Canada: Look(s) Bad For Former Directors

In its decision in Cytrynbaum v. Look Communications Inc. released July 4, 2013, the Ontario Court of Appeal affirmed a lower court ruling that "advancement" by the corporation to Look's former directors, for advance funding of the directors' legal costs to defend against an action brought by the corporation, is subject to Court approval. The former directors had been sued by Look (at the behest of successor directors), and had sought advancement of consequent expenses under their indemnity agreements with Look. Look declined to advance the expenses, and the former directors sued for an order compelling payment. On the facts as found, the trial Court refused to order advancement, and the Court of Appeal upheld that decision.

Look's business had been in serious decline for several years. Its board ultimately negotiated a sale of assets through a CBCA plan of arrangement and under the supervision of a monitor. In May 2009, the terms of sale were agreed for a purchase price of $80 million (less $16 million to be paid to one of the purchasers to settle outstanding litigation). The sale closed in September 2009. In June 2009, the board approved $11 million in severance, retention and bonus payments to insiders. It also approved using a 40 cent per share price to determine and pay out gains under Look's share appreciation plan, in which the directors participated. The Court determined that the actual fair market value of the shares was 20 cents per share, and that this was the price that should have been used to calculate gains. All in all, the Court concluded that the directors, officers, employees and consultants had pocketed 32 percent of the net sale proceeds, or approximately $20 million.

Although these payments had been approved by the board in June 2009, they were not disclosed until January 2010 when a management information circular was issued. Once the payments were disclosed, they were strongly criticized by Look's shareholders, who began a proxy contest that quickly gathered steam. The directors anticipated that they would be replaced and sued, and in June 2010, they authorized and directed Look to pay $1.55 million as retainers to three law firms representing the directors, personally. Immediately after these payments were made, those involved resigned as directors and as officers of Look.

The former directors claimed that their indemnification agreements with Look entitled them to advance funding of their defence costs without any need for Court approval. The Court determined that the indemnity agreements could not override the express terms of the CBCA, that the Court construed as requiring prior Court approval. Although section 124(4) of the CBCA was headed by a "marginal note", "Indemnification in derivative actions", and the action by Look against the former directors was not derivative, but rather a direct action, the Court held that the marginal note was not determinative and refused to follow a similar Ontario case that had restricted the section to derivative actions. The Court concluded that the wording of the section was clear because it applied to actions "by" the corporation and not solely those "brought on behalf of" the corporation. The Court also declined to follow Delaware law because Delaware does not require Court approval of payments of this sort, as both the CBCA and OBCA do.

The Court reaffirmed the principle that directors are entitled to a presumption of good faith, but said that this presumption can be overcome where the corporation can demonstrate a strong prima facie case of bad faith. The Court said, "It is a stringent test that gives significant weight to the protection of directors. It ensures that they will ordinarily receive advance funding but leaves open the possibility that advancement will be denied when there is strong evidence of bad faith."

The Court concluded that Look had demonstrated a strong prima facie case of bad faith by the former directors because the directors had not provided the Court with reasonable explanations for the cash payments and for the use of a 40 cent share price to buy out share appreciation plan rights. The Court also concluded that the retainer payments were part of a pattern of self-interested behaviour.

The Court's conclusions were highly fact-specific and should not be taken to suggest that payments of bonuses or for retention in the context of an M&A transaction will not be sustained. Similarly, making arrangements to ensure that directors have funds available to pay their defence costs is not necessarily a prohibited action. A better process, with supporting advice from experts, and evidence on each point could have helped to support that the directors' actions were undertaken in the best interests of the corporation and were not about the directors' intentions to enrich or to simply attend to themselves. It will be important for directors in future situations to consider the best interests of the corporation in those circumstances, how their actions can be said to be in support of those interests, and what contemporaneous evidence may exist to support the directors' decisions and actions.

It remains the case that the "strong prima facie case of bad faith" standard is a high bar, so directors need not be unduly reticent in making their decisions. Nevertheless, the decision serves as an important warning that the actions of directors seeking indemnity advancement may be subject to Court review and can benefit from timely, expert advice: suitable motivation, careful consideration and evidence in support will be elements of avoiding a successful challenge.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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