LLC Indemnification under the Revised Ohio LLC Act, R.C. 1706

Ohio has a new LLC statute that will apply to all LLCs in the state as of January 1, 2022. That’s great and all, but it just about takes a dump on the blog article I feel like I just wrote about LLC indemnification, so I woke up early to read the whole new statute and update my post on indemnification of members and managers in Ohio LLC operating agreements.

The new statute, known as the Ohio Revised Limited Liability Company Act, is section 1706 of the Ohio Revised Code, effective April 12, 2021 and applicable to all LLCs as of January 1, 2022. Not sure why there’s an effective date and a separate applicability date. The current Ohio LLC statute is R.C. 1705, and is scheduled to be repealed on January 1, 2022.

I’ll post more on the new statute in a while, but I want to revise my indemnification analysis first.

Key Change: No Guidance; No Indemnification of Right

The current LLC Act (R.C. 1705) contains usable language addressing indemnification of members, so it has been easy to just kind of order off the menu by saying in the operating agreement, “we’ll take the indemnification.” The current LLC Act also gives members a right to indemnification if they prevail in their lawsuits, so the members were protected to some degree at all times. Some lawyers, who might not want not want to spend a lot of time on back burner operating agreement language like indemnification, figured they could refer to the language of the statute and end up with a perfectly workable policy. That worked great before, but now not so much.

The Revised LLC Act, section 1706, does not provide any indemnification of right, and does not give any guidance. Here is R.C. 1706.32 in its entirety:

A limited liability company, or a series thereof, may indemnify and hold harmless a member or other person, pay in advance or reimburse expenses incurred by a member or other person, and purchase and maintain insurance on behalf of a member or other person.

That kind of language does not help a company decide when to indemnify someone. The point is that companies that relied on the language of the old LLC Act for indemnification guidance (e.g., indemnification for members “to the extent permissible under applicable law”) no longer have a statutory provision that reasonably supports that reliance.

Indemnification Basics

The LLC can protect its members and managers by agreeing to be responsible for the losses and liabilities incurred by the individuals involved in various sorts of disputes or claims. This coverage can take the form of indemnification (which means reimbursement, basically), defense (which means bearing the cost of dealing with responding to claims), and advancement of costs (which means paying the indemnification costs up front, rather than just reimbursing the indemnitee). There is also a right called “hold harmless” which has an ambiguous or evolving meaning – apparently it either means “indemnification” or “indemnification plus more stuff,” so I still use it when I want the indemnification provision to apply more broadly.

Operating agreements should first define the scope of indemnification by stating that indemnification rights apply only to disputes or claims arising from the member’s status as a member. (The stuff I’m saying about members can also be applied generally to managers.) The LLC should not be put in the position of indemnifying personal matters. Another important initial definition is the status of the dispute – is the indemnitee covered when the dispute is threatened or raised, or does coverage only start when a claim is formally filed?

The parties to indemnified disputes can be categorized into a few predicable groups: third parties, other members or managers, and the LLC itself. Each of these parties may sue or be sued by the member, so consider whether indemnification language provides coverage to a member who is initiating or threatening an action. Indemnification clauses also often distinguish separate standards for derivative claims – when the member purports to bring a claim on behalf of the LLC itself. In this case, the Revised LLC Act can be helpful, because there’s a whole section on when someone can bring a derivative claim (1706.61, et seq.).

Fiduciary Duty

The Revised LLC Act allows an operating agreement to bind the members to any defined standard of duty, as long as it does not “eliminate the implied covenant of good faith and fair dealing.” This seems to mean something, but if we take it in context of section 1706.06(A), which says, “This chapter shall be construed to give maximum effect to the principles of freedom of contract and to the enforceability of operating agreements,” I think there’s a basis for attenuating to the point of meaninglessness, if not expressly eliminating, the principles of good faith and fair dealing.

Drawing a clear line on a standard of duty is important in corporate indemnification because members get involved in disputes about competing with the company, taking business opportunities from each other, and allegations of mismanagement and incompetence – claims that hinge on the idea of breaching a duty. In some LLCs, such actions are perfectly all right or even contemplated; in others, they can be seen as a betrayal of the basic premise of the company!

The default standard of duty imposed on Ohio LLC members has softened a great deal over the years, and the Revised LLC Act codifies another significant change. In the early years of LLCs, Ohio case law assigned LLC members a duty of the “utmost trust and loyalty” to each other – a true fiduciary duty arising from the common law of partnerships and close corporations (see, e.g., McConnell v. Hunt Sports Ent., 132 Ohio App.3d 657, 725 N.E.2d 1193 (Ohio App. 10 Dist. 1999)). Later, the old LLC Act stated that members were obligated only to uphold defined duties of loyalty and care (R.C. 1705.281). The Revised LLC Act carries over definitions of the duties of loyalty and care, but applies them to members only if the operating agreement does not modify them, and if the LLC has not appointed managers. That is, in a manager-managed LLC, the members have only the duty to uphold the implied covenant of good faith and fair dealing.

Anyway, my point here is that an LLC that wants to limit its indemnification obligations on the basis of good and bad acts will have to draft clear standards of duty into the indemnification policy.

Summary. Here’s an outline of issues when structuring an LLC indemnification provision under the Revised LLC Act:

• Define the nature of the right: indemnification; defense or representation; advance payments; hold harmless.

• Condition on the specific status of the indemnitee as a member or manager; determine whether derivative claims are treated specially

• Define the status of indemnified claims: do that have to be actual claims, or are threatened claims also covered?

• Is there a standard of duty that members have to meet before the LLC’s indemnification obligation applies? If so, what is it, exactly? If it’s hard to tell, who can decide whether to advance payments?