In New York, courts strictly construe indemnification clauses. This means that:
- Courts do not allow advancement of fees, such as legal fees and litigation expenses, unless it is explicitly required by the limited liability company’s operating agreement; and
- Indemnification is invalid where a member or manager has breached a fiduciary duty, i.e., acted not in the best interests of the company.
Under New York Limited Liability Company Law § 420, LLCs are permitted to indemnify, hold harmless, and advance expenses (including legal fees incurred in litigation) to members, managers, or other persons in connection with legal claims, except where such person acted in bad faith, engaged in deliberate dishonesty, or derived an improper personal financial benefit.
What is indemnification?
Indemnification is an undertaking to pay after the resolution of a case. It is typically framed as: “The Company shall indemnify, defend, and hold harmless… from and against all claims, losses, liabilities… arising out of or in connection with the Company’s activities and business…”
What is the advancement of fees?
Advancement of fees is an undertaking to pay expenses during the pendency of a case. It is typically expressed as: “The Company shall advance reasonable legal fees and expenses in connection with any legal proceeding involving a member, manager, or other affiliated person…”
Additionally, indemnification provisions commonly include limitations, excluding coverage for acts constituting willful misconduct, gross negligence, or similar conduct.
Moreover, courts may require repayment of advanced fees if it is ultimately determined that the individual was not entitled to indemnification, for example, where the operating agreement is silent as to advancement of litigation expenses or where the individual acted contrary to the best interests of the company.
Notably, New York courts are more likely to award litigation expenses where: (i) the operating agreement expressly authorizes such advancement; (ii) the language of the indemnification provision is clear, broad, and inclusive; and (iii) the agreement distinctly differentiates between indemnification and advancement of fees.
Conclusively, a well-drafted indemnification and advancement clause can protect founders’ personal assets, facilitate the recruitment of qualified managers and officers, and allocate the burden of potentially significant legal expenses incurred in defending claims arising from the company’s activities.