Limited liability companies (LLCs) are famously referred to as “creatures of contract”, whereas the governance of a corporation is comparatively fixed by statute. When forming an LLC, the members have broad discretion to determine the substance and scope of fundamental features including management, tax and indemnification matters. Parties are largely free to draft an LLC’s operating agreement as they desire, and Delaware law will “give maximum effect to the principle of freedom of contract and to the enforceability of limited liability company agreements.”[1]
But the corollary to a near-unfettered freedom to contract outside the confines of statutory requirements is an increased opportunity for an operating agreement to fail to reflect the intent of the parties. Mimicking language and structure that carries particular significance in other contexts such as copying provisions from a corporation law statute risks unintentionally importing rules and concepts into the operating agreement that may not align with the bargain the parties contracted for.
Precision and purpose matter in drafting. And a recent decision by the Delaware Court of Chancery is a reminder that non-deliberate, imprecise use of what seems like boilerplate or precedential language can lead to unforeseen outcomes. As the court bluntly noted, “[t]he choices that the drafters make have consequences.”[2]
In Freeman Family LLC v. Park Ave. Landing LLC, the Court of Chancery considered a dispute over whether Freeman Family LLC (Freeman Family), a member of Park Ave. Landing LLC (the Company,) was entitled to indemnification and advancement under the Company’s operating agreement. The operating agreement included call rights that enabled the managing member, non-party Hugo Neu Corporation (Hugo Neu), to buy back Freeman Family’s membership interest in two circumstances. When Hugo Neu exercised its call rights, Freeman Family argued the rights had been waived. Hugo Neu filed a complaint seeking to enforce the call rights and, in response, Freeman Family brought a separate action to obtain advancement of its legal fees under the Company’s operating agreement.
The case turned on the interpretation of the operating agreement, which provided, in relevant part:
“The Company shall indemnify any person (each, an ‘Indemnitee’) who was or is a party or is threatened to be made a party to any threatened, pending or completed action, suit or proceeding brought by or against the Company, or otherwise . . . including, without limitation, any action by or in the right of the Company to procure a judgment in its favor, by reason of the fact that such Indemnitee is or was a Managing Member, Member or an officer of the Company.
. . . .
The Company shall pay expenses incurred by any Indemnitee in defending any action, suit or proceeding described in Section 14(a) in advance of the final disposition of such action, suit or proceeding upon receipt of an undertaking by or on behalf of such Indemnitee to repay such advance if it shall ultimately be determined that such Indemnitee is not entitled to be indemnified by the Company pursuant to this Section 14.”
The Company took the position that, notwithstanding its status as an LLC, those provisions in the operating agreement should be interpreted in light of Delaware’s well-developed body of corporate case law addressing indemnification and advancement. The court agreed.
In its analysis, the court noted that provisions of the Company’s operating agreement carefully mirrored the language in Sections 145(a) and 145(b) of the Delaware General Corporation Law (DGCL). It regarded that choice of language to be significant, observing that the “contractual freedom that the LLC Act creates allows drafters of an LLC agreement or operating agreement to adopt concepts from the laws of other entities.”[3] Accordingly, the court reasoned that the choice to “use language that is nearly identical to the corporate statute” reflected an intent “to import a predictable and well-defined rule from corporate statutory and case law.”[4] But even the application of a predictable and well-defined rule to the situation did not immediately resolve the issue.
The Company took the position that the call rights related to a personal obligation and therefore failed to satisfy the requirement under Delaware’s statutory indemnification provisions that such action be brought against the indemnitee “by reason of the fact” that such person was serving in certain capacities. The DGCL’s provisions contemplated an officer or director acting on behalf of the corporation. And although it acknowledged that the application of the corporate standard to Freeman Family in its capacity as a non-managing member “was not as simple as when the party in question is a CEO or director with defined duties[,]”[5] the court ultimately concluded that indemnification and advancement for Freeman Family was warranted.
Freeman Family offers important lessons for those forming and utilizing LLCs. Private equity firms should take particular note of this case as they often appoint members of their firms or affiliated entities as officers and directors of their portfolio companies. Further, there have been increasing instances of private equity sponsors being named as defendants in litigation involving their portfolio companies, particularly when they are actively involved in driving strategic decisions and policy for such portfolio companies.
Freeman Family warns that using language from the DGCL in an LLC operating agreement may subject the LLC to rules deriving from corporate case law. In the context of indemnification, this means that the indemnification available to members and managers of the LLC may be significantly narrower than the Delaware Limited Liability Company Act’s (DLLCA) broad permission to indemnify any person “from and against any and all claims and demands whatsoever.”[6] But indemnification is just one example of where importing language from other contexts could override the parties’ intent. For example, the scope of fiduciary duties or standards for approval and review of actions by managers and members of an LLC may, if desired, deviate in some respects from the well accepted norms and rules established by corporate statutory and case law.
More generally, the case illustrates that the freedom to contract comes with an obligation to be precise and intentional. As noted in earlier blog posts, boilerplate is not always boilerplate and using precedents without considering their application to the particular facts and circumstances can lead to undesirable results. Contracts should always be reviewed carefully in their entirety to make sure that they reflect the actual intent of the parties and are consistent with current market terms and legal requirements.
The entire question of the availability of advancement could have been avoided had the parties taken advantage of the flexibility afforded by the DLLCA and clearly set out the desired scope of indemnification provisions. But, by simply copying language from the DGCL, the intent of the parties was obscured.
[1] 6 Del. C. § 18-1101(b).
[2] Freeman Family LLC v. Park Avenue Landing, LLC, C.A. No. 2018-0683-TMR, 2019 Del. Ch. LEXIS 149 (Del Ch. Apr. 30, 2019) (quoting Obeid v. Hogan, 2016 Del. Ch. LEXIS 86, 2016 WL 3356851, at *6 (Del. Ch. June 10, 2016)).
[3] Id. at *9.
[4] Id. at *11.
[5] Id. at *17.
[6] 6 Del. C. § 18-108.
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