Presiding Justice Jonathan Lippman of the Appellate Division, First Department (pictured), who was recently nominated by Governor Paterson to become New York’s Chief Judge on the Court of Appeals, has written a significant decision addressing rights of advancement and indemnification for litigation expenses in the limited liability company setting.   Ficus Investments, Inc. v. Private Capital Management, LLC, 61 AD3d 1, 2009 NY Slip Op 00263 (1st Dept Jan. 20, 2009).

Not only is the substantive issue in the case — affirming the right of an LLC member-manager to require the LLC to advance legal expenses defending an action brought by another LLC member — one of great importance, the decision also reads like a legal travelogue in which a New York court looks to Delaware law to construe an operating agreement of a Florida LLC headquartered in New York.

Private Capital Group (Capital) is a Florida LLC owned 80% by the plaintiff Ficus Investments, Inc. (Ficus) and 20% by defendant Private Capital Management, LLC (Management).  Capital buys, manages and sells non-performing mortgages, and was capitalized by loans from Ficus over $300 million.  Capital began operations in December 2005.  A dispute arose after Management’s two owners, Thomas Donovan and Lawrence Cline, transferred about $10 million from Capital to Management.  Under Capital’s operating agreement, Donovan served as Capital’s CEO and Cline as its President.  In March 2007, Ficus adopted resolutions taking over Capital’s management and it also commenced a lawsuit against Donovan, Cline and Management for breach of fiduciary duty, conversion and unjust enrichment.

The hostilities escalated after suit was filed, with Ficus accusing the defendants of removing books and financial records and misappropriating an additional $12.5 million.  Then Cline and some other defendants settled with Ficus and gave statements supporting Ficus’s ongoing litigation against Donovan and the remaining defendants. Meanwhile, Donovan set up a new business and took with him virtually all of Capital’s employees, which triggered a new round of accusations by Ficus and a series of interim injunctions against the defendants.

In the course of these proceedings, Donovan and two other defendants moved for indemnification and advancement of their legal expenses totaling over $2.7 million related to the litigation under the terms of Capital’s operating agreement.  New York County Commercial Division Justice Bernard J. Fried, in a written decision dated April 24, 2008, granted Donovan’s request but denied it as to the two others, finding that advancement of their expenses was discretionary with Capital since they were not officers under the operating agreement.  An appeal followed.

This being a question of contractual rather than statutory rights to advancement and indemnification, Justice Lippman’s opinion for the appellate court focuses on the terms of Capital’s operating agreement, which provides that it will be construed under and governed by Florida law.  Section 3.4.3 of the Operating Agreement, entitled “Advance for Expenses,” provides that

The Company must, before final disposition of a Proceeding, advance funds to pay for or reimburse the reasonable Expenses incurred by a Person who is a Party to a Proceeding because he or she is a Member, Manager or Officer if such Person delivers to the Company a written affirmation of his or her good faith belief that his or her conduct does not constitute behavior that would result in Liability for (i) intentional misconduct or a knowing violation of law, or (ii) any transaction for which such Member, Manager or Officer received a personal benefit in violation or breach of any provision of this Agreement; and such Member, Manager or Officer furnishes the Company a written undertaking, executed personally or on his or her behalf, to repay any advances if it is ultimately determined that he or she is not entitled to indemnification under this Section 3.4 or the Florida [Limited Liability Company] Act” (subd [a]).

Another provision, Section 3.4.2, entitled “Obligation to Indemnify; Limits,” relieves Capital of the obligation to indemnify a member, manager or officer who “is adjudged liable to the Company or is subjected to injunctive relief in favor of the Company” for intentional misconduct or a knowing violation of law or for any transaction for which the individual received an unauthorized personal benefit.

Ficus argued that since the trial court already issued multiple interim injunctions against Donovan, ultimately he would not be entitled to indemnification under the language of Section 3.4.2, thereby rendering “academic” his entitlement to advancement of expenses. 

The appellate court disagreed, with Justice Lippman writing that

the section referring to injunctive relief pertains solely to indemnification.  It is separate and distinct from section 3.4.3, which imposes the obligation to advance funds.  Advancement is contingent only upon the person’s submission of a written affirmation that he or she has not engaged in prohibited conduct and an undertaking to repay any funds disbursed.

Justice Lippman’s opinion cites no Florida law on the subject of contractual advancement and indemnification.  It’s not unusual for New York courts to look to Delaware case precedent in deciding issues of corporate law, and in this case Justice Lippman does exactly that.  His analysis of Delaware law is worth quoting in full:

Delaware courts have had ample opportunity to address these issues of indemnification for and advancement of expenses and, although not binding as to either Florida or New York law, their holdings can be instructive. Under Delaware law, a clear distinction is drawn between the two provisions: whether an officer is entitled to advancement is determined in a summary proceeding, while the right to indemnification is delayed until the conclusion of the matter (see Kaung v Cole National Corp., 884 A2d 500, 509 [Del 2005]).  The rights are recognized as independent of one another, in that “an advancement proceeding is summary in nature and not appropriate for litigating indemnification or recoupment. The detailed analysis required of such claims is both premature and inconsistent with the purpose of a summary proceeding” (id. at 510). Delaware has also noted that one of the beneficial purposes behind both indemnification and advancement is to help attract capable individuals into corporate service by easing the burden of litigation-related expenses (see Homestore, Inc. v Tafeen, 888 A2d 204, 211 [Del 2005]).  In particular, “[a]dvancement provides corporate officials with 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” (id.).

Capital’s operating agreement, Justice Lippman concludes, “distinguishes between the relief available to a corporate officer at the conclusion of the proceedings and that which is available while the proceedings are ongoing.”  In other words, “advancement does not depend on whether or not the officer will eventually be indemnified.”  So while Donovan may have to return the advances in the end, depending on the outcome of the litigation, in the meantime he enjoys top-notch legal defense effectively at his adversaries’ expense. 

As I’ve written before, the advancement and indemnification of legal expenses can tilt the playing field in litigation between co-owners of closely held companies.  In some circumstances it can put decisive pressure on the non-indemnified side to settle.  Although the players in Ficus seem to possess fat checkbooks, and while I don’t pretend to know the effect of the court’s ruling on the majority owner’s appetite for this litigation — judging from the ever burgeoning size of the court’s docket listings viewable online, I’d have to say the appetite on both sides remains voracious — I still have to think that laying out millions for Donovan’s legal defense, secured only by his non-collateralized written undertaking in the event he’s ultimately compelled to repay the advancements, is a bitter pill to swallow.

Update March 30, 2010:  A Manhattan appeals court today affirmed a follow-up ruling by Justice Fried, denying Donovan recovery of statutory interest on the advances.  Read here.