Indemnity Boilerplate Can Come-Back to Bite in Unexpected Ways

March 31, 2014

Organizers, managing members, officers and directors (collectively, “Insiders”) often demand broad indemnity agreements, from the company, to protect themselves against third-party claims. However, the companies rarely consider the devastating consequences that the language, of such agreements, may have, upon the company itself, if an allegedly nefarious Insider seeks to take advantage of that language to defend himself against claims by the company.

In a recent Delaware case, the Insider wanted the company to advance his attorney’s fees for (a) defending himself against the company’s counterclaims against him, and (b) answering the company’s affirmative defenses against his claims for severance pay and relief from his noncompete. [1] There, the consequences, of the company’s relatively boilerplate indemnity agreement, were summed-up, in the first two paragraphs of the “Master’s Report”, as follows:

“This dispute is standard fare in the world of indemnification and advancement. The plaintiff, Karl Fillip (“Fillip”), is a member, manager, and the former CEO of defendant Centerstone Linen Services, LLC (“Centerstone” or the “Company”). In 2012, Fillip resigned his position as CEO and then filed a lawsuit in Georgia when Centerstone refused to pay Fillip the severance to which he believed he was entitled. Centerstone quickly alleged counterclaims and affirmative defenses against Fillip in the Georgia case, alleging he breached [2] his fiduciary duties and certain contractual obligations by manipulating the Company’s earnings and revenues [to obtain larger bonuses for himself], paying kickbacks, modifying the terms of a note obligation between the Company and Fillip’s holding company, and attempting to sell Centerstone without the board of managers’ authorization. When Fillip demanded Centerstone advance his attorneys’ fees and expenses related to the affirmative defenses and counterclaims, Centerstone sought to avoid its advancement obligations by filing amended counterclaims omitting the counts alleging Fillip breached his fiduciary duties. Centerstone argued Fillip was not entitled to advancement for the remaining counts because those claims were personal to Fillip and did not involve actions he took in the performance of his duties as CEO. This lawsuit soon followed.

Centerstone is not the first company to experience the uncomfortable remorse of having granted advancement rights to an official the company now believes engaged in grievous misconduct, nor is it the first to attempt to evade its contractual advancement obligations by offering an awkward or illogical interpretation of the advancement obligation or the underlying litigation. Those arguments [3] rarely succeed, and they meet no different fate in this case. The only reasonable reading of the language at issue leads to the conclusion that Fillip is entitled to advancement for at least two of the three counterclaims asserted by Centerstone, as well as the dismissed counterclaims and the affirmative defenses that relate to his alleged wrongdoing as CEO.”

The Court itself concluded, in relevant part:

“It is far from uncommon that an entity finds it useful to offer broad advancement rights when encouraging an employee to enter a contract, and then finds it financially unpalatable, even morally repugnant, to perform that contract once it alleges wrongdoing against the employee. For the foregoing reasons, I find that Article 3.7 of the LLC Agreement mandates advancement of expenses, including costs, incurred by any Centerstone Manager or Officer by reason of his position [20] as officer or manager.”

The company would probably be entitled to recoup those advances if and when it prevailed on the merits of its counterclaims and defenses. However, such recoupment rights (a) may not offset the higher settlement value, of the case, created by the fact that the Insider is able to fund his litigation, against the company, using the company’s own money; and (b) leave the company with any difficulties of actually collecting such recoupments against the Insider.

Without going into the nuisances of the language of the particular indemnity agreement in that case, the case leaves us with the following take-aways that a company and the Insiders should consider, among other things, when drafting indemnity agreements:

  • Whether such indemnity agreements should apply to claims (a) by the company itself against Insiders, or (b) by Insiders against the company itself. On one hand, as indicated by the Court, no Insider wants to be exposed to the costs of litigating the types of personal accusations that can accompany a boardroom brawl or a proxy fight. As a middle ground for a company that can ill-afford paying both party’s attorneys’ fees in on-going litigation, perhaps a fair procedure would be (a) to obtain, up-front, an independent review of the claims and to deny such coverage if that review finds probably liability on the part of the Insider; and (b) in the event of such a denial, to retroactively reinstate such coverage, and to pay, if and when the Insider prevails on the merits in the main litigation.
  • A duty to defend is different from a duty to indemnify.
  • The statute, 6 Del. C. §18-108, itself imposes no limits upon how far a LLC may agree to indemnify. However, 6 Del. C. §§18-1101 and 18-1104 and, presumably, other regulatory and criminal statutes, impose some limits. Nevertheless, as shown by the subject case, an Insider’s rights to advancements of his attorneys’ fees and other litigation expenses can be treated differently from his indemnity rights. Both of those matters should be specifically addressed in the indemnity agreement.
  • To “rub salt” into the company’s “wound”, the company conceded that, under the subject indemnity agreement, the company also had to pay fees on fees, i.e. the attorneys’ fees spent by the Insider just to enforce his rights to have the company pay his attorneys’ fees in the main litigation.

[1] This Article addresses Fillip v. Centerstone Linen Servs., LLC, 2014 Del. Ch. LEXIS 30 (February 27, 2014) (the “Case”); and the “Master’s Report” therein at 2013 Del. Ch. LEXIS 294 (December 3, 2013).