Under the so-called "American Rule," litigants must pay their own lawyer fees, even if they win, unless a contract, statute, or court rule provides otherwise. But in business divorce and other private company disputes against or between closely held business co-owners, there are a variety of ways for individual defendants to cause the business entity to assume payment of their legal fees in defense of a lawsuit. How?
The answer depends on several factors: (1) what kind of entity; (2) what kind of claim; (3) in what capacity is one being sued; and (4) if there is a contract, what does it say. In this article, we take a close look at the rules of law governing advancement and indemnification of legal fees in business divorce litigation, including some recent case law developments from the New York State Court of Appeals.
Advancement Versus Indemnification
First and foremost, what is "advancement" and "indemnification" in business divorce litigation? "Indemnification and advancement of legal fees are two distinct corporate obligations."1
"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."2
"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."3
Generally, "whether an officer is entitled to advancement is determined in a summary proceeding" under Article 4 of the CPLR, "while the right to indemnification is delayed until the conclusion of the matter."4
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 a matter of policy, 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."5
Limited Liability Companies
In business divorce litigation, whether one is entitled to advancement or indemnification (whether discretionary or mandatory) depends above all upon the kind of entity involved.
For LLCs, as with most things, the right to advancement and indemnification is generally governed by the operating agreement. "To determine whether advancement is appropriate" for an LLC manager or member, "it is necessary to review relevant portions of the Company's Operating Agreement."6
Section 420 of the Limited Liability Company Law (the "LLC Law") provides that "[s]ubject 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 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."7
If no provision in the operating agreement addresses the subject of advancement or indemnity, courts may decline to enjoin advancement where not prohibited by the operating agreement, as seen in Van Der Lande v. Stout. 8
In the order appealed from in Van Der Lande, the plaintiff sought a "permanent injunction restraining the defendants," his co-members, "from using company money to defend" his lawsuit for waste, fraud, and mismanagement.9 The motion court ruled that "absent a contrary provision in the operating agreement, an LLC has the power to indemnify any member," and "[s]ince the defendants themselves constitute a majority of the shareholders, it is clear that plaintiff is not entitled to enjoin them from obtaining an advance on legal expenses."10
On appeal, the First Department affirmed, ruling that absent an express prohibition in the operating agreement, "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."11
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Footnotes
1. Crossroads ABL LLC v. Canaras Capital Mgt., LLC, 105 A.D.3d 645, 646 (1st Dep't 2013).
2. In re Adelphia Comms. Corp., 323 B.R. 345, 375 (Bankr. S.D.N.Y. 2005).
3. Ryu v. Hope Bancorp, Inc., 2018 WL 1989591, at *3 (S.D.N.Y. Apr. 26, 2018) (internal quotations omitted).
4. Ficus Investments, Inc. v. Private Capital Mgt., LLC, 61 A.D.3d 1, 9 (1st Dep't 2009).
5. Id. (quotations omitted).
6. Id. at 7.
7. Comer v. Krolick, 2015 N.Y. Slip Op. 32274(U), *11 (Sup. Ct. N.Y. Cnty. 2015).
8. Van Der Lande v. Stout, 13 A.D.3d 261 (1st Dep't 2004).
9. Van Der Lande v. Stout, Index No. 123895/2001, 2003 WL 25519857, at *2 (Sup. Ct. N.Y. Cnty. Apr. 1, 2003).
10. Id.
11. Van Der Lande v. Stout, 13 A.D.3d at 262-63.
Originally Published by New York State Bar Association's NYLitigator
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.