See full size imageIf there’s a more litigious partnership falling-out than that of the closely-held mortgage company, Private Capital Group (PCG), I don’t know about it.  The case, entitled Ficus Investments, Inc. v. Private Capital Management, LLC,  has racked up 87 motions since it was filed in Manhattan Supreme Court in March 2007, including several contempt applications.  The court’s docket lists over 2,300 separate documents filed, and the case isn’t even close to being tried.  There have been three interlocutory appeals decided thus far, with several others awaiting decision.  Did I mention the parties have filed at least five other, related cases?

PCG was a New York-based Florida limited liability company formed to buy, manage and sell non-performing mortgages.  Ficus Investments, Inc. (Ficus), the 80% member and sole manager of PCG, put up $300 million debt financing.  Private Capital Management (PCM), the 20% member, operated PCG’s mortgage business by PCM’s two beneficial owners, Thomas Donovan and Lawrence Cline.  The conflagration started a little over a year after operations began, in March 2007, when Ficus ousted Donovan and Cline and brought suit accusing them of misappropriating over $20 million.

The complex, high stakes litigation not surprisingly has generated millions in legal bills, which in turn has spawned a litigation within the litigation over the issue of the defendants’ entitlement to advancement and indemnification of legal expenses under the provisions of PCG’s operating agreement. 

A year ago I wrote about a January 2009 appellate decision in Ficus in which the court held that the primary defendant, Thomas Donovan, as a former officer of PCG was entitled to seek advancement of his legal defense costs under the operating agreement.  The primary issue there was whether the trial court’s issuance of preliminary injunctions against Donovan defeated his advancement rights.  Manhattan Commercial Division Justice Bernard Fried ruled (read here), and the Appellate Division affirmed (read here), that the ultimate determination of Donovan’s indemnification rights had no impact on his interim advancement rights under the operating agreement’s terms.  The rulings resulted in reimbursement to Donovan of approximately $1.5 million in legal fees incurred through the end of 2007, which was upheld by yet another appellate court ruling in June 2009 (read here).

As it turned out, 2007 was just a warm-up for the next year, in which Donovan incurred another $3.8 million in legal defense costs for which he also sought advancement.  Ficus opposed the bulk of the request, arguing that Donovan was not entitled to advancement for fees incurred opposing Ficus’s applications for discovery and contempt sanctions concerning Donovan’s alleged misconduct after he was terminated as an officer, during the course of litigation.  Donovan’s alleged misconduct included the "hacking" of former co-defendant Cline’s e-mail account — early in the case Cline and Ficus entered into settlement and cooperation agreements — and failing to turn over company books and records in violation of court order.

The arguments raised in this second go-round, and the court’s recent decision in favor of Ficus, raise novel legal issues with important ramifications for advancement and indemnification litigation in this and other cases.

Here’s a summary of the proceedings leading to the latest decision:

  • The litigation began in March 2007, shortly after which Justice Fried issued orders requiring Donovan to turn over Ficus books and records.
  • In September 2007, Ficus filed a motion by Order to Show Cause (read here) seeking to hold Donovan in civil contempt of court for failing to return company funds along with certain books and records.
  • In a November 2007 order (read here), based on the parties’ conflicting allegations, Justice Fried referred the books and records dispute to a Special Referee to hear and report.
  • In May 2008, Ficus filed another motion by Order to Show Cause (read here) asking the court to impose various sanctions against Donovan allegedly for gaining unauthorized access to (i.e., hacking) Cline’s e-mail account beginning in November 2007, and thereby obtaining confidential attorney-client communications.
  • In a July 2008 order (read here), Justice Fried found disputed issues of fact requiring a hearing, and again referred the matter to the same Special Referee to hear and report. 

The Special Referee held lengthy evidentiary hearings and issued two reports, in August 2009 (read here) and November 2009 (read here) in which she concluded: (1) that Donovan deliberately violated Justice Fried’s orders requiring the turnover of Ficus books and records and should be held in contempt with appropriate sanctions including costs engendered by his actions; and (2) that Donovan without authorization accessed Cline’s confidential e-mail communications and should be sanctioned by the dismissal of his claims against Cline and others, and reimbursement of Cline’s and Ficus’s counsel fees.  Both reports currently are the subject of dueling motions to confirm and to reject the Special Referee’s findings and recommendations.

The Special Referee also conducted a separate evidentiary hearing as to Donovan’s request for advancements totaling $3.8 million for legal expenses incurred in 2008.  Her July 2009 report (read here) found that Donovan’s acts of hacking e-mail and his removal and non-disclosure of books and records occurred well after he left office at Ficus and were never intended for the benefit of anyone but himself.  The Special Referee recommended that Donovan was only entitled to advancement of counsel fees in the approximate amount of $1.8 million, or about $2 million less than he sought, reflecting her exclusion of expenses incurred primarily for the books and records and e-mail hacking proceedings. 

Ficus and Donovan filed motions to confirm and to reject, respectively, the Special Referee’s July 2009 report insofar as it excluded fees for the books and records and e-mail hacking proceedings.  The lengthy briefs submitted by both sides raise a host of issues and arguments, factual and legal, beyond the space limitations of this post.  In a nutshell, Ficus contended that the operating agreement’s provision for advancement and indemnification of expenses of an officer "who is a Party to a Proceeding because he or she is a[n] . . . Officer" does not encompass expenses unrelated to the person’s conduct as an officer.  Donovan countered that the agreement’s quoted language does not permit the extraneous consideration whether the particular subject matter of a motion or hearing within the "Proceeding" concerns the defendant’s conduct as an officer.  (For anyone interested in reading the parties’ briefs, here they are: Donovan Brief; Ficus Brief; Donovan Reply Brief; Ficus Reply Brief).

In his Decision and Order dated December 22, 2009, Justice Fried sided with Ficus and upheld the Special Referee’s determination to exclude the $2 million relating to the books and records and e-mail hacking proceedings.  Here’s the key passage from the court’s decision: 

There is no dispute that if Donovan were made a party to this action on the basis of conduct other than that which he engaged in as an Officer of PCG, he would not be entitled to advancement or indemnification under the Operating Agreement.  Likewise, Donovan cannot expect to be advanced funds to cover the expenses incurred in connection with defending against allegations of misconduct that commenced after he left PCG.  That the misconduct complained of was undertaken in connection with the suit against Donovan the Officer is of no moment; it was Donovan the individual who took the actions, for the benefit of and on behalf of, Donovan the individual.  There is no requirement within the Operating Agreement that PCG advance the litigation expenses of Donovan the individual.  The Special Referee’s conclusion that the mere fact that certain expenses arose out of the action in which Donovan the Officer was sued "is not necessarily sufficient to mandate that the fees" are advanceable, and her conclusion that fees for hearings on activities undertaken – admittedly – on Donovan’s own behalf and not on behalf of the Company are outside the scope of advanceable fees, are thus not erroneous.

The arguments on both sides raise important considerations of contract construction, the policies underlying advancement and indemnification of company officers, and conservation of judicial resources.  The threshold analytical hurdle stems from the fact that all conduct undertaken by a former officer in the course of a company-brought litigation for abuse of office, by definition, is conduct not undertaken "as an officer" of the company.  What principal distinguishes conduct within or outside the duty to advance and indemnify?  Donovan’s bright-line, contract-based argument offers the advantage of certainty — not a small consideration given the purpose of advancement and indemnification clauses to encourage service as a company officer or director — and reduced judicial intervention.  Yet it also could encourage a former officer to engage in abusive extra-judicial tactics under the guise of defense measures, or force the company to commence a separate lawsuit for post-termination litigation misconduct so as not to implicate the advancement and indemnification provisions.

Justice Fried undoubtedly is correct in suggesting that, had Ficus sued Donovan in a separate lawsuit for damages or other relief not directly impairing Donovan’s defense of Ficus’s claims in the main action, Donovan would not have a basis to seek advancement and indemnification.  The relief requested in the Orders to Show Cause (linked above) submitted by Ficus in support of its motions relating to the books and records and e-mail hacking proceedings appears to include preclusion orders directed at Donovan’s use of evidence in his defense of Ficus’s claims against him for his conduct as a former officer, as well as seeking other preclusion orders directed against Donovan’s prosecution of his own claims against Ficus.  On the other hand, the Special Referee’s recommended sanctions, assuming they’re adopted by the court, don’t appear to include any preclusion of Donovan vis-a-vis his defense of the main action.  Should any of these factors make a difference?

More questions:  Does a litigation-misconduct exception to advancement and indemnification pose a slippery slope, implicating many, easily imagined scenarios in which the defendant’s actions relating to the litigation cannot readily be pigeon-holed as related solely to defense of the company claims versus in pursuit of personal objectives?  Will the court be required to make factual inquiry and findings in each instance whether the conduct somehow relates to the defense of the company’s claims versus promotion of the former officer’s extra-litigation objectives?  Should company counsel revise the advancement and indemnification clauses used in bylaws and agreements to carve out conduct such as that at issue in Ficus, and if they do so, will it have a chilling effect on willingness to serve as an officer or director?

It looks like these questions are destined to be answered by a higher authority.  Donovan’s counsel recently filed a notice of appeal from Justice Fried’s ruling and, given the amount at stake, it’s probably a safe bet that the appeal will be perfected and that, some time later this year, the appellate court will have its say.  Stay tuned.

Update March 8, 2010:  My prediction for an appeal looks shakier in light of a decision on March 2, 2010, by Justice Fried in an unrelated action brought by a prior judgment creditor of Donovan, in which the court ruled that Donovan’s advancement and indemnification rights vis-a-vis PCG constitutes a "debt" subject to levy under New York’s judgment collection statutes.  The decision can be read here.  Might this ruling, cutting off payment of future advances to Donovan’s counsel, effectively bring down the curtain on the Ficus litigation juggernaut?  We shall see.

Update May 3, 2010:  The circle continues to close around Donovan.  In an order dated April 26, 2010, Justice Fried confirmed the referee’s report and recommendation to dismiss all of Donovan’s claims and counterclaims against Cline and the Ficus parties as a sanction for his hacking of Cline’s emails.  In another order dated April 29, 2010, Justice Fried ruled that Donovan’s contempt of the court’s prior orders requiring turnover of mortgage proceeds negated his contractual entitlement to advancement of his defense costs under Private Capital Group’s operating agreement.