/>iIn a real-life case of adding insult to financial injury, companies harmed by the disloyal actions of their former partners, officers, managers or employees (the “former insiders”) may also have to pay their legal fees when the company sues them to recover for their misconduct. In this situation, if the company’s governance documents (and specific indemnity provisions) have not been carefully drafted, the company may have to pay the legal fees the insiders incur when they defend claims filed against them by the company.
This situation arises because almost all corporate bylaws, company agreements for LLCs, and partnership agreements for limited partnerships contain indemnity provisions protecting current or former insiders if they are named in a lawsuit because of their position with the company. Frequently, the governing documents will provide these insiders with the right to receive current payment of their legal fees during the litigation and before the lawsuit is ever resolved. And in some instances, the governing documents grant these rights to every company employee rather than to just partners, officers, directors and managers of the company.
Companies include these indemnity provisions in their governance documents because they encourage business leaders to serve in management roles without fear of sustaining personal loss from lawsuits, regulatory actions, or other legal proceedings related to their services for the company. These assurances also support sound decision-making and responsible risk taking by managing leaders that benefit the company. But, as noted, if the indemnity provisions in the company’s governing documents are not carefully drafted, these often-overlooked terms can result in some costly unintended consequences for the company. More specifically, the company could be forced to fund the legal fees incurred by both sides of the company’s lawsuit against a disloyal former insider. This post provides an overview of well-drafted indemnification and advancement rights and how they should be used by companies to achieve their best effect.
Indemnification and Advancement Defined
Typically, a company’s obligation to indemnify will arise from a contract (i.e., a company agreement), a statute, or a combination of the two. When a company provides indemnity, it usually covers legal fees, settlements, and judgments that are incurred or entered against an individual who was sued because of his or her services for the company. Generally, a company’s indemnity obligation will either indemnify insiders against liabilities or damages, or indemnify them against both liabilities and damages. When a company indemnifies against liabilities, the indemnification is owed when the liabilities become “fixed and certain,” such as when a judgment becomes final. But when a company indemnifies against damages, the indemnity becomes due when the indemnitee is compelled to pay the judgment or debt.
Although the right to indemnification and advancement are related, they are separate and distinct rights with notable differences. When a company provides the right of advancement, this enables the insider to receive advance payment of the legal expenses the insider incurs in defending against any claims that relate to that person’s services for the company. In other words, the advancement provision provides insiders with immediate interim relief from the burden of paying for the defense of a claim rather than waiting until the point at which the litigation concludes. Further, because the right to receive advanced payment of legal fees is not dependent on the right to receive indemnification, whether the company insider actually engaged in the misconduct alleged in the lawsuit is irrelevant to the insider’s right to receive advancement of legal fees.
The Scope of the Indemnity Provision Is Critical to Understand
Majority business owners who direct their companies to file suit against disloyal former insiders often assume that their company won’t be required to indemnify or advance legal expenses for the insider’s egregious or even blatant misconduct — regardless of what the company’s governing documents may say. But if the company is an LLC or GP, that assumption can be both incorrect and very costly.
This common misunderstanding may stem from the statutory scheme for indemnification and advancement for corporations. Specifically, the Texas Business Organizations Code (TBOC) codifies certain “default” rules applicable to corporations (and other Texas entities other than LLCs and GPs). For example, the TBOC specifies the circumstances under which a Texas corporation is required to indemnify a governing person, permitted to indemnify a governing person, and prohibited from indemnifying a governing person:
- Mandatory Indemnification – First, Texas corporations are required to indemnify their current or former governing persons if they are wholly successful in defending a lawsuit to which they were a defendant because of their position in the company.
- Permissive Indemnification – Second, a corporation is permitted, without the necessity of any enabling provision in its governing documents, to indemnify a governing person who meets certain standards. In civil proceedings, this standard requires that the governing person (1) acted in good faith and (2) reasonably believed the conduct was in the best interest of the corporation (or was not opposed to the corporation’s best interest if the conduct was outside the person’s official capacity).
- Prohibited Indemnification – And third, corporations are statutorily prohibited from providing indemnification to a person “in relation to a proceeding in which the person has been liable for (A) [willful] or intentional misconduct in the performance of the person’s duty to the enterprise; (B) breach of the person’s duty of loyalty owed to the enterprise; or (C) an act or omission not committed in good faith that constitutes a breach of a duty owed by the person to the enterprise.”
TBOC also permits corporations to advance legal fees and other litigation-related expenses to individuals, either through their governing documents or on a case-by-case basis, as long as the individual provides the company with (1) a written affirmation that they believe they have met the standard of conduct necessary for indemnification, and (2) an undertaking, which is a promise to repay the amount advanced if there is a final determination that the person has not met the standard for indemnification.
But LLCs and GPs enjoy significantly more leeway than corporations in permitting the owners to grant or completely omit indemnification and advancement rights for managers and others. That is because, in contrast to corporations, TBOC’s indemnification and advancement provisions are not applicable to LLCs and general partnerships by default. Instead, as it relates to indemnification and advancement, the owners of LLCs and GPs may either expressly adopt the Texas statute applicable to corporations or “may contain other provisions, which will be enforceable.” In most cases, LLCs and general partnerships will choose the second option, which restricts the company’s advancement and indemnification obligations solely to those that are listed in the governing documents. If these standards and restrictions are broad (e.g., any proceeding that the individual is made a party to because of his or her employment), then the company will likely be required to indemnify and advance expenses to a former employee, regardless of how wrongful the former insider’s conduct may have been.
In sum, owners of LLCs and general partnerships need to decide whether the indemnity provisions that protect insiders in their governance documents will protect them solely from third-party claims brought by third parties or whether they will also apply to first-party claims that are brought against them by the company. In almost all cases, the owner will want to limit the scope and protection of indemnity provisions solely to third-party claims that are filed against former insiders.
Conclusion
Companies need to provide indemnification and advancement rights to attract and retain talented managers and employees, but the company’s governance documents need to set forth these rights in a manner that is no more expansive than the company intended. In almost all cases, the scope of the indemnity protection should be limited solely to claims made by third parties; these are claims filed against company insiders by third parties based solely on the fact that the insiders are affiliated with the company. If the company’s governance documents properly limit the scope of the indemnity provision, then, in any future suit by the company against disloyal former insiders, they will not be able to obtain any indemnity protection or advancement of their legal fees from the company. This careful drafting of indemnity provisions avoids a situation where the company is required to foot the fees for legal counsel on both sides of the lawsuit.
