Drafting an LLC Indemnification Provision
I’m drafting an operating agreement for an Ohio LLC, and [over]thinking about the indemnification section, where the company establishes its obligation to indemnify and defend the members and others in direct and derivative actions. There’s my form language I wrote a while ago, but maybe it’s time to refresh the analysis now that I’m my own associate.
The statutory guideline is RC 1705.32, which describes indemnification rights and sets the parameters for any operating agreement policy.
Section (A) says that an LLC may indemnify people for direct claims, provided they have upheld a certain standard of conduct, which is “in good faith and in a manner he reasonably believed to be in or not opposed to the best interests of the company and, in connection with any criminal action or proceeding, had no reasonable cause to believe his conduct was unlawful.”
Section (B) says that an LLC may indemnify people for derivative claims, under a different standard of conduct, which is, “in good faith and in a manner he reasonably believed to be in or not opposed to the best interests of the company, except that an indemnification shall not be made in respect of any claim, issue, or matter as to which the person is adjudged to be liable for negligence or misconduct in the performance of his duty to the company unless and only to the extent that the court of common pleas or the court in which the action or suit was brought determines, upon application, that, despite the adjudication of liability but in view of all the circumstances of the case, the person is fairly and reasonably entitled to indemnification for expenses that the court considers proper.”
Section (C) then establishes a right of indemnification for those who prevail under Section A or B: “To the extent that a manager, officer, employee, or agent of a limited liability company has been successful on the merits or otherwise in defense of any action, suit, or proceeding referred to in division (A) or (B) of this section or has been successful in defense of any claim, issue, or matter in an action, suit, or proceeding referred to in those divisions, he shall be indemnified against expenses, including attorney's fees, that were actually and reasonably incurred by him in connection with the action, suit, or proceeding.”
Section (D) allows the company to go back to its members or disinterested managers to determine the path for indemnification specific instances (among other rights inuring to the potential indemnitee).
Given the statutory guidance, what should the operating agreement promise?
I am representing the company, not the individual members. From the company’s perspective, whom do I want to cover? I want to cover members, managers, employees personally from outside lawsuits that are basically attacks against the interests of the company. Breach of contract, insurance claims, accidents occurring in the course of business. I also want to cover members and managers in derivative claims, to the extent they are in the interest of the company. If a member sues to compel the company to fire a supervisor who is suspected of harassing workers, for instance, but management has not taken action – I want the company to have to indemnify that member without having to prevail in the claim, and I don’t want the indemnification right to be subject to the discretion of a manager who may be the subject of the action.
On the other hand, I don’t want to create opportunities for bad actors to harm the company and claim a right to indemnification. I don’t think I want to create a clear obligation for the company to indemnify everyone in a weak minority member fiduciary duty claim, for instance.
Some issues are on the bubble, though. What if I have two members who are spouses, and they get into a divorce battle about their membership interests, each suing the company to deliver the other spouse’s interest? The issue would probably be handled best in the transfer restriction provisions, but could it drag in the company’s obligation to indemnify one or both of them? That’s a colossal waste that could destroy a lot of companies.
I also don’t know if I want to cover the supervisor who is accused of harassment or discrimination and incurs personal liability under ORC 4112, either. On the other hand, what about a supervisor who incurs personal liability under the FLSA, maybe in a misclassification claim, where the standard of conduct question could be much closer?
And what about “agents”? When should the company cover agents? You know who’s an “agent”? Me, that’s who! The contractually engaged lawyer drafting the operating agreement! Is it any kind of conflict to draft a client document that protects me from them? Can I draft this thing so that if they sue me for malpractice, I can claim indemnification by right?
For this company, my initial impulse was to break it down in a chart by (1) role of potential indemnitee (member, agent, etc.), (2) type of action (direct or derivative), and (3) applicability of standard of conduct; then draft accordingly, knowing that the company is going to have to pay if the person prevails. After writing out these notes, though, I think I’ll give broad indemnification and defense rights to all, unless the potential indemnitee’s standard of conduct is questioned by any disinterested manager or member, in which case the disinterested members will review the facts and make decision about indemnification and defense under Section D.