January 28, 2010
In Paolino v. Mace Security International, Inc., C.A. No. 4462-VCL (Del. Ch. Dec. 8, 2009), the Court of Chancery denied a motion to dismiss and granted partial summary judgment in favor of plaintiff Louis D. Paolino, Jr. (“Paolino”), a former officer and director of defendant Mace Security International, Inc. (the “Company”), establishing Paolino’s right to advancement to defend against counterclaims asserted by the Company in a pending arbitration proceeding initiated by Paolino. Notably, because the Company argued that it was impossible to distinguish between expenses incurred by Paolino in connection with the Company’s counterclaims and expenses incurred on Paolino’s affirmative claims, the Court concluded that all of Paolino’s expenses for the arbitration must be advanced.
From 1999 until his termination on May 20, 2008, Paolino was the chairman and CEO of the Company. Shortly after his termination, Paolino filed a demand for arbitration, claiming that he was wrongfully discharged and that the Company breached his employment agreement in doing so. The Company asserted counterclaims against Paolino, alleging, among other things, that Paolino breached his contractual, fiduciary, statutory and common law duties owed to the Company, its board and its stockholders (the “Counterclaims”). Paolino filed an action in the Court of Chancery seeking advancement and indemnification for defending the Counterclaims. Determining the indemnification claim to be premature, the Court stayed that claim and addressed only Paolino’s advancement claim.
The Company’s bylaws provided current and former directors and officers with broad and mandatory indemnification and advancement rights. Specifically, the Company’s bylaws provided for a right to mandatory indemnification “to the fullest extent permitted by law.” The bylaws also contained a common carve-out that eliminated indemnification for any proceeding (or part thereof) initiated by an indemnitee without prior board approval. With respect to advancement, the Company’s bylaws granted a right to mandatory advancement keyed off of the scope of the indemnification right. Thus, the Court concluded, the bylaws granted broad and mandatory advancement rights to any indemnitee faced with “defending” a “proceeding” in which indemnification theoretically could be available. Importantly, the Court noted, the advancement rights provided for in the Company’s bylaws encompassed not only any proceeding for which Paolino could be indemnified under Section 145(a) or (b) of the General Corporation Law (i.e., where Paolino satisfied the state of mind requirements of Section 145(a) and (b)), but also any proceeding for which indemnification could be required under Section 145(c) of the General Corporation Law (i.e., where Paolino was successful on the merits or otherwise in defending against the Counterclaims). Because Paolino was “defending” a “proceeding” to which his right to indemnification could extend (for example, if he was successful under Section 145(c)), the Court held that Paolino had stated a claim for advancement with respect to the Counterclaims.
The Company argued that Paolino was not entitled to advancement of fees incurred to defend the Counterclaims because the Counterclaims were part of the affirmative suit Paolino had initially filed, and thus Paolino’s purported defense of the Counterclaims was not truly “defensive” in nature. In support of its argument, the Company attempted to use existing Delaware precedent holding that “defending” includes offensive counterclaims where such counterclaims are (i) advanced to defeat or offset the claims against the covered person, and (ii) qualify as compulsory counterclaims under the prevailing test employed under Federal Rule of Civil Procedure 13 and its Delaware analog. The Company asserted that the “mirror-image” concept should apply, so that when a person initiates a proceeding and a corporation asserts counterclaims defensively, those counterclaims are defensive only as to the corporation and the initiating person is stuck on the “offensive” side. The Court, however, rejected this argument, explaining that the operative question is not, as the Company suggested, “who started the lawsuit?” but rather, “has a claim been asserted against the covered person?” Because the Company had asserted counterclaims against Paolino, his defense of those claims was covered by the Company’s mandatory advancement provision in its bylaws.
The Company further asserted that since Paolino had initiated the arbitration without board authorization, advancement for the Counterclaims was precluded by the carve-out in the bylaws that the Company need not indemnify or provide advancement to a covered person in respect of a proceeding (or part thereof) initiated by that person unless the proceeding (or part thereof) was authorized by the board. The Court disagreed, explaining that while the arbitration was initiated by Paolino, the Counterclaims were initiated by the Company. Accordingly, the carve-out did not apply to Paolino’s right to advancement in defending the Counterclaims.
Lastly, the Company argued that Paolino was not entitled to advancement because the Counterclaims did not arise “by reason of the fact” that Paolino was a director and officer of the Company; rather, they arose out of his employment agreement. While the Court conceded that the permissive indemnification and advancement provisions of Section 145 of the General Corporation Law would not apply when the parties are litigating a specific and personal contractual obligation that does not involve the exercise of judgment, discretion or decision-making authority on behalf of the company, this was not such an instance. Given the allegations in the Counterclaims, which facially implicated breach of “fiduciary” obligations, including alleged failures of oversight and willful refusal to manage the Company, the Court found that the Counterclaims implicated Paolino’s duties as an officer and director and thus fell within the scope of the indemnification/advancement provisions of the bylaws of the Company.