Working For An Alternative Business Entity? Check Your Indemnification Rights Carefully
We’ve frequently discussed the well-established indemnification and advancement rights of corporate directors and officers (see here and here, for example). These benefits protect individuals from claims asserted against them by shareholders or regulators. Corporate charters and bylaws typically expand these rights to the fullest extent permitted by law, but these provisions are merely an overlay to the statutory provisions which guarantee basic indemnification protections for directors and officers.
However, that isn’t the case for alternative business entities, such as limited partnerships (“LPs”), limited liability partnerships (“LLPs”) and limited liability companies (“LLCs”). Those entities don’t always have a statutory back stop that guarantees indemnification and advancement for their employees. In recent years, founders are just as likely to choose these alternative structures for their new business as they are to choose the corporate form. Therefore, protection of these key employees will be a growing issue.
The laws governing alternative business entities are designed to favor flexibility, allowing participants to contract for any legal terms they feel appropriate. But if the agreement creating the entity does not expressly create a right to indemnification or advancement, then such right will not exist, leaving employees without protection or resources to mount a proper defense.
For example, the Delaware General Corporation Law (the “DGCL”) requires a corporation to indemnify its officers, directors, employees and other agents who are subjected to claims by reason of their relationship to the corporation in the event they prevail on the merits of the claims. (For a discussion of this “by reason of” standard, see our recent post here.) Additionally, the DGCL permits a corporation to provide indemnification in a wide range of other circumstances, provided the employee acted in good faith and did not know the conduct was wrongful. Finally, the DGCL allows, but does not require, corporations to advance funds during the course of a litigation to cover the ongoing costs associated with defense, on the theory that a well-funded defense is the best way to avoid liability claims.
By contrast, the Delaware Limited Liability Company Act (the “DLLCA”), which governs the formation and operation of Delaware limited liability companies, simply provides as follows:
Subject to such standards and restrictions, if any, as are set forth in its limited liability company agreement, a limited liability company may, and shall have the power to, indemnify and hold harmless any member or manager or other person from and against any and all claims and demands whatsoever.
The Delaware Court of Chancery has held that this provision gives the entity complete discretion to determine the nature and scope of indemnification and advancement rights for employees of the LLC. See Majkowski v. American Imaging Management Services, LLC, 913 A.2d 572, 591 (Del. Ch. 2006). (We discussed this provision in a prior post here.)
The DLLCA also specifically states that “it is the policy of this Chapter to give maximum effect to the principal of freedom of contract and to the enforceability of limited liability company agreements.” 6 Del. C.§ 18-1101(b). As a result, the Delaware courts defer to the contractual provisions in the LLC agreement in determining whether to permit indemnification and advancement. Unfortunately, when trouble starts, if the agreement is not plain (and sometimes when it is) the entity may attempt to avoid its obligation to defend the employee.
For example, in the case of Stockman v. Heartland Industrial Partners L.P., two officers were criminally charged after certain accounting irregularities were disclosed and corrected. Stockman v. Heartland Industrial Partners L.P., C.A. No. 4227-VCS, slip op. at 1 (Del.Ch. July 14, 2009). The individuals were also named as defendants in a numerous civil proceedings brought by investors. After the criminal proceedings were dismissed through a nolle prosequi order, and after multiple insurance policies had been exhausted covering legal fees and expenses, the officers sought advancement of fees and indemnification directly from Heartland, claiming that the limited partnership agreement mandated these payments. Stockman v. Heartland Industrial Partners L.P., slip op. at 7.
Heartland responded that it had the right to condition any advancement of fees on the officers agreeing to sign an undertaking in which they pledged to repay the fees in the event they were not successful on the merits. Stockman v. Heartland Industrial Partners L.P., slip op. at 8. Heartland also claimed that the nolle prosequi order was not a sufficiently favorable outcome to establish that the officers were entitled to indemnification. Specifically, Heartland claimed that since the dismissal was without prejudice and no determination had been made with respect to the merits of the criminal charges, the officers could still be convicted of the criminal charges in a later proceeding, so they should be required to make a showing of their good faith before any indemnification payments would be made.
The Delaware Chancery Court disagreed. The language of the partnership agreement provided that advancement was mandatory and that the limiting provision was merely to insure that a demand was properly made. Stockman v. Heartland Industrial Partners L.P., slip op. at 13. In addition, the partnership agreement contained expansive language which directed indemnification to be provided “to the fullest extent allowed by law.” Stockman v. Heartland Industrial Partners L.P., slip op. at 27. Delaware law permits an entity to indemnify any officer or director who avoids conviction in a criminal proceeding, regardless of whether any affirmative finding was made with respect to culpability. The court concluded that the nolle prosequi order was sufficient to trigger Heartland’s indemnification obligations even if the order was without prejudice to future actions.
Plainly, entities should take care when they are drafting their indemnification and advancement provisions so that they have an up-front understanding as to the legal protections that officers and employees will receive. Because the Delaware LLC law does not provide its own standards for indemnification, courts are likely to honor the specific terms of the operating agreement, whatever they may be. Unfortunately, many entities never focus on these provisions until they are needed. Then, they may find that they have granted more or less protection than they desired at the outset. This can be an unpleasant surprise for either the employees who seek indemnification or the company that may end up footing the bill.