The Company Advances Defense Costs?

Robert Royal,  |  March 16, 2017

Your client, who is a director, officer, or employee of a corporation or a manager, member, or employee of an LLC has called you and reported that they have been sued.They advise they do not have much money to pay for legal fees in defense of the claim.Fortunately, the Arizona statutes provide a method, if certain conditions are met, for these persons to have the company they work for advance on their behalf the cost of legal fees.This advancement for payment of defense costs is found in both the Arizona Corporate Code and probably the LLC statutes.Whether the litigation involves intra-corporate issues or a business divorce, the fact that the company is advancing the attorney fees for the defendants significantly alters the playing field.

The basic principle of advancement for expenses is that a corporation or LLC may pay for or reimburse the reasonable expenses incurred by a director/manager who is a party to a proceeding in advance of any final judgment.The purpose is to allow the director, who was acting on behalf of the company at the time of the alleged conduct, to have the company step up for his defense, advance the expenses, and relieve the director of the burden of those expenses, including attorney fees.Thus, it is more likely that quality persons will serve as directors knowing that should they be named in a proceeding; the company will be there to back them up financially.

To qualify for an advance of reasonable expenses, the director must furnish to the corporation their written statement that in their belief, they acted in good faith, and, they must furnish to the corporation a written “undertaking” to repay the advance if they are not entitled to mandatory indemnification and it is ultimately determined that the director did not meet certain standards of conduct.In effect, the corporation makes a loan to the director that will need to be repaid if the director actually took action or failed to take action which harmed the company.The director must confirm that the director’s conduct was in good faith, that the director reasonably believed that the director acted in an official capacity with the corporation which was in the best interests of the corporation or at least not opposed to the corporation’s best interest, and in the case of criminal proceedings that the individual had no reasonable cause to believe the conduct at issue was unlawful.The director may alternatively or in addition thereto give a written affirmation to the corporation that liability for the director’s alleged conduct was eliminated by the Articles of Incorporation.

With respect to an outside director of the company, one who is not an officer, employee, or holder of more than 5% of the shares of the stock of the corporation, the rules are slightly different.The outside director must still affirm to the corporation that they had a good faith belief they met the standard of conduct referenced above and have furnished their written promise to repay the advance if it is determined they did not meet such standard of conduct.This promise to repay is an unlimited general obligation which may not be secured by the company and shall be accepted without reference to the outside director’s financial ability to make a repayment.

A director is defined as not only a director of the corporation but also an officer, partner, trustee, employee or agent of another foreign or domestic corporation, partnership, joint venture, trust, employee benefit plan or other entity.

The director must repay the advancement if they are not entitled to mandatory indemnification and either a court or the Board of Directors, special legal counsel, or shareholder vote determines that the director did not meet the standard of conduct.

A few additional rules are required for advancement to officers.If the individual is an officer but not a director the advancement may be made to “… the further extent as may be provided by the Articles of Incorporation, the Bylaws, a resolution to the Board of Directors or contract. …” If the company will not advance the expenses, directors and officers may apply to a court for an advance of expenses to the same extent to which a director is entitled to an advance.The court conducting the proceeding or any other court with jurisdiction may order the advance of expenses if the director is entitled to mandatory indemnification or the director is “fairly and reasonably” entitled to the advance.

Under the LLC statutes, an LLC has the power to “indemnify a member, manager, employee, officer, or agent or any other person.”The LLC statutes are structured to allow the Operating Agreement to provide the terms and conditions of indemnification, including advancement.However, a court would likely allow advancement in an LLC context in light of the Arizona corporate statutes.

Persons bringing intra-corporate claims who are owners of the entity must realize prior to bringing suit that should they name management or employees in such a suit, it is likely that such defendants will seek and obtain an advancement from the company to pay defense costs.Thus, in effect, the plaintiffs, by virtue of their ownership in the entity, are paying a portion of their assets and interest in the company to cover the advanced attorney fees of their opponents.Within any intra-corporate dispute or business divorce context, the balance of the issues may be shifted purely by the fact the company’s accounts are being drained to pay the defendants’ attorneys’ fees.While some may claim foul, the advancement statutes are an important protection for management brought into any kind of proceeding; giving them assurance that their personal funds are not at risk while defending themselves for acts allegedly taken while they were acting in their official capacity for the company.