COURT OF CHANCERY CONSTRUES INDEMNIFICATION CLAUSES FOR LIMITED LIABILITY COMPANY OFFICERS

Jul 06 2017

In Meyers et al. v. Quiz-Dia LLC et al., No. 9878-VCL (Del. Ch. June 6, 2017), the Court of Chancery, entered a summary judgment in favor of the plaintiffs entitling them to indemnification from Quizmark LLC (“Quizmark”) and QCE Gift Card LLC (“QCE Gift Card”). The Chancery Court also determined that the plaintiffs were not entitled to indemnification from Quiz-Dia LLC (“Quiz-Dia”).

The plaintiffs, Greg MacDonald (“MacDonald”) and Dennis Smyth (“Smyth”), were officers of the principal operating entity of Quiznos, QCE LLC (“OpCo”), and claim to have been officers of all of OpCo’s subsidiaries, including Quizmark, QCE Gift Card, and Quiz-Dia (collectively, the “Subs”). By 2012, various investment funds (the “Funds”) had accumulated substantial positions in OpCo’s debt and OpCo was having difficulty operating its business. This granted the Funds the power to declare a default under OpCo’s loan agreements. To neutralize the threat of default, OpCo entered into a complex restructuring transaction which transferred the ultimate ownership of OpCo and its subsidiaries to the Funds (the “Restructuring”). MacDonald and Smythe left Quiznos shortly thereafter.

In 2013, the Funds invited MacDonald and Smyth to attend various meetings in New York City and Denver as they were not happy with Quizno’s post Restructuring performance. MacDonald and Smyth, suspecting that the Funds were contemplating litigation, retained legal counsel to investigate potential claims that the Funds may pursue. In March 2014, OpCo and a number of its affiliates filed for bankruptcy and disclosed that the reorganized debtors and the Funds intended to pursue all claims and causes of action that could be brought against MacDonald and Smythe. In July 2014, after demanding indemnification and advancement from Quiznos for “all expenses incurred in connection with the threatened claims,” MacDonald and Smythe sued the Quiznos entities in the Court of Chancery for indemnification and advancement under a range of agreements, but not under the Subs’ operating agreements (the plaintiffs amended their complaint to include the operating agreements in September). The Court of Chancery refrained from issuing an opinion as the issue was not yet ripe.

Less than two weeks later, the Funds brought an action in Colorado alleging that MacDonald and Smythe induced the Funds to participate in the Restructuring by providing false or misleading projections (the “Colorado Action”). In September, the federal district court in Colorado dismissed the Colorado Action for lack of jurisdiction, which the Court of Appeals subsequently affirmed, and the deadline to petition the United States Supreme Court passed in March of 2017. Since the deadline to petition the United States Supreme Court had passed, the indemnification issue became ripe, and the Court of Chancery was in a position to issue a decision with respect to MacDonald and Smythe’s indemnification claims.

The indemnification provisions in the operating agreements for each of the Subs granted its officers a right to mandatory indemnification for “any loss, damage or claim incurred by such . . . Officer by reason of any act or omission performed or omitted by such . . . Officer in good faith on behalf of the Company. . . .” Thus, the court analyzed whether (i) MacDonald and Smyth were considered officers of each of the Subs, (ii) the Colorado Action fell within the scope of the indemnification provision, (iii) MacDonald and Smyth’s pre-litigation expenses should be included, and (iv) MacDonald and Smyth needed to prove that they acted in good faith.

The Court of Chancery determined that MacDonald and Smyth were officers of QCE Gift Card and Quizmark as neither party contested the written consents evidencing such. No such consent was present for Quiz-DIA. Despite the lack of a written consent, MacDonald and Smyth argued that they were de facto officers of Quiz-DIA because they performed the same functions for every entity, including Quiz-DIA. The Court of Chancery rejected this argument because Quiz-DIA required its officers to undergo a background check since it held a Colorado Liquor license. MacDonald and Smyth never underwent a background check and, thus, could not be considered officers of Quiz-DIA. Because only officers are entitled to the protections under the indemnification provision of the Quiz-DIA operating agreement, the Court of Chancery ruled that MacDonald and Smythe could not seek indemnification from Quiz-Dia. The Court of Chancery continued with its analysis as MacDonald and Smythe were determined to be officers of QCE Gift Card and Quizmark.

The Court of Chancery determined that the Colorado Action fell within the scope of the indemnification provision as the “by reason of” standard is meet “if there is a nexus or causal connection between any of the underlying proceedings . . . and one’s official corporate capacity, . . . regard[less] [of] one’s motivation for engaging in that conduct.” (Homestore, Inc. v. Tafeen, 888 A.2d 204, 214 (Del. 2005). In this instance, MacDonald and Smyth’s involvement in the Restructuring was intended to save Quiznos from financial ruin and MacDonald and Smyth’s actions as CEO and CFO were “taken on behalf of the entire Quiznos family of companies, including Quizmark and QCE Gift Card.”

The Court of Chancery also determined that the pre-litigation expenses incurred by MacDonald and Smyth were covered by the indemnification provision as the “any loss, damage or claim incurred” language captures pre-litigation expenses. The Court of Chancery cited numerous cases for the proposition that, in the indemnification context, “the concept of losses generally includes not only fines or judgments, but also the costs of investigation and defense” and reasoned “[i]t was reasonable for MacDonald and Smyth to believe that the Funds were threatening a lawsuit and that it was necessary to investigate the claims that the funds might bring as part of their defense.”

Quizmark and QCE claimed the indemnification provision only applies if the officers acted “in good faith on behalf of the Company” and that MacDonald and Smyth needed to prove that they acted in good faith. The Court of Chancery did not accept this argument, as the good faith requirement does not apply if the officer was successful on the merits or otherwise. In this instance, because the Colorado Action was dismissed for lack of jurisdiction, the Court of Appeals had affirmed the decision, and because the deadline to petition the United States Supreme Court for had passed, MacDonald and Smyth were successful on the merits or otherwise.

In summary, the Court of Chancery ruled that MacDonald and Smythe were entitled to indemnification from Quizmark and QCE Gift Card for their costs incurred in connection with preparation and defense of the Colorado Action, but they were not entitled to any indemnification from Quiz-DIA as they were not officers of Quiz-DIA.

Meyers et al. v. Quiz-Dia LLC et al., No. 9878-VCL (Del. Ch. June 6, 2017).