Paulino v. Mace Security: Delaware and Advancements for Fiduciaries

In Paolino v. Mace Security International Inc., Louis D. Paolino, Jr. sought indemnification and advancement of fees and expenses incurred in defending against counterclaims asserted against him by Mace Security International (“Mace”).  On December 14, 2010, the Delaware Court of Chancery denied Mace’s motion to dismiss the claim for advancement.   

Paolino, the Chairman and Chief Executive Officer of Mace from 1999 until May 20, 2008 was terminated by the company.  Upon dismissal, he filed a demand for arbitration, and claimed that he was terminated in retaliation for insisting that the Board publicly disclose certain material facts and events affecting Mace’s business, which the Board refused to do. 

Mace filed counterclaims.  Mace argued that Paolino refused to follow the Board’s direction, refused to properly inform and/or seek Board approval for Paolino’s actions, refused to comply with Mace’s corporate governance principles and bylaws, refused to reduce corporate overhead and expense as directed by the Board, and inappropriately interfered with the Board’s investigation of matters.  Mace alleged that Paolino’s actions constituted willful misconduct, which according to the terms of an employment agreement, negated any severance payment Mace may have owed to Paolino.

Paolino sought indemnification and advancement of fees and expenses incurred in defending against counterclaims. Mace moved to dismiss the complaint alleging that Paolino was not entitled to advancements because Paolino was not defending against the counterclaims, a carve-out in the provision barred recovery, and the counterclaims did not arise out of Paolino’s role as a director or officer of Mace.

The court stayed the action to the extent it sought indemnification pending final disposition of the arbitration, but continued Paolino’s action to enforce the mandatory advancement right granted to him under Mace’s Bylaws.  Under Section 145(e) of Delaware’s General Corporation Law, corporations may pay expenses incurred by directors and officers in defending any civil, criminal, administrative or investigative action, suit or proceeding “in advance of the final disposition of such action.”  Pursuant to this authority, Mace adopted Bylaws that entitled current and former directors and officers of Mace to broad and mandatory indemnification and advancement rights.  As the Bylaws provided:  

• §6.01—Each person who was or is made a party…in any action, suit or proceeding, whether civil, criminal, administrative or investigative, by reason of the fact that he or she…is or was a director or officer of the Corporation…shall be indemnified and held harmless by the Corporation to the fullest extent authorized by the Delaware General Corporation Law…provided, however, that except as provided in paragraph (b) hereof, the Corporation shall indemnify any such person seeking indemnification in connection with a proceeding (or part thereof) initiated by such person only if such proceeding (or part thereof) was authorized by the Board of Directors of the Corporation.
• §6.02—The right to indemnification conferred by Article 6 shall include the right to be paid by the Corporation the expenses incurred in defending any such proceeding in advance of its final disposition, including without limitation, attorney’s fees, expert's fees and all costs of litigation.

Because Paolino was defending against the counterclaims, he was entitled to advances under the Bylaws. 

Mace argued, however, that Delaware precedents did not require the advancement of expenses.  Mace alleged that where a covered person initiated a proceeding and a corporation asserted counterclaims defensively, those claims were not defensive.  Mace further argued that the counterclaims were part of the covered person’s offensive proceeding and did not qualify for advancements. 

The Vice Chancellor held that Mace’s argument contradicted the core public policies underlying Section 145.  The Section was intended (a) to allow corporate officials to resist unjustified lawsuits so that the corporation will bear the expenses of litigation in the event the Plaintiffs are successful; and (b) to encourage capable candidates to serve as corporate officers and directors because the corporation will absorb the cost of defending their honesty and integrity.  The court held that the procedural posture of the claim wasn't important, only whether the office or director was placed in a posture of having to defend.  

• For purposes of determining whether someone is “defending” a proceeding, the operative question is not “who started the lawsuit?” as Mace suggests, but rather “has a claim been asserted against the covered person?” If a claim has been asserted, whether as an initial claim, counterclaim, or third party claim, then the covered person is “defending.”

The court also stated that the carve-out within the Bylaw did not bar Paolino from receiving advancements.  Mace argued that the carve-out in Section 6.01 foreclosed advancement because Paulino initiated the proceeding.  The carve-out provided that payments would not be made where the officer or director "initiated" the proceeding unless "authorized by the Board of Directors of the Corporation.”  Furthermore, Section 6.02 provided that “the right to indemnification conferred by Article 6 shall include the right to be paid by the Corporation the expenses incurred in defending any such proceeding in advance of its final disposition.”  The court held that Paolino was not seeking advancements or indemnification in connection with a proceeding initiated by him.  Rather, the counterclaims were part of the proceeding that Mace initiated because the counterclaims were a separate cause of action for purposes of Section 145 analysis. 

Lastly, the court stated that the employment agreement between Paolino and Mace did not alter his right to recover.  Mace argued that Paolino was not entitled to recover because the counterclaims did not arise “by reason of the fact” that Paulino was CEO and Chairman of Mace, but rather out of his employment agreement.  Plaintiff needed only to show the existence of a "nexus or casual connection between a claim and [the officer's] official capacity."  The court concluded that the counterclaims broadly asserted that Paolino breached his fiduciary obligations and contractual, statutory, and common law duties owed to Mace.  Thus, the counterclaims implicated his duties as an officer and director. 

Additionally, the requisite connection was established “if the corporate powers were used or necessary for the commission of the alleged misconduct.”  Under this test, a claim against a director or officer for matters that related to a corporation would fall within Section 145, even if the individual was a party to an employment agreement.  The court further stated that in order for the corporation to avoid advancements, the claim must involve a specific and limited contractual obligation without any nexus or casual connection to official duties.

The primary materials for this post are available on the DU Corporate Governance website.