What Indemnification Means
Every business needs protection that allows its leaders to act with audacity rather than fear. That shield can be the indemnification provision in a partnership agreement. An indemnification is a legal obligation a company undertakes to cover its managers, members, officers, and possibly other people (collectively named “agents”). These individuals act on behalf of the company, make business decisions, and, at times, make mistakes or poor judgments.
Indemnification essentially covers an agent’s personal liability for actions taken on behalf of the entity. It ensures they are not held personally responsible for decisions made in good faith, meaning they honestly tried to pursue the company’s best interests.
Indemnification “covers” means the company may:
- Compensate settlement.
- Compensate the incurred losses
- Pay legal fees for agents’ defense
- Compensate damages if a third party wins a judgment
Double Purpose
An indemnification provision serves a double purpose. By including an indemnification clause in an LLC operating agreement, the company promises to absorb potential financial losses. This gives agents more freedom to take bold actions without fear of personal liability. Furthermore, an indemnification clause in company documents provides certainty to investors and encourages them to commit capital.
To further mitigate the entity’s exposure, the indemnification provision can mandate specific insurance coverage. This measure ensures that the company’s obligation to its agents is backed by an external policy rather than its own capital.
Where the Indemnification Clause Found
The indemnification clauses are typically found in an LLC Operating Agreement or a Shareholders’ Agreement. The clause can grant agents a higher level of protection than the protections provided by applicable statutory law.
For example, LLC statutes in various states usually allow members to agree on indemnification terms in the company’s operating agreement that differ from the statutory defaults, provided the relevant clause is included.
Scope of Protection
The clause protects agents from claims brought by:
- Unsatisfied investors
- Vendors
- Third parties alleging wrongdoing
It can also potentially cover actions brought against members, managers, or officers acting in bad faith. In this case, the company would be a plaintiff, and the member or officer would be a defendant and would not be protected by indemnification.
That is why an issue often arises between founders: who should be included as a “covered agent”? LLC Members must decide if a hired manager should be covered, or only the members themselves. If there are officers, they must determine whether the indemnification applies to all of them (President, Treasurer, etc.) or only to specific roles.
Indemnification In Action
Example. An LLC member signs a contract with a software provider. After a few months, the member terminates the contract because the provider failed to meet specific milestones. The provider disagrees and claims the termination was wrongful. He sues the member personally, alleging negligence. Because the member acted in good faith in the LLC’s best interests, the indemnification provision is triggered. The LLC is now legally obligated to hire and pay for the member’s defense counsel and court-ordered damages, if any.
Ultimately, regardless of the specific limitations, a clear indemnification clause protects the people behind the business from lawsuits and bad surprises.