My last post on the subject of advancement and indemnification summarized the basic rules by which closely-held business owners, officers, directors, managers, and members may be entitled to use company funds to pay their legal fees.
This article considers the flip side of the coin: some common-law and statutory limits on the ability of businesses to advance and indemnify legal fees.
At first blush, advancement and indemnification rights may seem broad in business divorce disputes, but the doctrine of “unmistakably clear” fee-shifting agreements, the distinction between first- and third-party disputes, and the general prohibition on recovery of “fees on fees” all provide significant restrictions on advancement and indemnification rights.
Unmistakably Clear Fee-Shifting Agreements
Two decades ago, New York’s highest court pronounced a legal rule that has become a cornerstone of the law of advancement and indemnification:
Inasmuch as a promise by one party to a contract to indemnify the other for attorney’s fees incurred in litigation between them is contrary to the well-understood rule that parties are responsible for their own attorney’s fees, the court should not infer a party’s intention to waive the benefit of the rule unless the intention to do so is unmistakably clear from the language of the promise” (Hooper Assoc., Ltd. v AGS Computers, Inc., 74 NY2d 487 ).
Under Hooper, for one party to assume the other party’s legal fees, the agreement to do so must be “unmistakably clear.” How does Hooper come into play in disputes between closely-held business owners? Let’s see.
Third-Party Versus First-Party Disputes
In business divorce cases, disputes often arise over whether contractual advancement or indemnification provisions (for example, in an LLC operating agreement) apply exclusively to suits brought by individuals or entities outside the company (third-party disputes), or also apply to disputes within the company (first-party disputes).
A classic example of a first-party dispute would be an LLC derivative suit brought by one member on behalf of the LLC against another member, the latter of whom then seeks advancement of her defense costs under the operating agreement. A well-developed body of case law addresses this issue.
“Hooper’s rule of contract interpretation” requires that an “indemnification clause must be ‘unmistakably clear’ in its intent to apply to suits between contracting parties, as opposed to between third parties and contracting parties” (Maiden Lane Hosp. Group LLC v Beck by David Cos., Opinion and Order, 18-civ-7476-PAE [SDNY June 10, 2019]).
“For an indemnification clause to serve as an attorney’s fees provision with respect to disputes between the parties to the contract, the provision must unequivocally be meant to cover claims between the contracting parties rather than third party claims” (Gotham Partners, L.P. v High River Ltd. Partnership, 76 AD3d 203 [1st Dept 2010]).
Applying this principle, where fee-shifting language in an operating or shareholders’ agreement “is typical of those indemnification agreements which contemplate reimbursement when the indemnitee is required to pay damages on a third-party claim,” but not a first-party claim (Eshaghian v Eshaghian, 170 AD3d 809 [2d Dept 2019]), the “indemnification provision . . . does not make it ‘unmistakably clear’ that the parties intended it to cover attorneys’ fees incurred in litigation between them” (W. Vernon Petroleum Corp. v Singer Holding Corp., 103 AD3d 623 [2d Dept 2013]).
For practitioners, if the intent is to confer advancement and/or indemnification rights for disputes between parties to an operating agreement, one could include language to the effect that the right of advancement shall “includ[e], without limitation, any and all disputes between or among the parties hereto, including any manager and/or member, in any way arising out of or relating to this agreement, the rights or duties of such manager and/or member, and/or to the affairs of the company.”
Fees on Fees
In Baker v Health Mgt. Sys., Inc., 98 NY2d 80 , the New York Court of Appeals held that, in the absence of a by-law, resolution, or agreement, Sections 722, 723, and 724 of the Business Corporation Law (“BCL”) do not permit a corporate officer or director to recover the attorneys’ fees incurred in filing a legal proceeding or motion to obtain an order granting a right to advancement or indemnification.
Recall that BCL 722 (a) permits indemnification of fees “actually and necessarily incurred as a result of [an] action or proceeding” against the officer or director. In Baker, the Court held that “the statutory language of section 722 (a) and the legislative history contain nothing indicating that the Legislature intended to provide coverage for fees on fees,” that is, legal fees incurred in proving the right to advancement or indemnification itself. The Court clarified that “corporations remain free to provide indemnification of fees on fees in bylaws, employment contracts or through insurance.”
Baker’s general principle against fees on fees has crept into the law of LLCs. In 546-552 W. 146th St. LLC v Arfa, 99 AD3d 117 [1st Dept 2012], the court, applying the LLC advancement statute, Section 420 of the Limited Liability Company Law (“LLC Law”), held:
While the language ‘any and all claims and demands whatsoever’ in Limited Liability Company Law § 420 may be broader than Business Corporation Law § 722 (a), it does not explicitly provide for an award of fees on fees. . . . Thus, as in Baker, while the language may arguably support an implied right of indemnification, the American Rule militates against that interpretation.
In contrast, in Delaware, the right of advancement generally includes the right to recover fees on fees. In Stifel Fin. Corp. v Cochran, 809 A2d 555 [Del 2002], the Delaware Supreme Court ruled:
We hold that indemnification for expenses incurred in successfully prosecuting an indemnification suit are permissible . . . . Allowing indemnification for the expenses incurred by a director in pursuing his indemnification rights gives recognition to the reality that the corporation itself is responsible for putting the director through the process of litigation.
It is a bitter pill to swallow for many business owners and fiduciaries in New York to learn they must pay the legal fees they incur in proving their entitlement to advancement and/or indemnification. For practitioners, to avoid this outcome and permit fees on fees, one could include language in an agreement to the effect that the right of advancement or indemnification shall “includ[e], without limitation, all attorneys’ fees, costs, and/or expenses incurred in establishing the right to advancement and/or indemnification hereunder and/or pursuant to any applicable statute.”
Injunctions, Recoupment, and Common-Law Damages
Our final topic concerning advancement and indemnification is an important one: what are the remedies for business owners when their entities wrongfully advance or indemnify another’s legal fees?
Where advancement or indemnification is made in violation of a statute or contract, one remedy is the injunction. Courts often issue injunctions where majority owners improperly attempt to advance their own legal fees. For example, “the overwhelming authority in . . . dissolution actions is for courts to enjoin the payment of legal fees by corporations on behalf of their majority shareholders” (Romita v Castle Oil Corp., Decision and Order, Index No. 053145/2011 [Sup Ct Westchester County Dec. 5, 2012]).
Another remedy is recoupment. Under the BCL and the LLC Law, if a party who received advancement is found disentitled to indemnification, he or she may be forced to repay all amounts advanced by the entity. BCL 723 (c) requires the posting of an “undertaking” to “repay” any amounts advanced to an officer or director if he or she is found ineligible for indemnification. In reality, an undertaking is little more than a promise, often in the form of a terse letter, to repay. Unless otherwise required in a contract, no security or bond is necessary, making it sometimes difficult or impossible to recover fees wrongfully advanced by the entity.
A third remedy is to simply allege a common-law claim of breach of fiduciary duty, delf-dealing, or waste against an individual whose legal fees were improperly advanced or indemnified by the entity. One may also allege breach of the applicable contract, if any.
In sum, advancement and indemnification encourage individuals and entities to invest in, and serve as fiduciaries for, closely-held businesses. They are valuable rights, which can provide a dramatic advantage to those receiving company funds for their own legal defense. But as we have seen, advancement and indemnification rights have their limits. Where advancement rights are misused, the best defense, as they say, is a good offense.