Was American Apparel’s Lawsuit Against Former CEO Dov Charney Brought “By Reason of the Fact” That He Was Its CEO, Such That It Must Advance His Legal Fees?

| Jason M. Knott

The legal saga of American Apparel and its founder and former CEO, Dov Charney, has more twists and turns than the latest season of Game of Thrones.  We’ve previously blogged about the sundry clashes between the two, including Charney’s ongoing arbitration for severance, the sexual harassment allegations against Charney, and a lender’s threat of default on a major loan after Charney was fired.

Now, Charney and American Apparel are battling in two separate cases in Delaware Chancery Court.  In the first, American Apparel has sued Charney for violating a standstill agreement by becoming involved in shareholder suits and commenting to the press.  The second case is a follow-on to the first: Charney has sued to force the company to advance his fees for the standstill lawsuit.  In this Game of Thrones, you win or you pay for your defense out of your own pocket.

Last week, as reported by Law360, Vice Chancellor Andre Bouchard held a hearing on the parties’ competing summary judgment motions in the advancement case.  In its motion, American Apparel argues that Charney’s indemnity agreement only requires it to advance fees for cases brought against him “by reason of the fact” that he was a corporate officer, and that its standstill case does not qualify under that test. 

The “by reason of the fact” language cited by American Apparel is commonly found in indemnity agreements.  It is also found in 8 Del. Code § 145, the statutory provision that authorizes Delaware corporations to indemnify their officers, directors, employees, and agents for lawsuits and investigations when they are made a party “by reason of the fact” that they have that status.

American Apparel says that its standstill lawsuit isn’t brought “by reason of” Charney’s former corporate capacity, because he entered into the standstill agreement only in his personal capacity, and he didn’t use his corporate powers in breaching the agreement (since the breaches occurred after he was suspended as an employee and then fired).  In his answering brief, meanwhile, Charney argues that his “broad access to [American Apparel]’s information and his ability to influence American Apparel employees result from his position as CEO and enabled him to take the actions alleged” in American Apparel’s suit.  Further, he says, he signed the standstill agreement while he was still a corporate employee and officer.

It’s worth noting that the parties are presenting these arguments in the context of an advancement proceeding.  As we’ve previously outlined here, indemnification is the reimbursement of legal fees after a proceeding is concluded.  Advancement requires payment of fees before a proceeding is finally resolved, subject to repayment if it’s later determined that the employee has no right to indemnification.   In Homestore, Inc. v. Tafeen, 888 A.2d 204 (Del. 2005) – a case involving a “by reason of the fact” dispute – the Delaware Supreme Court explained that proceedings for advancement have a “limited and narrow focus,” which precludes the “litigation of the merits of entitlement to indemnification for defending oneself in the underlying proceedings.”  Id. at 214.  Thus, “if there is a nexus or causal connection between any of the underlying proceedings contemplated by section 145(e) and one's official corporate capacity, those proceedings are ‘by reason of the fact’ that one was a corporate officer, without regard to one's motivation for engaging in that conduct.”  Id.  Accordingly, the court affirmed the Chancery Court’s decision that the officer (Tafeen) was “a party to the underlying Proceedings because of his alleged role in a scheme to inflate Homestore's financial results while serving as an officer of Homestore.”

However, when a claim “clearly involve[s] a specific and limited contractual obligation without any nexus or causal connection to official duties,” then it does not fall within the “by reason of the fact” standard.  Paolino v. Mace Sec. Int’l, Inc., 985 A.2d 392, 407 (Del. 2009).  For example, in Stifel Financial Corp. v. Cochran, 809 A.2d 555, the Delaware Supreme Court held that an officer was not entitled to indemnification for his breach of his individual obligations under his employment contract, because those breaches were “entirely … personal … , pursued for his sole benefit.”  Id. at 562.

Even if Vice Chancellor Bouchard decides that this case falls on the Cochran side of the line, Charney has other arguments: in his own motion, he contends that other provisions in the standstill agreement and indemnity agreement provide advancement and indemnity for cases “related to” his status as officer, even if the suits are not brought “by reason of the fact” that he was an officer.  American Apparel, however, says in its answering brief that this broader indemnity would conflict with Delaware law, and also claims that “the fact that Mr. Charney was once a director, officer, and fiduciary of American Apparel bears no relation to the fact that, after he was stripped of these powers, he chose to participate in litigation efforts and labor rallies to remove directors or to make disparaging comments to the press.”

We’ll be watching to see how Vice Chancellor Bouchard resolves these thorny issues.  Regardless of how the case comes out, however, Charney will still have some of his legal fees fronted by the company.  American Apparel notes in its motion that “since Mr. Charney’s initial suspension from his duties as Chairman and CEO, the Company hasadvanced to him funds for the defense of multiple actions, including sexual harassment actions” – which it says “did arise by reason of the fact that Mr. Charney formerlyserved as a director and/or officer of the Company.”

Information provided on InsightZS should not be considered legal advice and expressed views are those of the authors alone. Readers should seek specific legal guidance before acting in any particular circumstance.

As the regulatory and business environments in which our clients operate grow increasingly complex, we identify and offer perspectives on significant legal developments affecting businesses, organizations, and individuals. Each post aims to address timely issues and trends by evaluating impactful decisions, sharing observations of key enforcement changes, or distilling best practices drawn from experience. InsightZS also features personal interest pieces about the impact of our legal work in our communities and about associate life at Zuckerman Spaeder.

Information provided on InsightZS should not be considered legal advice and expressed views are those of the authors alone. Readers should seek specific legal guidance before acting in any particular circumstance.