Imagine setting off on an exciting venture with a new business partner. You have a great business plan and have formed a new Delaware limited liability company. Your lawyer circulates the draft limited liability company agreement that will govern your relationship with your partner and the operation of the business. You flip immediately to the relevant sections. You are named as a “manager,” you are entitled to the agreed percentage of the profits that are soon to be rolling in and your name is correctly spelled on the schedule of members. Everything looks great. You sign on the dotted line and get to work.
Fast forward a few years. Things have not worked out so well. Your business partner has dumped you and you are being sued for mismanagement by the company you helped build. You feel that ultimately you will prevail against these claims, but how will you afford to defend yourself? Are you entitled to any advancement or reimbursement from the company for your legal fees?
Look no further than the limited liability company agreement for the answer to these questions. Somewhere in the agreement between the part enumerating the powers of the managers and the seemingly never-ending tax sections, there should be a provision on “indemnification.” If you did not pay close attention to this section when you negotiated the limited liability company agreement, you may find yourself out of luck and out-of-pocket.
The Delaware Limited Liability Company Act (the Delaware LLC Act) gives parties wide latitude to set their own terms for the indemnification of managers, members, employees and other parties, and the advancement of litigation expenses. Delaware courts have made clear that they will honor the parties’ agreement on these issues and will give effect to the plain meaning of the relevant provisions in limited liability company agreements. This point was reiterated by the Delaware Court of Chancery in August in a transcript ruling granting a motion for summary judgment requiring advancement of expenses in John E. Harrison v. Quivus Systems, LLC (Harrison v. Quivus).1
Harrison v. Quivus involved a claim for advancement of expenses arising from a lawsuit brought by Quivus Systems, LLC (Quivus) against its former CEO, John Harrison (Harrison), alleging mismanagement, incompetence and corporate malfeasance. Harrison demanded that Quivus advance funds to pay for certain expenses that he incurred and would continue to incur in defending the actions against him and pursuing counterclaims that he had brought against Quivus.2
Quivus was a joint venture between Harrison’s company, Quivus Holdings, and Soroof International, a corporation organized under the laws of the Kingdom of Saudi Arabia and owned by His Highness Prince Bander Bin Adbulla Bin Mohammed Al-Saud. Soroof International owned 55 percent of Quivus and Harrison’s Quivus Holdings owned the remaining 45 percent. Harrison served as CEO of Quivus from 2007 until 2014 when he was removed as CEO by Soroof International after the business relationship between Harrison and Soroof International deteriorated.
In the ruling, the Delaware Court of Chancery (the Court) notes that “[c]laims for advancement of attorneys’ fees are particularly well-suited for resolution by way of a motion for summary judgment because the relevant question turns on the application of the terms of the corporate instruments setting forth the purported right to advancement and the pleadings in the proceedings for which advancement is sought.”3 The Court highlights a distinction between advancement claims involving limited liability companies and those involving corporations. As the Court pointed out, indemnification and advancement of expenses provisions of corporate charters and bylaws tend to track Section 145 of the Delaware General Corporation Law (DGCL) and often condition the right to advancement on whether a corporate officer is being sued by reason of the fact that he took action in his official corporate capacity.
The Delaware LLC Act is more permissive than the DGCL with respect to indemnification and advancement. Section 108 of the Delaware LLC Act provides that subject to the standards and restrictions, if any, 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.” As noted in Harrison v. Quivus, “Delaware courts have made clear that Section 108 defers completely to the contracting parties to create and to limit rights and obligations with respect to indemnification and advancement.”4
The indemnification and advancement provision in the Quivus limited liability company agreement provided that, subject to any limitations in the Delaware LLC Act, Quivus was required to “indemnify and advance expenses to each present and future Member or Manager of the Company (and, in either case, his heirs, estate, personal representatives or administrators) to the full extent allowed by the laws of the State of Delaware, both as now in effect and as hereafter adopted.”5
Soroof International tried to argue that, under the provision, only “present and future managers” were eligible for indemnification and advancement of expenses and given that Harrison was now a former manager, Harrison was not entitled to advancement for actions taken when he was a manager. The Court likens Soroof International’s complicated interpretation of “present” and “future” and the introduction of the word “former” to a scene from the Mel Brooks movie Spaceballs, where a character uses new technology to watch the entire film while it is still being made, only to become disoriented when he sees himself at that very moment watching the film. As the Court humorously recounted, his comrade tells him, “‘You’re looking at now, sir. Everything that happens now is happening now,’ and explains that they passed then just now, they’re at ‘now’ now, and they can’t go back to then because they missed it, but then will be now soon.”6
Similarly, according to Soroof International, “Harrison was a present manager in the past, not the present. Instead, in the present, where everything that happens now is happening now, Harrison is a former manager, or at least became one just now, but we can’t go back to then -- when Harrison was a present manager -- because we missed it.”7
The Court offers a different interpretation of the agreement that it describes as reasonable, unambiguous, and uncontroversial. According to the Court, when “the parties adopted the LLC agreement, Quivus became bound to provide each then-present member or manager of the company with mandatory indemnification and advancement. Quivus also became bound to provide mandatory indemnification and advancement to anyone who became a member or manager of the company sometime thereafter -- that is, in the future.”8
The Court recognized the public policy for advancement and indemnification rights, which is “to encourage capable men and women to serve as corporate directors, secure in the knowledge that expenses incurred by them in upholding their honesty and integrity as directors will be borne by the corporation they serve.”9 The Court noted, however, that the Delaware LLC Act is “less paternalistic” than the DGCL and requires parties to expressly contract for indemnification and advancement. According to the court, where the parties have exercised their contractual freedom to provide for expansive and mandatory indemnification, such as in the Quivus limited liability company agreement, the plain terms of the agreement will be enforced as written.
One of the most noteworthy facts of this case, as highlighted by the Court, was that the Quivus limited liability company agreement went through several rounds of comprehensive revisions during a period of approximately five weeks of negotiation, but the indemnification provision did not change at all from the first draft of the agreement circulated by Harrison’s counsel to the final version executed by the parties. Delaware courts have reiterated in many different contexts that limited liability companies are creatures of contract. This provides parties with tremendous flexibility, but imposes on the parties and their counsel responsibility for exploring and evaluating their options with respect to each provision of the limited liability company agreement. By glossing over provisions on indemnification and advancement, parties may miss out on an opportunity to tailor these provisions to their specific needs.
Some of the issues that the parties may consider addressing in indemnification and advancement provisions of their Delaware limited liability company agreements are the type of expenses covered, the procedures for requesting advancement of expenses, the timing for payment of expenses, and insurance coverage to ensure funds are available for indemnification and advancement. The parties may also consider specifying the conditions and procedures for return of amounts advanced if it is ultimately determined that the claimant is not entitled to. Further, the parties also may wish to specify how future changes in law or amendments to the agreement will affect indemnification and advancement rights set forth in the limited liability company agreement.
This GT Alert was co-authored by Jennifer Brady who is a freelance writer and attorney admitted in the State of New York.