Canada in Montreal. He can be reached at Trevor.McCann@clydeco.ca.

___________________________________________________________________________

Copyright 2013 Rogers Publishing Ltd. This article first appeared in the May 2013 edition of Canadian Insurance Top Broker magazine.

This story was originally published by Canadian Insurance Top Broker.