Indemnification and advancement are intended to protect individuals from claims asserted against them by shareholders or regulators by virtue of their position with a business entity.  A minimum level of protection is guaranteed by statute for corporate officers and directors.  As we covered in this post, statutory backstops do not exist for employees of alternative business entities, such as limited partnerships (“LPs”), limited liability partnerships (“LLPs”) and limited liability companies (“LLCs”).  Because these alternative business entities offer different advantages, they are chosen as frequently as corporations when a new business is formed.  Therefore, protection of individuals working for these entities will be a growing issue.

Alternative business entities are desirable because, among other things, the laws under which they are formed are designed to favor flexibility.  Management of an alternative business entity is principally controlled by the operating agreement among the stakeholders, which may contain whatever provisions the stakeholders deem appropriate.  For example, the Delaware Limited Liability Company Act (the “DLLCA”), which governs the formation and operation of Delaware limited liability companies, specifically provides 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).  The Delaware Revised Uniform Limited Partnership Act (“DRULPA”) has a similar policy statement, 6 Del. C.§ 17-1101(c).  However, if the agreement pursuant to which the alternative entity was formed does not expressly create a right to indemnification and advancement, employees may not have protection or resources to mount a proper defense in a time of need. 

The Delaware General Corporation Law (the “DGCL”) permits, but does not require, corporations to advance funds to employees during the course of a litigation to cover the ongoing costs associated with defense.  This remedy is distinct from indemnification, which is generally available to corporate employees at the successful conclusion of litigation.  In contrast, the DLLCA simply provides that “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.”  6 Del. C. § 18-108.  Since this provision is permissive rather than mandatory, a LLC may, or may not, provide indemnification and advancement to protect employees from litigation expenses.

Because Delaware courts usually defer to the contractual provisions in an operating agreement, the determination of whether to permit advancement will be controlled by the existing provisions of the entity.  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.

\Consider the case of Mark Majkowski, in which a relatively small underlying dispute resulted in multiple litigations in at least three jurisdictions and fees far in excess of the original amount at issue. Majkowski v. American Imaging Management Services, LLC, 913 A.2d 572, 575 (Del. Ch. 2006).  Majkowski had been an officer of American Imagining Management Services, LLC (“AIM”) as well as some of its affiliates.  After his termination, Majkowski sent AIM a letter asserting that he was wrongfully terminated by AIM and its affiliates and was improperly excluded from a management-led buyout of AIM.  Although AIM was a Delaware entity, with a principal place of business in Illinois, and its affiliates were formed under either Delaware or Illinois law, AIM sued Majkowski in Texas seeking a declaration that his claims were baseless.  Majkowski was then compelled to litigate in Texas, so he hired local counsel and alleged counterclaims against AIM and various AIM insiders.  In response to Majkowski’s counterclaims, the AIM insiders took the position that Majowski’s claims were subject to mandatory arbitration in Chicago, notwithstanding the fact that their LLC sued him in Texas.  Id. at 578.  

Having first been compelled to litigate in a distant forum, and then directed to arbitrate in a second jurisdiction, Majkowski sought advancement from AIM in Illinois state court and in Delaware.  AIM “spared no expense trying to deny” Majkowski’s request.  Id.  In the Illinois action, AIM again sought to compel arbitration.  When the Illinois court denied AIM’s request, AIM took an interlocutory appeal from that ruling and obtained a stay pending the appeal.  Knowing that the Illinois appeal process could drag on, Majkowski turned to the Delaware courts for relief.  

In the Delaware Chancery Court, AIM took the position that the advancement request was governed solely by Majkowski’s employment agreement and that, in accordance with that agreement, he was required to arbitrate his request.  Majkowski responded that his litigation expenses were related to his position with AIM and as a result the company’s operating agreement also controlled his advancement and indemnification rights.

Noting that advancement and indemnification are distinct and different legal rights, the Delaware Chancery Court reviewed the operating agreement closely to determine whether Majkowski was entitled to the relief sought.  Id. at 586.  In so doing, the court noted that the DLLCA does not expressly provide for advancement.  Rather, the court noted that it is a proper subject for an operating agreement.  Therefore, the court concluded that if such a right existed, it must be contained in AIM’s formation documents.  Id. at 589. 

While the operating agreement contained a typical indemnification provision, and Majkowski could seek indemnification in the event he was ultimately successful on the merits, the operating agreement did not include an advancement provision.  Although the court was sympathetic with Majkowski’s unfortunate situation, it found no way to grant the advancement relief requested.  Id. at 587.

Managers and other key employees of alternative business entities should take heed.  The freedom to contract that makes these entities attractive can be a double-edged sword.  Courts cannot create an advancement remedy where one does not exist.  Even though Majkowski’s initial consulting agreement with AIM contractually obligated AIM to include an advancement provision in its organizational documents, the parties failed to carry through on the execution of the documents.  Id. at 583 n.28.  (Majkowski abandoned the argument that the consulting agreement required advancement, because then he would have had to arbitrate his claim.)

Best practices dictate that an organization should consider the scope of advancement and indemnification rights that it wants to grant at the formation stage, before they are needed.  Failure to include or clarify these rights at an early stage can result in expensive litigation when the company and its employees are at odds.

Moreover, although it is an additional expense, insurance coverage for directors and officers may save all parties the pain of litigation over contractual advancement obligations.  If AIM had such a policy (and if it covered  its officers’ cost of defending against this kind of case), Majkowski could have sought advancement from the insurer instead of being forced to fight for resources from his litigation opponent.