Recently, the Delaware Court of Chancery granted a motion to compel directors to repay advanced funds, finding that the corporation's controlling stockholders and directors could not retroactively adopt a by-law for the advancement of funds for legal fees after the initiation of a lawsuit that created a conflict of interest for the stockholder-directors (White v. Kern, No. 7872-VCG, (Del. Ch. Jan. 24, 2014) (TRANSCRIPT)).

The motion was brought by petitioners Thomas and Georgeann White, who together own one-third of the shares of A.E. Moore Incorporated, a Delaware corporation. The respondents, Steven Kern and David Wharton, are each one-third stockholders of A.E. Moore, and together control two of the board's three seats. The petitioners had brought claims against the respondents alleging, among other things:

Following initiation of that suit, the corporation, through action taken by the board-controlling respondents under Section 145(e) of the Delaware General Corporation Law (DGCL) (8 Del. C. § 145(e)), advanced funds to the respondents for their legal fees. The respondents took that action even though A.E. Moore's by-laws did not include a provision for advancement of legal expenses at the time of the advancement. The petitioners filed a motion to compel repayment of the advanced funds on the basis that the directors' action was a continuation of their alleged self-dealing. At the hearing, the respondents sought to retroactively amend the by-laws to permit advancement of legal fees in order to keep the fees already advanced.

As raised by the petitioners at the hearing, the court noted that earlier cases have established that a decision to amend the by-laws to allow advancement, though authorized under Section 145 of the DGCL, is subject to review by the Court of Chancery to ensure satisfaction of fiduciary duties (see Underbrink v. Warrior Energy Serv. Corp., No. 2982-VCP, (Del. Ch. May 30, 2008) and Havens v. Attar, No. 15134, (Del. Ch. Jan. 30, 1997)). That review is ordinarily made with the presumptions of the business judgment rule (an entitlement that the directors can lose if, as in Havens, they do not properly weigh the best interests of the corporation). However, if the directors (or controlling stockholders) have a conflict of interest at the time they seek to amend the by-laws, they are not entitled to the presumption of the business judgment rule. Instead, the court will review the decision to amend the by-laws to permit advancement under the standard of entire fairness.

Here in Kern, the court found that because the by-laws did not already provide for advancement, the respondents could only advance themselves funds after adopting an advancement by-law under Section 145(d) by either director action or stockholder vote (8 Del. C. § 145(d)). The court ruled that such an amendment could not pass entire fairness because the respondents were both controlling stockholders and directors and were attempting to advance themselves funds in response to a particular litigation expense. The court distinguished this from a situation where the appropriate by-law is already in place and is not itself in dispute (though even in that situation the court can review the appropriateness of the advancement itself under Section 145(k) (8 Del. C. § 145(k))). The court added that the respondents could seek to adopt an advancement by-law on the basis of an opinion of independent legal counsel under Section 145(d)(3), but was skeptical that they would be able to find independent counsel who would render an opinion affirming that advancement was in the best interests of the corporation. The court also ordered that any future attempt to advance funds must first be brought to the court's attention for approval.

The White v. Kern decision highlights the principle that while by-laws may be amended under Section 145 of the DGCL to permit or require advancement of legal fees to directors, the decision to amend is still subject to review, including review of a controlling stockholder's fiduciary duties. In particular, while decisions to amend the by-laws are generally entitled to the presumptions of the business judgment rule, when there is a conflict of interests, those decisions are subject to the entire fairness test. The court is also not limited to an after-the-fact review, but can, if petitioned (as was done in Kern), rule that an amendment to the by-laws under Section 145 cannot be adopted in the first instance. Therefore, if a Delaware corporation wishes to provide for advancement of legal fees, it must already have a by-law authorizing advancement in place. An attempt to adopt a by-law under the specter of specific litigation will have difficulty satisfying the board or controlling stockholder's fiduciary duties.