HIGHLIGHT CORNER
HIGHLIGHT CORNER
ADAM RABIN
Tips for an LLC to Protect Against a Former Manager ’ s Claim for “ Advancement ” of Attorney ’ s Fees and Costs When the Former Manager Acted in Bad Faith
Under Florida law , a former manager of an LLC may have the right to require the LLC to indemnify his or her attorney ’ s fees and costs in a lawsuit in which the former manager has been sued as a defendant . In addition , depending on the language of the LLC ’ s operating agreement , the former manager may have the right to require the LLC to “ advance ” the former manager ’ s attorney ’ s fees and costs . And while a former manager ’ s rights to indemnification and advancement are related , they have material differences that may bear significantly on the LLC ’ s burden to fund a former manager ’ s defense in litigation .
Indemnification is the right of a former manager to require the LLC to pay , at the end of a lawsuit , for the former manager ’ s liability and any attorney ’ s fees and costs incurred . Indemnification usually requires the former manager to have met several conditions , including proving that the manager acted in good faith . In contrast , advancement is the right to immediate , interim relief from the LLC for attorney ’ s fees and costs incurred during the pendency of the lawsuit . Advancement is in the nature of a loan , where the LLC is obligated to pay the former manager ’ s attorney ’ s fees and costs as they are incurred , subject to a statutory or contractual obligation to repay the loan to the LLC if the former manager is unsuccessful at trial on his or her indemnification claim .
The central difference between the right to indemnification and the right to advancement is that the right of advancement does not allow the LLC to present any “ merits ” defenses to the claim , including but not limited to whether the former manager acted in bad faith or whether there is an indemnifiable loss . Without the opportunity for the LLC to present any merits defenses to an advancement claim , a former manager ’ s claim for advancement can present a “ heads I win , tails you lose ” proposition for the former manager . This is because , absent certain protective language in the LLC ’ s operating agreement , the LLC may be forced to pay the former manager ’ s attorney ’ s fees and costs as they are incurred , with nothing more than an unsecured claim for repayment against the former manager after the litigation concludes . This burden to the LLC may be even more significant , if not draconian , when the LLC ’ s obligation to advance the former manager ’ s attorney ’ s fees and costs extends to a lawsuit in which the LLC is the very plaintiff suing the former manager for damages arising from the former manager ’ s misconduct .
It is , therefore , critical for an LLC ’ s managers and members — before and after a former manager has departed from the LLC — to confirm that the LLC ’ s operating agreement does not require the LLC to advance the attorney ’ s fees and costs to defend a former manager in a lawsuit unless the former manager was acting in good faith during the former manager ’ s term . In contrast , where the former manager engaged in self-dealing and damaged the LLC , the LLC reasonably should not be required to advance the attorney ’ s fees and costs on behalf of the former manager .
To limit the risk that an LLC may be required to advance a former manager ’ s attorney ’ s fees and costs , without the opportunity to present any defenses until the related indemnification claim is tried on the merits , the LLC should ensure that certain protective language is included in the LLC ’ s operating agreement . Thus , here are five tips for language that an LLC should include in its operating agreement that may limit the LLC ’ s duty to advance funds for a former manager ’ s legal defense in circumstances where it would be unreasonable to do so .
1 . The operating agreement should make the LLC ’ s obligation to advance attorney ’ s fees and costs permissive , not mandatory
An LLC ’ s management may not be aware of one-sided language that exists in the LLC ’ s operating agreement ’ s reimbursement provision that may unduly favor a former
PBCBA BAR BULLETIN 10 manager when it comes to advancement . It is common , particularly where an LLC copies a standard-form operating agreement , to not pay close attention to the details of the reimbursement clauses set forth in the operating agreement . The difference between “ shall ” and “ may ” when it comes to the LLC ’ s duty to advance a former manager ’ s attorney ’ s fees and costs incurred in defending a lawsuit may save the LLC hundreds of thousands , or even in excess of a million dollars in complex cases . For some LLCs having financial issues , this burden may be enough to “ break the bank ” and can create unjust and unanticipated leverage in favor of the former manager vis-à-vis the LLC .
Florida ’ s LLC code empowers an LLC to advance a former manager ’ s reasonable attorney ’ s fees and costs incurred in defending against a claim but does not make it mandatory . Thus , to avoid the unnecessary risk of having to advance a former manager ’ s fees and costs in litigation , the LLC should track the Florida statute and ensure its reimbursement provisions make advancement only permissive and not mandatory .
2 . The operating agreement should narrowly define who is a “ covered person ”
Another hazard for an LLC that does not appreciate the breadth of any reimbursement rights set forth in the LLC ’ s operating agreement is that a “ covered person ” may be defined as anyone acting within the scope of his or her duties for the LLC . It is , therefore , important that an LLC anticipate potential broad-brush claims that a person who was not intended to be a “ covered person ” may argue in favor of the right to be reimbursed for his or her attorney ’ s fees and costs in defending a lawsuit .