By: Michael H. Masri and Katarina Thallner
This article, written by litigators, is intended to inform drafters of the need for clearly delineated rights to indemnification, on one hand, and fee advancement on the other.
In the limited liability company (LLC) context, indemnification is an LLC’s contractual obligation to reimburse defense expenses. Fee advancement is an LLC’s contractual obligation to pay incurred litigation expenses, before the right to indemnification is established.
LLC members do not always understand their fiduciary and/or contractual obligations and generally assume the LLC will indemnify and defend them in connection with any legal dispute. But what happens when this is a dispute between members? Is a defendant member still entitled to indemnification or fee advancement while being accused of fraud or other misconduct?
This article addresses such questions and surveys New York’s interpretation of Limited Liability Company Law §420 (NY LLCL §420) and identifies considerations for both indemnification and fee advancement.
NY LLCL §420 states:
…a limited liability company may, and shall have the power to, indemnify and hold harmless, and advance expenses to, any member, manager or other person, or any testator or intestate of such member…from and against any and all claims and demands whatsoever; provided, however, that no indemnification may be made to or on behalf of any member…if a judgment or other final adjudication adverse to such member… establishes (a) that his or her 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 (b) that he or she personally gained in fact a financial profit or other advantage to which he or she was not legally entitled.
Accordingly, NY LLCL §420 provides: (i) LLCs are permitted but not required to indemnify, hold harmless, and advance legal fees to members, defending a legal claim or demand, and (ii) any indemnification or advancement of legal fees protection is void if a court finds that the member acted in bad faith, acted with deliberate dishonesty or gained an unfair financial advantage.
Drafting Guidelines Based on Case Law
A draftsperson may clarify indemnification and fee advancement provisions by:
- Specifically addressing the advancement of attorneys’ fees to avoid uncertainty.
- Clearly distinguishing between indemnification and fee advancement provisions in the operating agreement.
- Defining when both indemnification and fee advancement are appropriate and include, by way of example, demands, letters, pre-litigation demands, and actual actions, suits, arbitrations, mediations or proceedings.
- Addressing capital call obligations.
Where Courts Allowed for Member Indemnification or Advancement of Fees
In Crossroads ABL v. Canaras Capital Management, 105 A.D.3d 645, 646 (1st Dep’t. 2013), involving a dispute between LLC members, the First Department affirmed plaintiff LLC member was entitled to advancement of fees because the operating agreement (i) distinguished between indemnification and fee advancement clauses, (ii) used broad and highly inclusive language and (iii) listed examples of proceedings for which indemnification and fee advancement would be required.
In Fuiaxis v. 111 Huron St., 58 A.D.3d 798, 799 (2d. Dep’t. 2009), involving an LLC member suing three other members, the Second Department affirmed defendants’ rights to advanced fees in a dissolution suit. The plaintiff sought a preliminary injunction against defendants’ $10,000 demand for litigation costs. The trial court denied the motion citing NY LLCL §420, but the appellate court affirmed on different grounds—stating it was not clear whether NY LLCL §420 applied but the demand was authorized based on the capital call provision in the operating agreement.
Similarly, in Van Der Lande v. Stout, 13 A.D.3d 261, 261-262 (1st Dep’t. 2004), concerning an LLC member dispute, the First Department ruled NY LLCL §420 allowed for the LLC to advance fees to members where there had been no ‘final adjudication’ that the individual defendants acted in bad faith, were dishonest or personally gained profit to which they were not entitled.
The court further required the plaintiff tender capital contributions, because it was approved by a vote of the member defendants, who represented a quorum.
Where Court Did Not Allow for Advancement of Fees
In Mangovski v. DiMarco, 175 A.D.3d 947, 949 (4th Dep’t 2019), involving an LLC member suing another member for breach of contract and breach of fiduciary duty, the Fourth Department ruled the LLC was not required to advance defense costs because the operating agreement only provided for indemnification after adjudication absolving the defendant member of any breach and did not include an advancement permission fee.
Where Court Did Not Award Attorneys’ Fees in Indemnification Litigation
In 546-552 W. 146th St. v. Arfa, 99 A.D.3d 117, 122 (1st Dep’t. 2012), concerning an LLC suing its members and managers, the First Department held that defendants were not entitled to recover attorneys’ fees incurred in indemnification litigation under the LLC operating agreement because the indemnification provision did not specifically provide for an award of “fees on fees.”
The court explained that although the agreement included the broad “any and all” and “to the maximum extent permitted by the Act” language, the provision was limited in that it authorized indemnification only with respect to “claims and demands” and did not specifically authorize expenses or legal fees incurred in obtaining indemnification. Therefore, it was not “unmistakably clear” that fees on fees were contemplated.
Recent Case Law
While the line of appellate cases on this issue is sparse, there is a recent New York case where a member claims legal fees from the LLC under NY LLCL §420 and the operating agreement language.
In Darwish Auto Group & Darwish General v. TD Bank, N.A. & Walid Darwish (2022 WL 21769004), the plaintiff dealership managers sought to enjoin defendant sole member of dealership LLC from transferring LLC funds to pay his legal fees incurred in litigation between the parties. The defendant argues that there has been no final adjudication that establishes defendant acted with bad faith, deliberate dishonesty, or that he personally gained a profit, and therefore the defendant should be able to use his company’s funds to protect himself.
The court has yet to reach a decision on this issue.
Final Thoughts
When drafting an indemnification provision for LLC member clients in New York, consult the key points and case law cited in this article. A careful drafter will anticipate potential legal disputes among members and adopt a comprehensive approach when drafting to encompass a broad range of scenarios. Carefully crafted indemnification and fee advancement provisions serve as a proactive measure, preventing future litigation among members. Lastly, always prioritize compliance with current laws and regulations during the drafting process.
Reprinted with permission from the New York Law Journal, An ALM Publication