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Receding advancements: Legal fees and Ohio's corporate directors

By Chad Readler, Louis Chaiten and Amanda Parker
 
In 1986, the Ohio State Bar Association advocated changing Ohio’s corporate laws to add a default rule of “mandatory advancement” of legal fees for directors of Ohio corporations. The amendment was put forward to address the increasing likelihood that directors, by their corporate service, would incur legal fees associated with investigations, legal proceedings and other legal matters, what the Seventh Circuit Court of Appeals has described as “an occupational hazard” for corporate directors.1
 
The OSBA and other backers of the law believed it would enhance Ohio’s ability to attract and retain talented directors. A 1986 Ohio legislative report noted the state’s “urgent need to attract qualified individuals to serve as directors of corporations and to assure that corporations remain incorporated in this state.” The right to advancement answered the concern that talented directors would be dissuaded from serving Ohio corporations, given the likelihood of legal proceedings at some point during their service.
 
The enacting legislation was given “emergency” status and passed the General Assembly with overwhelming support.2 Now codified at R.C. 1701.13(E)(5)(a), the advancement provision provides that “expenses, including attorney’s fees, incurred by a director in defending” an action brought against the director by reason of the director’s corporate service “shall be paid by the corporation as they are incurred, in advance of the final disposition of the action … , upon receipt of an undertaking by or on behalf of the director in which the director agrees to” both (1) repay the advanced amounts if it is later determined that the director is not entitled to indemnification, and (2) “[r]easonably cooperate with the corporation concerning the action.”3
 
For nearly 25 years following its enactment, the advancement statute operated as intended, providing directors with the certainty that legal fees incurred in these circumstances would be advanced to them, without the worry of self-funding a legal defense. But seemingly nothing lasts forever, especially in this litigious age. In 2010, the 11th District Court of Appeals decided Miller v. Miller, an intra-company dispute between corporate directors. 4 The court of appeals’ resolution of the case cast doubt over the commonly understood application of Ohio’s advancement statute, holding, among other things, that mandatory advancement applies only when a director is a plaintiff in a legal proceeding, and that the statute creates an “opt-in,” rather than an “optout,” option for corporations.
 
The intermediate appellate decision prompted action from the Supreme Court of Ohio. At the request of the Miller defendants as well as the OSBA, which participated in the case as an amicus curiae, the Supreme Court resolved these newfound legal tensions, confirming that the scope of protections for Ohio directors includes the requirement that a corporation must advance a director’s litigation expenses unless its articles or regulations specifically provide otherwise.5

Corporate directors bring suit against fellow directors

In Miller, Trumbull Industries, an Ohio corporation, along with two of its shareholders and directors, sued Sam M. Miller, a director, shareholder and officer of Trumbull, claiming that he breached his fiduciary duties by usurping a corporate opportunity. Seeking advancement of legal expenses he was incurring to defend himself against Trumbull’s allegations, Sam M. Miller provided to Trumbull an undertaking pursuant to R.C. 1701.13(E)(5)(a). Both the plaintiffs and Miller subsequently sought declaratory judgments regarding Trumbull’s obligation to pay his litigation expenses. Applying R.C. 1701.13(E)(5)(a), the trial court concluded that Trumbull was required to advance Sam M. Miller’s litigation expenses, and held Trumbull in contempt. From that order, the plaintiffs appealed to the 11th District Court of Appeals.
 
On appeal, the court agreed that R.C. 1701.13(E)(5)(a) “is mandatory in its application.” It determined, however, that the statute did not require Trumbull to advance Sam M. Miller’s litigation expenses because he was not “sued as a result of any ‘act or omission’ on behalf of the corporation,” but instead for breach “of his fiduciary duties as a director of Trumbull.” The court of appeals additionally rejected the argument that “in the absence of an advancement provision in the articles of incorporation, as contemplated by R.C. 1701.13(E)(5)(a), the advancement of fees is mandatory.” In doing so, it relied on an Eastern District of Virginia decision holding that Ohio’s statute “cannot be read to mandate advancement as the default rule for all employees under all circumstances.” Accordingly, the court of appeals concluded, Trumbull was not required to advance litigation expenses to its director sued for breach of his fiduciary duties.

Clarification from the Supreme Court of Ohio

At the urging of Sam M. Miller and the OSBA, the Supreme Court of Ohio accepted jurisdiction with respect to four propositions of law:
 
R.C. 1701.13(E)(2) and (E)(5) provide, respectively, for (a) the post-litigation reimbursement and (b) the current advancement of attorneys fees incurred by a corporate director who has been sued by the corporation or by any of the corporation’s shareholders and directors. Contrary to the holding of the Court of Appeals, those statutory provisions are not limited to—and, indeed, have no application to—a lawsuit filed by a director to secure a benefit for the corporation.

The mandatory duty of advancement imposed on Ohio corporations by division (E)(5) of R.C. 1701.13 is not limited to cases in which a director is alleged to have committed acts or omissions on behalf of the corporation.

In order for a corporation to avoid the mandatory duty imposed by [R.C.] 1701.13(E)(5), the corporation must include in its articles of incorporation or code of regulations a specific statement that the provisions of [R.C.] 1701.13(E)(5) do not apply to that corporation.

A corporation’s mandatory duty under [R.C.] 1701.13(E)(5) to advance the legal fees of a director who has been sued for breach of fiduciary duty is not limited to directors who are alleged to have engaged in conduct protected by the business judgment rule.

Before Miller, the Supreme Court of Ohio had “not had an occasion to review the statute” and, indeed, no Ohio court had addressed in detail the meaning of the law, making review of the decision below especially appropriate.
 
In resolving the matter, the Court first clarified that Sam M. Miller was seeking advancement, not indemnification. It found it “necessary at the outset” to emphasize that advancement and indemnification, “although related, are not the same and should not be used as synonyms.” The General Assembly, the Court observed, “provided for both the advancement of expenses and the indemnification of expenses in R.C. 1701.13(E), but set forth different procedures for each.” Additionally, indemnification and advancement provide different protections for directors. Relying heavily on Delaware law, the Court explained that indemnification (i.e., reimbursement) “encourages corporate service” by protecting a corporate official’s “personal financial resources from depletion by expenses [incurred] during an investigation or litigation that results by reason of that service.” Advancement, too, encourages corporate service, the Court noted, but in a different way—it “provides corporate officials with immediate interim relief from the personal outof- pocket financial burden of paying the significant on-going expenses inevitably involved with investigations and legal proceedings.” In sum, “[t]he critical point about advancement of defense costs—as distinguished from . . . indemnification after the fact—is that its value ‘is that it is granted or denied while the underlying action is pending.’”
 
Turning to the statutory text, the Court agreed with the appellate court that “the advancement of a director’s fees [is] mandatory.” From there, however, the Court parted ways with the court of appeals’ “flawed” analysis. To start, the Court reiterated that “advancement of fees is neither determined by nor dependent upon whether a director is entitled to indemnification,” contrary to the reasoning in the decision below. Accordingly, whether Sam M. Miller violated his fiduciary duties, making him ineligible for indemnification, the Court emphasized, “is not appropriate for our review. The only issue that is properly before this court now”—and that was before the court below—“ is whether Sam M. is entitled to advancement of expenses.” So the Court’s decision concerned only a director’s right to advancement, and did not address indemnification, which (unlike advancement) is determined after the merits of the case are resolved.
 
Next, the Court rejected the plaintiffs’ argument that Trumbull could “avoid [its] statutory obligation of advancement of expenses by claiming … that Sam M.’s conduct, if proven, would foreclose indemnification due to an alleged breach of his fiduciary duties. Allowing corporations to avoid advancement by asserting that a director breached his fiduciary duty,” the Court found, “would make the advancement statute pointless.” After all, the Court noted, “the inherent nature of the right is to receive the funds as the defense costs are incurred”—resolving an advancement claim “cannot wait until the underlying case is over, when … indemnification [is] determined.”
 
The Court also confirmed the opt-out structure of the statute. R.C. 1701.13(E)(5)(a) directs that advancement is not mandatory if “the articles or the regulations of a corporation state, by specific reference to this division, that the provisions of this division do not apply to the corporation.” Based on that language, the Court found that the statute “explicitly sets forth the process for a corporation to avoid mandatory advancement.” Here, “Trumbull did not opt out of the mandatory advancement requirement because its articles of incorporation failed to include the necessary language set forth in R.C. 1701.13(E)(5)(a).” Accordingly, advancement was mandatory. In reaching that conclusion, the Court declined to follow the holding of the Eastern District of Virginia, relied on by the court of appeals, that “advancement is mandated only when the corporation has exercised the underlying right to make indemnification available.”
 
Pulling together its many legal conclusions regarding the advancement statute, the Supreme Court summed up by holding “that when a corporation has received from a director the undertaking described in R.C. 1701.13(E)(5)(a), the corporation is required to advance expenses to the director unless the corporation’s articles or regulations specifically state that R.C. 1701.13(E) does not apply to the corporation.” Regarding the undertaking, the Court clarified that when “a director is being sued by his corporation, any duty to ‘reasonably cooperate’ should not require the director to surrender his right to defend himself.” Thus, a corporation suing a director cannot defeat advancement by claiming (as Trumbull did) that a director’s agreement to reasonably cooperate with the corporation is “a sham.”

The decision’s effect on Ohio’s corporations

The Supreme Court’s holding is important for Ohio corporations. R.C. 1701.13(E)(5)(a) was part of an emergency measure enacted in 1986 to forestall the flight of Ohio corporations. The 1986 amendments responded to “an urgent need to attract qualified individuals to serve as directors of corporations and to assure that corporations remain incorporated in this state.” At that time, corporate directors, facing increasing exposure to meritless lawsuits at great personal expense, became increasingly unwilling to serve on the boards of Ohio corporations. Corporations, in turn, began leaving Ohio for jurisdictions with laws more amenable to recruiting and retaining directors. As part of its effort to attract talented directors, the General Assembly adopted a default rule requiring Ohio corporations to advance a director’s litigation expenses incurred in defending a lawsuit brought by reason of the director’s corporate service.

The advancement statute also leveled the playing field in suits (like Miller) between feuding factions of small corporations. Without advancement, defendant-directors would be forced to personally fund their legal defense, while the directors in control of the corporation could pay their legal expenses out of corporate funds.

The appellate court’s decision threatened these important protections. Its holding that advancement was not mandatory for directors sued for breach of fiduciary duty, as is the case in virtually all suits against directors, would have rendered the right to advancement a nullity. What is more, the court of appeals’ determination that advancement was not mandatory even where the corporation failed to state in its articles or regulations that R.C. 1701.13(E)(5)(a) did not apply—a conclusion amounting to a rewriting of the statute—would (if allowed to stand) have created significant uncertainty for Ohio corporations and their directors. By successfully petitioning the Supreme Court of Ohio to accept jurisdiction and to reverse the court of appeals’ mistaken interpretation of R.C. 1701.13(E)(5)(a), the OSBA helped to ensure that Ohio’s mandatory advancement regime will be consistently applied, removing an obstacle to the efforts of Ohio corporations to attract high-quality directors.

Author bios
Chad Readler, a partner in Jones Day's Columbus office, focuses on appellate, constitutional and complex litigation, including matters before the Supreme Court of Ohio, where he argued Miller v. Miller on behalf of the Ohio State Bar Association.

Louis Chaiten, a partner in Jones Day's Cleveland office, focuses on appellate and complex commercial and financial litigation. He previously clerked for U.S. Supreme Court Justice Antonin Scalia and Sixth Circuit Judge Jeffrey Sutton, and worked in the Office of Legal Counsel, U.S. Department of Justice.

Amanda Parker is an associate in Jones Day's Washington office, focusing on complex and appellate litigation.

Readler, Chaiten and Parker represented the OSBA before the Supreme Court of Ohio in Miller v. Miller.

Endnotes
1 Heffernan v. Pac. Dunlop GNB Corp., 965 F.2d 369, 370 (7th Cir. 1992).
2 See Am.Sub.H.B. No. 902, 116th Gen. Assembly., Reg. Session (1985-1986); “Ohio Passes Law to Curb Lawsuits Against Directors,” Corp. Fin. Wk., Dec. 1, 1986, at 4.
3 R.C. 1701.13(E)(5)(a) establishes a default rule of mandatory advancement only for directors. Advancement for officers and other corporate employees is governed by R.C. 1701.13(E)(5)(b), which permits, but does not require, advancement of expenses.
4 Miller v. Miller, 2010-Ohio-5662 (11th District).
5 See Miller v. Miller, 2012-Ohio-2928 (July 3, 2012).  

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