United States: Beware The Interplay Between Indemnification Provisions And D&O Advancement Provisions In Merger Agreements

Originally appeared in Kaye Scholer's Summer 2016 M&A and Corporate Governance Newsletter.

Shareholders may have a backdoor way to force buyers to fund their litigation costs in defending against indemnification claims

Hyatt v. Al Jazeera America Holdings II, LLC, C.A. No. 11465-VCG (Del . Ch. Mar. 31, 2016) involved a D&O advancement claim by Joel Hyatt and Albert Gore, Jr., both former members and directors, and Hyatt a former officer, of Current Media LLC, against its acquirer, Al Jazeera. The advancement action stemmed from a separate action brought by Hyatt and Gore against Al Jazeera seeking the release of indemnity escrow funds pursuant to the deal merger agreement (Underlying Action). In that action, Al Jazeera counterclaimed, alleging that Hyatt, as Members' Representative under the merger agreement, had wrongfully rejected various Al Jazeera claims for indemnification. Hyatt and Gore then brought a claim against Al Jazeera for advancement of their litigation costs in the Underlying Action, based on a merger agreement provision that obligated Al Jazeera to honor the D&O indemnification and advancement provisions in Current Media's operating agreement for six years. The court's decision in favor of Hyatt and Gore serves as a warning to buyers that D&O advancement provisions can be used by sellers to undermine buyers' indemnification rights under a merger agreement.

The Merger Agreement Provisions

Al Jazeera involves the interplay between two separate sections of the merger agreement. The merger agreement contained standard indemnification provisions, pursuant to which Al Jazeera was entitled to seek indemnification for specified losses, upon delivery of a claim certificate. The indemnifications section contained a fee shifting provision, pursuant to which the nonprevailing party in a court action would be obligated to pay the prevailing party's fees and expenses.

The merger agreement also contained standard D&O indemnification and advancement provisions that obligated Al Jazeera to indemnify and advance fees and expenses to Current Media's former directors and officers, for a period of six years, to the same extent provided for under Current Media's Second Amended and Restated Operating Agreement (Operating Agreement).

The Parties' Arguments

Hyatt and Gore brought the Underlying Action in Hyatt's capacity as Members' Representative and Gore's capacity as a member of Current Media. They conceded that their claims in the Underlying Action did not trigger advancement rights under the merger agreement. However, in its counterclaims, Al Jazeera claimed that Al Jazeera was entitled to indemnification under the merger agreement based on breaches of representations and warranties arising from alleged breaches by Current Media of various most favored nation provisions under contracts with third parties. Hyatt and Gore argued that these counterclaims depended on Al Jazeera's contention that Hyatt and Gore, as directors and/or officers of Current Media, had caused the breach. Hyatt and Gore argued that they had a financial interest in appearing and defending their actions as directors and/or officers, and it was this situation that triggered the D&O advancement rights under the merger agreement.

Al Jazeera, on the other hand, argued that the fee shifting provisions in the indemnification section of the merger agreement evidenced an intent by the parties to solely provide indemnification, and not D&O advancement, in any dispute relating to the indemnity escrow.

The Court's Reasoning

The court noted that the dispute turned on whether, and in what circumstances, the parties intended the fee shifting provisions or the D&O advancement provisions to control the reimbursement of fees and expenses incurred to defend Al Jazeera's counterclaims.

The court rejected Al Jazeera's argument that the fee shifting provision supplanted the D&O advancement provision because, according to the court, they involved different rights that served separate purposes. The court also rejected Al Jazeera's argument that advancement was not appropriate because Hyatt was sued in his capacity as Members' Representative and not as a former officer or director. The court held that Hyatt's rights in each capacity were preserved, noting that the parties could have, but chose not to, exempt Hyatt from the right to D&O advancement under the merger agreement.

The court then considered the scope of D&O advancement. The merger agreement entitled directors and officer to advancement to the extent they would have been entitled under the Operating Agreement. The Operating Agreement provided for mandatory indemnification in pending or threatened actions, suits or proceedings "by reason of the fact" that such person was an officer or director of Current Media, and indemnification included the right to advancement of reasonable expenses of the type entitled to be indemnified. Citing Homestore, Inc. v. Tafeen, 888 A.2d 2014 (Del. 2005), the court equated "by reason of the fact" to there being a "nexus or causal connection" between the underlying proceedings and the defendant's "official corporate capacity". According to the court, this nexus exists if "corporate powers were used or necessary for the commission of the alleged misconduct," which does not require any allegation of breach of fiduciary duty. On the other hand, no nexus exists "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 corporation."

In finding that the requisite nexus existed with respect to Al Jazeera's indemnification claims alleging breaches by Current Media of various most favored nation provisions under contracts with third parties, the court wrote: "although the Counterclaims appear on their face to merely implicate Hyatt's role as Members' Representative, the resolution of the validity of the [indemnification claims] in the Underlying Action, in part, necessarily requires Hyatt and Gore to defend their actions as former officers and directors, for which they are contractually entitled to advancement." On the other hand, the court found that Hyatt and Gore were not entitled to advancement with respect to a separate Al Jazeera claim that Current Media's former members agreed to indemnify Al Jazeera for fifty percent of expenses it incurred with respect to termination of a specified agreement because that claim did not require Hyatt and Gore to defend actions taken in an officer or director capacity.

The Lesson for Practitioners

This decision serves as an important warning to buyers that D&O advancement provisions can be used by shareholders to circumvent their indemnification obligations under a merger agreement. Buyers who bring a court action to enforce an indemnification claim may find themselves in the position of funding the shareholders' litigation costs, which can, at a minimum, significantly alter the incentives and 

negotiating leverage in the litigation. Moreover, while the Al Jazeera decision focused on advancement rights, the logic could potentially be applicable in the context of D&O indemnification rights. This could potentially permit sellers to round-trip shareholder indemnification obligations under the merger agreement by claiming that they are indemnifiable losses for offices and directors under the merger agreement's D&O indemnification and advancement provisions.

Fortunately, the Al Jazeera court gave some clear guidance to buyers on how to address the risk. The court noted that the parties could have contractually exempted Hyatt from the right to D&O advancement under the merger agreement. Thus, the D&O indemnification and advancement section under the agreement could contain an exemption providing that such indemnification and advancement would not be available with respect to claims that relate to matters that are the subject of a buyer indemnification claim under the merger agreement. To be effective, the exemptive language should be included in both the merger agreement and any charter or other documents of the surviving corporation that contain D&O advancement and indemnification rights.

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