The Canada Business Corporations Act ("CBCA") and the Ontario Business Corporations Act ("OBCA") provide that in certain instances a director will have a right to indemnification from a corporation for all costs, charges and expenses, including an amount paid to settle an action or satisfy a judgment, reasonably incurred in respect of any civil, criminal, administrative, investigative or other proceeding in which the director is involved because of his or her association with the corporation. However, the entitlement to indemnification for directors under the CBCA and OBCA (collectively, the "Acts") is not absolute and there exists circumstances in which a corporation will be prohibited from indemnifying a director.
The rationale for indemnification is that in order to attract and maintain competent directors, corporations must assure directors that they will not suffer negative financial consequences resulting from well-intentioned entrepreneurial initiatives undertaken by them on the corporation's behalf.
Nonetheless, the Acts prohibit indemnification of directors by corporations under certain circumstances. For example, a director will not be indemnified where he or she has acted dishonestly, in bad faith, or, in the case of criminal or regulatory penalties, without reasonable grounds for believing his or her conduct was lawful. These prohibitions are intended to serve as a deterrent against director misconduct.
The recent decision of the Ontario Court of Appeal in Bennett v. Bennett Environmental Inc.1 provides valuable judicial consideration of the circumstances in which indemnification is prohibited by the CBCA (which circumstances are mirrored in the OBCA). Directors should be aware of these recent developments.
The Bennett Case
Bennett Environmental Inc. ("BEI") is a publicly traded soil removal company. John Bennett served on BEI's Board of Directors and was a member of its Disclosure Committee.
In June 2003, BEI announced that it had been awarded the largest soil remediation contract in its history. In August and September 2003, BEI was notified that the consent to the contract would be withdrawn due to a protest by one of the other bidders. BEI rebid on a second contract for a much smaller volume of soil, which contract was signed in June 2004. Despite the withdrawal of consent to the original contract, BEI continued to publicly list this larger contract as part of its inventory of projects until July 2004, at which time it issued a press release explaining that it had been awarded the second, smaller contract and further work with respect to the original contract was "highly unlikely." In the ten days following the press release, the price of BEI shares fell by almost 50 per cent.
In 2006, the Ontario Securities Commission ("OSC") reprimanded Bennett for violating the disclosure requirements of the Securities Act. In a settlement agreement with the OSC, Bennett admitted that the dispute about the original contract constituted a material change and that BEI had failed to disclose that change in accordance with the Securities Act. As part of the settlement agreement, Bennett was fined $250,000 and ordered to pay $50,000 in costs.
In December 2006, Bennett sought indemnification from BEI for the fine and costs he had incurred throughout the OSC proceedings. BEI refused to indemnify Bennett. In the reasons given for refusal, BEI referred to the prohibitions against indemnification contained in its by-law (which mirror equivalent prohibitions found in the Acts). The application judge ruled that Bennett was entitled to indemnification, and BEI appealed.
On March 5, 2009, the Ontario Court of Appeal upheld the application judge's decision that Bennett was entitled to indemnification. The reasons given by the court for its decision include a number of important findings of which directors should be cognizant.
(a) Corporation Bears the Burden
Under subsection 124(3) of the CBCA (which is mirrored in the OBCA and BEI's by-law), in order for a director to be entitled to indemnification he or she must have (a) acted honestly and in good faith in the best interests of the corporation, and (b) in the case of criminal or regulatory penalties, the director must have had reasonable grounds for believing his or her conduct was lawful.
The court held that there is a presumption that directors have acted in good faith, and that they believe that they are acting lawfully and with reasonable grounds for holding such a belief. As such, the onus falls on the corporation to demonstrate otherwise. The allocation of this onus makes practical sense, the court stated, as corporations will most likely have the advantage of unrestricted access to corporate documents relevant to the indemnification proceeding. The court also affirmed that the good faith test under clause 124(3)(a) of the CBCA is a subjective one.
The court agreed with the conclusion of the application judge that BEI failed to satisfy the burden of establishing that Bennett had not acted in good faith or in the best interests of the corporation. The court further concluded that the surrounding circumstances demonstrated that Bennett's good faith belief in his conduct was an informed one, and the honesty of his belief was demonstrated by the absence of any motive to withhold disclosure.
BEI also failed to discharge its onus of establishing that Bennett did not have reasonable grounds to believe his conduct was lawful. The court concluded that Bennett honestly and reasonably believed that the original contract was not in jeopardy, so there was no basis upon which he ought to believe that he had a disclosure obligation.
(b) The Contextual Perspective
The determination of a director's entitlement to indemnification, instructed the court, must be decided on the basis of the circumstances that existed at the time that the impugned conduct took place. The benefit of hindsight is thus removed. Accordingly, an investigation into the reasonableness of a director's grounds for believing that his or her conduct was lawful will not be informed by the ultimate consequences of that conduct.
(c) Professional or Legal Advice
Finally, the court commented on the significance of directors obtaining professional or legal advice. The court stated that, while reliance on such advice is not a prerequisite to establishing reasonable grounds for belief that the conduct of the director was lawful, it would substantially assist a director seeking indemnification to have relied on such advice. The court further stated that the failure to obtain professional or legal advice may raise questions about the reasonableness of the director's conduct or good faith belief, and may prompt an examination of the surrounding circumstances at the relevant time in order to assess reasonableness.
The primary lesson to directors is that a corporation will not be prohibited from indemnifying one of its directors unless it can establish that the director acted in bad faith, or, in the case of criminal or regulatory penalties, that the director did not have reasonable grounds for believing he or she was acting lawfully. In attempting to establish either, the corporation will not be entitled to the benefit of hindsight. The corporation will have to prove that, under the circumstances that existed at the time the impugned conduct took place, the director acted in bad faith or without reasonable grounds for believing he or she was acting lawfully. While this alone should provide some comfort to directors, in order to maximize the likelihood of entitlement to indemnification, a director should ensure that his or her actions are well-informed, rely on professional or legal advice as needed and avoid conflicts of interest that may provide a motive to avoid disclosure.
1 Bennett v. Bennett Environmental Inc., 2009 ONCA 198 (CanLII).
*Jennifer Heath is an associate and member of the firm's Litigation Group and Labour and Employment Team.
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