Under the so-called “American Rule,” litigants usually must pay their own lawyer fees. But in business divorce and other private company disputes between business co-owners, there are a variety of ways for individual defendants to have the business assume payment of their legal fees in defense of a lawsuit. How? The answer depends on several factors – what kind of entity; what kind of claim; in what capacity is one being sued. In this article, we take a close look at the basics of New York’s law of indemnification and advancement.
Advancement Versus Indemnification
“Indemnification and advancement of legal fees are two distinct corporate obligations” (Crossroads ABL LLC v Canaras Capital Mgt., LLC, 105 AD3d 645 [1st Dept 2013]).
“Advancement is a species of loan—essentially simply a decision to advance credit—to a [corporate official] pending later determination of that person’s right to receive and retain indemnification. The corporation maintains the right to be repaid all sums advanced, if the individual is ultimately shown not to be entitled to indemnification” (In re Adelphia Comms. Corp., 323 BR 345 [Bankr SD NY 2005]).
“Indemnification is the right to be reimbursed for all out of pocket expenses and losses caused by an underlying claim, and generally cannot be resolved until after the merits of the underlying controversy are decided” (Ryu v Hope Bancorp, Inc., 18-cv-1236-JSR, Opinion and Order [SD NY Apr. 26, 2018]).
Generally, “whether an officer is entitled to advancement is determined in a summary proceeding, while the right to indemnification is delayed until the conclusion of the matter” (Ficus Investments, Inc. v Private Capital Mgt., LLC, 61 AD3d 1 [1st Dept 2009]).
Mandatory Versus Discretionary
Under New York law, advancement and indemnification can be either mandatory or discretionary. Mandatory means the entity’s organizational documents, a resolution, or a contract explicitly entitle a person to advancement or indemnification. Discretionary (i.e., court-ordered) means there is no document expressly creating a right of advancement or indemnification, but the court has the power to order it nonetheless.
As the court held in Ficus, advancement rights are generally construed broadly “to help attract capable individuals into corporate service by easing the burden of litigation-related expenses” and to provide “immediate interim relief from the personal out-of-pocket financial burden of paying the significant on-going expenses inevitably involved with investigations and legal proceedings.”
Limited Liability Companies
In business divorce litigation, whether one is entitled to advancement or indemnification (be it discretionary or mandatory) depends first and foremost on the kind of entity involved. For LLCs, as with most things, the right to advancement and indemnification is generally governed by the operating agreement. As the court held in Ficus, “[t]o determine whether advancement is appropriate” for an LLC manager or member, “it is necessary to review relevant portions of the Company’s Operating Agreement.”
Section 420 of the Limited Liability Company Law (the “LLC Law”) provides: “Subject to the standards and restrictions, if any, set forth in the operating agreement,” an LLC “may, and shall have the power to, indemnify and hold harmless, and advance expenses to, any member, manager or other person . . . from and against any and all claims and demands whatsoever.”
But LLC Law 420 prohibits any indemnification if there is a “judgment” or “final adjudication” against the party seeking indemnification of i) “bad faith,” ii) “active and deliberate dishonesty,” or iii) receipt of a “financial profit or other advantage to which [the manager or member] was not legally entitled.”
If an operating agreement contains the word “shall” in the context of advancement or indemnification, the right generally should be considered “mandatory” (Comer v Krolick, 2015 NY Slip Op 32274(U) [Sup Ct NY County Dec. 2, 2015]).
Even in the absence of a provision in the operating agreement, courts may decline to enjoin advancement where not prohibited by the operating agreement, as seen in Van Der Lande v Stout, 13 AD3d 261 [1st Dept 2004], wherein the court held that “Limited Liability Company Law § 420 allows the LLC to advance and pay its members’ legal expenses where . . . there has been no judgment or ‘final adjudication’ that the individual defendants acted in bad faith, were dishonest or personally gained profit to which they were not entitled.”
Corporations
Corporations have the most complex advancement and indemnification statutes.
Section 721 of the Business Corporation Law (the “BCL”) establishes the ways in which a corporation may grant mandatory advancement and indemnification. There are several ways: i) the certificate of incorporation, ii) by-laws, iii) shareholder resolution, iv) board resolution, or v) “an agreement providing for such indemnification” of advancement, like a shareholders’ or employment agreement.
BCL 722 establishes the applicable legal standard for indemnification:
A corporation may indemnify any person made . . . . a party to an action . . . whether civil or criminal . . . by reason of the fact that he . . . was a director or officer of the corporation . . . against judgments, fines, amounts paid in settlement and reasonable expenses, including attorneys’ fees actually and necessarily incurred as a result of such action . . . if such director or officer acted, in good faith, for a purpose which he reasonably believed to be in, or . . . not opposed to, the best interests of the corporation . . .
BCL 723 establishes the procedures by which a board or the shareholders may adopt a resolution authorizing indemnification or advancement.
BCL 724 (a) authorizes discretionary indemnification by court order even if the corporation does not provide a right of mandatory indemnification, providing, “Notwithstanding the failure of a corporation to provide indemnification . . . indemnification shall be awarded by a court to the extent authorized under section 722.”
BCL 724 (c) authorizes court-ordered advancement of legal expenses incurred by corporate directors and officers. BCL 724 (c) provides:
Where indemnification is sought by judicial action, the court may allow a person such reasonable expenses, including attorneys’ fees, during the pendency of the litigation as are necessary in connection with his defense therein, if the court shall find that the defendant has by his pleadings or during the course of the litigation raised genuine issues of fact or law.
How do these statutes work in practice? Under BCL 724 and 722, a defendant needs to satisfy four elements to be entitled to advancement and/or indemnification:
- First, that s/he was sued in an action “by reason of the fact that he . . . was a director or officer of the corporation.”
- Second, that s/he seeks indemnification for “judgments, fines, amounts paid in settlement and reasonable expenses, including attorneys’ fees actually and necessarily incurred as a result of such action.”
- Third, to be entitled to advancement, he must show, at the commencement of the case, that “by his pleadings or during the course of the litigation,” he has “raised genuine issues of fact or law.”
- Fourth, to be entitled to indemnification, s/he must show, at the conclusion of the case, that he “acted, in good faith, for a purpose which he reasonably believed to be in, or . . . not opposed to, the best interests of the corporation.”
New York courts often apply a liberal standard adopted by Delaware courts for determining whether a director or officer has been sued “by reason of the fact” s/he was a director or officer. In Schlossberg v Schwartz, 43 Misc 3d 1224(A) [Sup Ct Nassau County 2014], Justice DeStefano explained:
The Delaware case law . . . indicates that a broad interpretation of that phrase, which would include a wide array of claims that might be asserted against a director or officer, is warranted. Courts have shown some latitude in interpreting this language such that if there is a nexus or causal connection between any of the underlying proceedings and one’s official corporate capacity, those proceedings are ‘by reason of the fact’ that one was an officer or director.
The standard for raising an “issue of fact” for advancement is also quite liberal. As former Justice Demarest held, “Where there are issues of fact in a dispute over whether a director participated in alleged wrongful conduct and acted in good faith on behalf of the corporation, courts have generally permitted the relief of advanced litigation expenses, including attorney’s fees, subject to reallocation at the end of the action” (Gen. Plumbing Corp. v Parklot Holding Co., 44 Misc 3d 1218(A) [Sup Ct Kings County 2014]).
The last statute, BCL 725, requires repayment of advanced legal fees if the court determines the officer or directed was not entitled to indemnification under the standard in BCL 722. We’ll address this subject in more detail in our next advancement post in connection with the “undertaking” requirement.
Partnerships
The Partnership Law addresses the subject of advancement and indemnification for limited partnership derivative lawsuits.
Partnership Law 115-c, applicable to limited partnership formed before July 1, 1991, provides that a limited partnership “may indemnify any general partner” sued “by reason of the fact that he . . . was a general partner” in a derivative suit against the general partner unless “such general partner is adjudged to have breached his duty to the limited partnership.”
Partnership Law 121-1004, applicable to limited partnerships formed after July 1, 1991, provides that a limited partnership “may indemnify, and may advance expenses to, any general partner” in a derivative suit unless “a judgment or other final adjudication adverse to the general partner establishes that his acts were committed in bad faith or were the result of active and deliberate dishonesty and were material to the cause of action so adjudicated, or that he personally gained in fact a financial profit or other advantage to which he was not legally entitled.” If this language looks familar, it is because portions of LLC Law 420 were taken from it almost verbatim.
In Barrett v Toroyan, 35 AD3d 278 [1st Dept 2006], the court, relying upon Delaware law, broadly construed the right to advancement, holding that a general partner had the “absolute right to obtain legal and other expert counsel at the expense of the partnership, even in litigation commenced by a limited partner.”
Dissolution Claims
As seen above, the vast majority of cases in which advancement or indemnification is awarded involve derivative claims. What about dissolution claims? As one court held, “there is no authority for allowing counsel fees incurred in defending a dissolution proceeding . . . to be paid out of corporate funds” (Matter of Boucher v Carriage House Realty Corp., 105 AD3d 951 [2d Dept 2013]).
But even with dissolution claims, there are at least two potential ways to obtain advancement / indemnification.
First, under the right set of facts, “in cases involving derivative claims or in hybrid cases . . . involving both dissolution and derivative claims, courts have denied motions to enjoin the advancement of legal fees” (Romita v Castle Oil Corp., Decision and Order, Index No. 053145/2011 [Sup Ct Westchester County Dec. 5, 2012]).
Second, there is authority for the proposition that, in a dissolution case under BCL 1104-a with a buyout election under BCL 1118, “use of corporate funds to pay attorney’s fees after said election shall be deemed valid, however, any corporate funds used to pay attorney’s fees after the commencement of the dissolution but prior to the BCL § 1118 election shall be deemed improper” (Hammad v Al-Lid Food Corp., Decision and Order, Index No. 5184062017 [Sup Ct Kings County 2018]).
Conclusion
Advancement and indemnification rights are powerful tools for those who manage and own closely-held businesses. But the rules are complicated, and their application can be uncertain in a particular case. In my next post, we’ll look at some of the more difficult concepts, including intra- versus inter-party disputes, the concept of advancement and fee-shifting rights being “unmistakably clear,” “fees on fees,” and the requirement of posting an “undertaking.”
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