/>iWhile the merits of a dispute matter the most, a key factor — and potential source of leverage — is which parties pay the legal expenses and which parties are insulated from downside risk.
This article highlights indemnification and advancement clauses, which are commonly included in foundational business and fiduciary documents such as limited liability company (LLC) operating agreements and partnership agreements.[1]
As used in this article, indemnification is contractual protection against legal liability. Put simply, indemnification determines who will ultimately pay, sometimes for legal liabilities (monetary damages) and sometimes for legal fees and costs after a judgment. Many LLC operating agreements provide that the company will indemnify its management (whether managers, directors, or officers) for losses incurred by management in connection with their actions on behalf of the company.
While indemnification can protect a fiduciary from ultimate legal liability, such as an adverse judgment for monetary damages, it does not protect a fiduciary from the ongoing legal expenses incurred in defending against that legal liability, which can be staggering. In contrast, advancement is an interim contractual protection that requires a company to advance its fiduciary’s legal expenses as incurred while the dispute is ongoing.
A company’s founder or majority owner should carefully consider (1) whether to grant indemnification and advancement protections and, if so, to whom; (2) what types of liabilities those protections should cover (and exclude); and (3) when to make those protections available. Similarly, fiduciaries should consider requesting contractual indemnification and advancement protections before they risk exposure to legal liability and related legal expenses.
When negotiating indemnification and advancement protections, companies (and their fiduciaries) should consider the following issues.
Why should a company consider providing contractual indemnification and advancement protections, and to whom?
A closely held business will typically agree to indemnification and advancement protections for its management personnel. Other constituencies, such as minority owners of a business, may also request these protections.
Companies often provide their management personnel indemnification and advancement protections because qualified candidates demand those protections. These protections may also benefit the company that grants them. Managers who are given these protections may be more likely to take risks to advance the company’s interests, rather than acting cautiously to avoid even remote threats of personal liability.
What types of liabilities should indemnification clauses encompass?
Narrow clauses typically protect covered persons (such as managers) from potential liability in legal actions brought only by third parties, such as a company’s customers, vendors, or employees. If the covered person is found liable but is determined to have acted with proper authority and in good faith, the company will pay the judgment against the covered person.
Broad clauses protect covered persons from potential liability in a legal action related to their role as management that is brought by anyone, including the company either directly or derivatively, as long as the covered person is not found to have acted in bad faith, fraudulently, or in violation of criminal law.
When should company governing documents include advancement protections?
Advancement is a powerful protection for fiduciaries and other covered persons because it is an interim remedy that applies before the ultimate resolution of the underlying legal claim. If a covered person faces potential liability for which they may ultimately be entitled to indemnification, an advancement clause generally requires the company to advance their legal expenses as incurred — even where the potential liability stems from a lawsuit brought by the company against the covered person.
A company may attempt to argue that it should not have to advance its former manager’s legal expenses in a lawsuit brought by the company against the former manager, notwithstanding the plain language of an advancement clause, but this argument typically fails. For this reason, a company should consider making advancement protections discretionary rather than mandatory: in order to receive legal expenses advanced by the company, the covered person must receive approval from specified disinterested company representatives.
If the covered person is ultimately not entitled to indemnification, they must usually repay the legal expenses that were advanced on their behalf.
The existence and scope of indemnification and advancement clauses can significantly impact the duration and intensity of a dispute among companies and their fiduciaries, as well as the likelihood and terms of settlement. In a future post, we will illustrate how the existence or nonexistence of a broad advancement clause can change the result of a dispute.
[1] Indemnification and advancement may also be the subject of statutes concerning corporations and other business entities. This article does not address such statutory provisions.
