Monthly Archives: February 2015

The Company Advances Defense Costs? Part 2

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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.

The Company Advances Defense Costs? Part 1

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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.

Litigating the Business Divorce: Part 2

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6. Breach of the General Standards of Conduct for Directors and Officers, A.R.S. SS 10-830, 10-842. A director or officer may be liable for action or inaction which is not done in good faith with the care of an ordinarily prudent person under similar circumstances and in a manner the director or officer reasonably believes is in the best interest of the corporation. This statutory duty parallels the fiduciary duty which will be discussed in a future column.

7. Liability for Unlawful Distributions, A.R.S. S 10-833(A). A director who votes or assents to a distribution made in violation of the Arizona statutes has personal liability, generally in the amount of the distribution that exceeds what could have been distributed without violating Arizona law. If the director establishes that his or her action was done in compliance with the statutory standards of conduct set forth above, liability may be discharged.

8. The Director’s Conflict of Interest Transaction, A.R.S. SS 10-860 to 863. A director may be liable because a director or related person has a personal, economic, or other interest in a transaction with the corporation if the director’s action does not meet one of the safe harbors. These statutes require careful reading in their application.

9. Liability for False Statements, Reports, Certificates or Statements, A.R.S. S 10-1631. Directors and officers of a corporation may be jointly and severally liable to persons who have become a creditor or shareholder of a corporation on the faith of false, material representations in or alterations to any report, certificate, or other statement made or public notice given or if any book, record, or account of the corporation is knowingly or wrongfully altered. Such officers or directors or even their agents must knowingly or wrongfully authorize, sign or make the false report, certificate, other statement or notice.

10. Felony Liability for Interrogatory and Signature Violations, A.R.S. S 10-1632. Any person who knowingly fails or refuses within the time prescribed by statute to answer truthfully any interrogatories propounded by the Arizona Corporation Commission or signs any Articles, statement, report, application or other document filed with the Commission that is known by the person to be false is guilty of a Class 4 felony. A person who with intent to defraud or deceive knowingly falsifies, alters, steals, destroys, mutilates, defaces, removes or secretes the books, records or accounts of a corporation is guilty of a Class 5 felony. While this statute may not be a basis of a direct claim by a shareholder, it may be useful in negotiating a settlement of disputed litigation, but only in an ethical manner.

These primary areas of potential liability for directors and officers in a closely held corporation provide statutory bases of causes of action that may be filed in a business divorce. These statutory based claims are in addition to the more common tort claims that are likely present in a litigation between owners of a closely held corporation going through a business divorce.

Litigating the Business Divorce: Part 1

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This series of articles continues to now examine unique statutory claims that may exist when a business divorce cannot be avoided and the squeeze out actions reviewed in the last article leads to possible legal actions. Claims exist under the Arizona Corporation Code and arise from common law duties. Claims arising out of the Corporation Code are similar to those that may exist in limited liability company and partnership statutes. When your client has been wronged because of an intra-corporate dispute, you may want to examine the following statutes to see if a claim may be brought against the wrongdoers.

1. Liability for Non-Corporate Transactions, A.R.S. S 10-204. A person(s) who purports to act as or on behalf of a corporation with actual knowledge that the corporation does not exist is jointly and severally liable for all liabilities created.

2. Validity of Corporate Actions, A.R.S. S 10-304. A corporate action may not be challenged on the grounds that the corporation lacks power to act except at a proceeding by a shareholder to enjoin the act, in a proceeding by the corporation directly or derivatively against directors, officers, or agents, or in a proceeding by the Attorney General to dissolve the corporation. This statute must be considered when you are prosecuting unauthorized actions.

3. Liability of Subscribers and Shareholders, A.R.S. S 10-622. A director or officer who is a shareholder is not liable to the corporation’s creditors except for payment of his or her full consideration for the shares that are purchased. Further, shareholders are not personally liable for acts of the corporation or its debts. Exceptions to this statute are when a party attempts to pierce the corporate veil or in certain “trust fund” situations where an insider has paid themselves over a creditor.

4. Director Removal by Judicial Proceeding, A.R.S. S 10-809. A director can be removed from office if the director engages in fraudulent conduct or intentional criminal conduct with respect to the corporation and removal is in the best interest of the corporation.

5. Liability of Committee Members, A.R.S. S 10-825. A committee exercising the authority of the Board of Directors creates liability for committee members if the committee authorizes distributions, approves action which requires shareholders’ approval, fills Board vacancies, amends Articles and Bylaws, approves a merger or share reacquisition plan or a plan for issuance of shares of the corporation. Liability may also exist for determining rights of stockholders or director compensation.