Legal Blog

Indemnification

 Corporate lawyers often insert an indemnification provision in their basic corporate bylaws. This indemnification provision can come back to haunt the original controlling shareholder(s). The decision in Med-Chem Health Care Ltd. v. Misir (1990) 103 O.R. (3d) 769 (C.A.) demonstrates how.

 Complaint

 The controlling shareholder had a great idea: get financing to finance the cost of an IPO and then go public. The corporation did exactly that. A lender supplied the necessary financing and, we assume, the shareholder diluted his shares, but either received or was to receive a fistful of money as part of the exercise.

 As a condition of the financing, the lender had a representative on the board of directors. Additional directors were (or included) an officer of the corporation and the corporate lawyer.

 Within 26 months of the IPO, the corporation slid into the abyss and was adjudged bankrupt. By that time, all three directors had resigned.

 The shareholder asserted from the start that the lender was responsible for the corporation’s financial problems and that, by their wrongful conduct, the three directors had breached their duties to the corporation.

 The shareholder tried to persuade the trustee in bankruptcy to bring an action against the lender. The trustee refused because its independent counsel had opined that the corporation had no case. Instead, 6 years later, the shareholder commenced an action in his personal capacity against the lender and the three directors alleging that their conduct caused the corporation’s bankruptcy. He ultimately discontinued that action.

 Three years after the commencement of the aborted personal action and after the corporation was discharged from bankruptcy, the shareholder commenced the present action in the corporation’s name.

 Pay Me

 The lender and the directors, who had been fighting the shareholder for over five years, brought a motion for immediate indemnification of their legal fees, which, even at the pleadings stage, were significant.

 The shareholder faced the prospect of having to finance the legal fees of the lender and the directors, in addition to the corporation’s, in his quest to demonstrate that the defendants acted improperly.

 For reasons which will be apparent, the shareholder agreed that he had to pay all of their legal fees, but claimed that he only had to pay these fees at the end of the action, when, if all went well, he could set them off against the corporation’s damages.

 Bylaw

 The corporation’s basic bylaw contained the following indemnification provision:

 “Subject to the limitations contained in the Act, the Corporation shall indemnify a director and officer of the Corporation, a former director or officer, … against all damages, costs, charges and expenses, including an amount paid to settle an action or satisfy a judgment, reasonably incurred by him in respect of any civil, criminal or administrative action or proceeding to which he is made a party by reason of being or having been a director or officer of the Corporation … if (a) he acted honestly and in good faith with a view to the best interests of the Corporation or such body corporate; and (b) in the case of a criminal or administrative action or proceeding that is enforced by a monetary penalty, he had reasonable grounds for believing that his conduct was lawful…”

 We looked; this clause is almost word for word the same as the provision that we insert in all of our standard bylaws.

 The “Act” to which the bylaw referred was the Business Corporations Act. It states the following:

 136(1) A corporation may indemnify a director or officer of the corporation, a former director or officer of the corporation … against all costs, charges and expenses, including an amount paid to settle an action or satisfy a judgment, reasonably incurred by the individual in respect of any civil … or other proceeding in which the individual is involved because of that association with the corporation or other entity.

 (2) A corporation may advance money to a director, officer or other individual for the costs, charges and expenses of a proceeding referred to in subsection (1), but the individual shall repay the money if the individual does not fulfil the conditions set out in subsection (3).

 (3) A corporation shall not indemnify an individual under subsection (1) unless the individual acted honestly and in good faith with a view to the best interests of the corporation or, as the case may be, to the best interests of the other entity for which the individual acted as a director or officer or in a similar capacity at the corporation’s request.

 Arguments

 The shareholder argued:

 1. The bylaw made no mention of an obligation to advance; it just referenced an obligation to indemnify. The Court held that the Act allowed advances, if the bylaw authorised indemnification. Therefore the bylaw simply made mandatory what the Act made optional. The Act recognised that if an individual director had to fund a defence on an ongoing basis, the indemnification objective would be seriously impaired.

 2. Section 136(2) does not apply to former directors because, unlike subsection 1, it does not refer to them. The Court held that the words “other individual” in subsection 2 was just legislative shorthand encompassing all the people named in subsection 1.

 3. The directors did not act honestly and in good faith and therefore had no right to any indemnification. However, the motions judge disagreed and held that the corporation had not proven that the defendant directors had acted in bad faith. The Court held that the motions judge had sufficient evidence before her to come to that conclusion and therefore allowed the ruling to stand.

 4. Finally, the motions judge exercised her discretion improperly because she did not consider whether the defendant directors were able to pay their own legal fees or whether there might be sufficient insurance to fund them regardless. The Court held that these factors were irrelevant and agreed with the motions judge’s exercise of her discretion.

 Lender

 The shareholder also argued that the corporation should not have to advance funds to pay the legal fees of the lender. However, the loan agreement between the lender and the corporation stated that the corporation had to “pay upon demand all of the Lender’s … reasonable costs relating to … all other matters for which such costs may be incurred for so long as this Agreement shall be contemplated or in effect between the Lender and the Borrower.” Legal fees and disbursements were specifically included as part of those costs.

 The Court held that the clause was wide enough to encompass the corporation’s action.

 Result

 The corporation, and therefore the shareholder, must fund all of the legal fees of the action as it wends its way to trial. Once the shareholder was unable to demonstrate that the actions of the defendants failed to pass the smell test, the result was a foregone conclusion.