For the business owner without access to the company checkbook, and who therefore must foot his own legal bills, about the only thing worse than litigating a business divorce with a co-owner is seeing her use company funds to pay her lawyer.

Case precedent makes it pretty clear that, in a straightforward dissolution proceeding in which the company is a nominal party rather than an active litigant, neither side has the right to tap company funds for legal fees.  But often the dissolution claim by the non-controlling owner is tied to other claims seeking to impose personal liability against officers or managers of the company.  When that happens, the defending officer-owners may invoke a contractual right to indemnity including advancement of legal expenses by the company.  Alternatively, where the defending officer-owners have board control, they may authorize indemnity and advancement under indemnification statutes.

The latter occurred in Van Der Lande v. Stout, 3 AD3d 261 (1st Dept 2004), where a minority member of an LLC brought  a derivative action accusing the majority members of waste, fraud and mismanagement, alongside a separate proceeding to dissolve the LLC.   Over the plaintiff’s objection the defendant majority members made a substantial capital call upon all members — including the plaintiff — to fund the advancement of legal fees in defense of the derivative action.  The plaintiff moved for a preliminary injunction to prevent the LLC from compelling him to make contributions.  The trial court denied the motion.  The appeals court upheld the order under the authority of Section 420 of the New York Limited Liability Company Law, which allows the LLC to advance and pay its members’ legal expenses absent a final adjudication that the individual defendants acted in bad faith, were dishonest or personally gained profit to which they were not entitled.  “That plaintiff commenced the lawsuit which caused the need for the additional contribution”, the court added, “does not constitute an exception to his obligations to the LLC.”

An interesting indemnification fight of the contractual variety took center stage in a recently decided case called R&R Capital LLC v. Merritt, 2008 NY Slip Op 30087(U).  The court’s January 4, 2008 decision, written by Justice Charles E. Ramos of the New York County Supreme Court’s Commercial Division, describes the case as arising out of a failed business relationship between plaintiff R&R Capital LLC and defendant Linda Merritt who as 50-50 members formed nine Delaware LLCs for the purpose of investing in horse farms and other real property located in Pennsylvania.  R&R’s 38-page complaint filed in November 2005 sought Merritt’s ouster as sole manager of the LLCs and an award of damages based on allegations of fraud and mismanagement.  Early in the proceedings the court ordered that Merritt give R&R 48 hours notice before selling, transferring or encumbering any assets of the LLCs.

In 2007, after R&R objected, Merritt applied to the court for permission to sell some of the properties to satisfy about $2.8 million in company liabilities including $1 million borrowed by Merritt in her own name for the benefit of the LLCs and another $1 million bank loan guaranteed by Merritt.  Also included in that sum was over $200,000 for Merritt’s legal fees incurred in the litigation against R&R.

Justice Ramos turned to the parties’ operating agreement which included a provision requiring the company to indemnify any member

from and against any and all losses, claims, damages, liabilities, expenses . . . judgments, fines, settlements, and other amounts . . . arising from any and all claims . . . in which such indemnified party may be involved . . . by reason of such indemnified party’s service to . . . or management of the affairs of the Company, its properties, business or affairs . . . provided that such Indemnification Obligation resulted from a mistake of judgment, or from action or inaction . . . that did not constitute gross negligence, wilful misconduct or bad faith.

Based on this provision Justice Ramos held that Merritt was entitled to indemnification.  “There was no evidence”, the court wrote, “that suggests the Indemnification Obligation arose [from action or inaction constituting gross negligence, wilful misconduct or bad faith].”

There’s a fascinating footnote to this case.  Following the adverse indemnification decision, R&R filed a motion asking Justice Ramos to recuse himself based on an allegation that an attorney engaged by the parties as a neutral mediator “confessed” that he engaged in improper communications with the court regarding the case.  According to affidavits submitted by some of the owners of R&R, the mediator told them in a “moment of remorse” that he had been asked by Merritt’s attorney to attempt to, and actually did, “fix” the case against R&R.  The mediator submitted a sworn statement denying he ever made such a statement.  Justice Ramos in his May 7, 2008 decision denying the recusal motion (2008 NY Slip Op 31352(U)) also stated that the communication never occurred.   His order referred the matter to the District Attorney “with this Court’s strongest possible recommendation that immediate investigations be conducted into the circumstances surrounding these remarkable allegations”.

Update 11/25/08:  Justice Ramos’s decision denying the recusal motion was affirmed on appeal.

Update 10/10/09:  R&R subsequently filed a lawsuit in Delaware Chancery Court seeking to validate its removal of Merritt as manager of the several LLCs under the for-cause removal provisions in the operating agreements.  In a ruling dated September 3, 2009, Chancellor Chandler granted summary judgment in favor of R&R.

Update 4/11/10:  Read here the latest chapter in what Justice Ramos describes in his most recent decision in the case as the parties’ “tortured and tangled dispute” in its fifth year, encompassing lawsuits in five jurisdictions in three states.