Canada: Ontario Court Denies Advance On Former Directors’ Legal Costs - Makes Rare Interim Finding Of Bad Faith

The Ontario commercial court recently decided that a corporation did not have to advance legal fees to the former directors and officers that it had sued, notwithstanding the fact that the corporation’s by-law mandated the payments.

In Cytrynbaum et al. v. Look Communications Inc., 2012 ONSC 4578, the Ontario Superior Court of Justice (Commercial List) set a new standard for obtaining court approval of claims for indemnity advancements made by directors and officers who had been sued by their former corporations. The Court held it must consider whether the requirements for indemnification were met, and in particular consider whether the presumption of good faith had been rebutted. In this case, because the corporation had established a strong prima facie case that the directors and officers acted in bad faith, the Court denied advancement of indemnity under section 124(4) of the Canada Business Corporations Act, R.S.C. 1985, c. C44, (CBCA).

Look Communications is one of the few decisions that has resulted in a refusal to advance legal costs,¹ and may in practice expand the role of the Court in considering future requests.

Background

Following a successful proxy contest at its parent corporation, Look Communications Inc. (Look) sued a number of its former directors and officers for alleged self-dealing related to the sale of Look’s key assets in 2009. The former directors and officers in question (the Applicants) brought an application for a declaration that Look was required to advance their legal costs pursuant to Look’s by-laws and indemnification agreements.

Under s. 124 of the CBCA, a company may indemnify its officers and directors for any legal proceeding in which the individual is involved because of his or her association with the corporation, as long as the individual acted “honestly and in good faith with a view to the best interests of the corporation.”² Look’s by-laws provided that indemnification was mandatory if these CBCA conditions were met.

Additionally, Look had signed broader indemnification agreements with the Applicants that required Look to advance legal costs in any proceedings, including one brought by Look itself or a derivative action. Repayment of advances was only required if a court determined that the individual had not been entitled to be indemnified (e.g., had not acted in good faith). Such indemnification agreements are a common feature for most Canadian public companies.

The Applicants argued that the by-law and indemnification agreements required Look to automatically advance legal costs without considering whether or not the individuals were entitled to indemnification. They argued that entitlement to indemnification would be determined at trial, not before.

They also argued that s. 124(4) of the CBCA, which requires court approval for advancement of legal costs in respect of actions “by or on behalf of” the corporation, only applied to derivative actions and not to a direct lawsuit by the corporation against them, citing among other things the subtitle to s. 124(4), which reads “Indemnification in Derivative Actions.” The Applicants’ position regarding the applicability of s. 124(4) was recently adopted by the Ontario Court in Jolian Investments Ltd. v. Unique Broadband Systems Inc., 2011 ONSC 3241, a case involving certain of the same parties, relating to the virtually identical equivalent provisions in the Business Corporations Act (Ontario), R.S.O. 1990, c. B-16. 

Look took the position that an analysis of the underlying conduct of the parties seeking indemnification must be undertaken by the Court before advances could be permitted under section 124(4) of the CBCA. The Court had to determine if the parties had acted in good faith. In opposing the advances on indemnity, Look filed extensive affidavit evidence going to the conduct in question, including affidavits from seven witnesses, totalling about 4,000 pages.

The Court’s Findings

The Court held that the supervisory role of the court envisioned in section 124(4) of the CBCA applies to actions initiated by the corporation (and not just derivative actions), because “the very nature of these actions leaves both parties vulnerable to abuse from the other side.”³  In this respect, Justice Pattillo in Look Communications disagreed with the decision of Justice Marrocco in Unique Broadband Systems.

Justice Pattillo noted that court scrutiny would ensure that corporations could not arbitrarily deny indemnity obligations to former directors and officers who had acted in the best interests of the corporation. It would also ensure that directors and officers that had acted in bad faith to harm the corporation could not further draw upon the corporation to fund their own defence.

In Look Communications, the Court developed a test to determine when to deny advancement of monies under s. 124(4). The Court recognized that there was a presumption that former directors and officers had acted in good faith with a view to the corporation’s best interests. Accordingly, the Court held that for advancement to be denied when it is otherwise authorized by by-laws and agreements, a corporation must establish a strong prima facie case that the former director or officer acted in bad faith.

On the evidence before it, the Court found that the majority of the Applicants should not be given an advance on their legal fees. The evidence established a strong prima facie case that the Applicants acted in bad faith. The advancement of legal fees was approved for one Applicant, in part because it was not clear from the evidence that he participated in any of impugned decisions. The judge emphasized that the findings made in the applications were not binding on the trial judge.

The Alleged Self-Dealing Conduct

While the decision may appear on its face to signal a greater willingness on the part of courts to second-guess or interfere with indemnification rights that directors and officers often take for granted, it is worth noting that the facts in the case, as found on a interim basis, appear to have been exceptional. In particular, Look alleged that the directors and officers breached their fiduciary duties to Look through a series of egregious payments to themselves (and other employees and consultants) in the wake of a court-supervised sales process that resulted in the sale of their key spectrum and broadcast licence for $80 million. The judge noted that the payments in question totalled over $20 million, or about 32% of the net sale proceeds.

It was further alleged that upon disclosure of the payments in the following year’s management information circular and the resulting shareholder criticism, certain of the Applicants arranged for $1.55 million to be paid as retainers to three law firms acting for the Applicants immediately prior to their resignation from the Company, while ignoring and withholding from the board external legal advice to the effect that the retainer payments were questionable from a legal point of view. Justice Pattillo determined that Look had introduced sufficient evidence regarding the circumstances of both the post-sales process payments and the retainer amount payments that it had established a strong prima facie case that the Applicants had acted in bad faith, in their own self interests and not with a view to the best interests of Look.          

Conclusion

Look Communications confirmed that the supervisory role of the court to approve or deny advancement of indemnity to directors and officers applies to any action brought by a corporation against its directors or officers, and not just to derivative actions. The decision also holds that courts may deny indemnity on an interim basis without a final finding that the officer or director is guilty of bad faith. Accordingly, the decision may provide corporations with a greater ability to resist demands by directors and officers for indemnification where there is good evidence of their bad faith. It can be expected, however, that in some cases courts will be unable to make such determinations based on “paper records” and instead require live witnesses before them where questions of credibility are involved.

Footnotes

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