The Power of Corporations and LLCs to Indemnify: Similarities, Differences, and Risks

“The [corporation][LLC] shall indemnify its agents to the full extent permitted by law.”

Is it wise for corporate documents and limited liability company (“LLC”) operating agreements to provide such broad indemnification coverage in these or similar words?

The separate statutes that govern corporations and LLCs authorize indemnification of agents, in some cases imposing a mandatory requirement, but essentially permitting the entity to craft the indemnification terms. The risks in providing indemnification are similar, but the statutory applications are different. When drafting indemnification provisions, thought should be given regarding to whom coverage is being provided and for what actions.

A. Why Indemnification

Corporations and LLCs are inanimate entities that act through human beings, individuals who risk personal liability in making policy, taking action, or not taking action. By providing a degree of protection from financial loss, indemnification encourages wise and intelligent men and women, acting in good faith and placing the entity ahead of personal considerations, to serve as the entity’s decision makers. This not only benefits the investors who place their trust in the decision makers, but it is also good public policy. When, however, an agent acts adversely to the corporation or LLC for pure personal benefit, the concept of the wronged entity being required to provide that agent with indemnification is an anathema.

B. The Difference in Statutory Application

(i) Corporations

Originally, the privilege of forming a business endowed with limited liability was granted sparingly. Corporations were feared as encroachments upon the liberties of individuals. Whereas an individual may do whatever is not prohibited by law, an artificial entity is permitted to do only what is authorized by law and its charter. Modern corporate statutes authorize corporations to indemnify corporate agents and permit, subject to any mandatory requirement, the corporation to expand or limit the scope of indemnification. State statutes vary. Each subsection of an indemnification statute provides for a different result depending on the circumstance.

(ii) LLCs

LLC agents may also seek the comfort of being indemnified, and members may provide for it in the operating agreement. The Revised Uniform Limited Company Act (RULLCA) contains a section providing for mandatory indemnification, but because it is one of the statutory sections that may be altered by an operating agreement, it is a default provision that applies only when the operating agreement is silent on the subject. Hence members can write their own terms or agree that there shall be no indemnification unless determined by the members as situations arise.

In short, corporate indemnification, where mandatory, is not subject to change, and where permissive is subject to the terms provided in the corporate documents. LLC indemnification, if not spelled out in the operating agreement, is governed by the default terms of the statute.

C. Risks

When it works properly, indemnification benefits both the entity and its protected agents. When drafting its permitted terms, counsel must consider to which of the entity’s “agents,” a term often defined by the governing statute, the client desires to extend coverage. For example, if coverage extends to “officers,” does that term include nominal vice presidents who have been given a title but no executive authority? Should all or only some employees to be covered? What about others remotely serving the entity?

The entity undoubtedly desires to protect whomever falls within the scope of coverage from actions brought by unhappy investors or aggrieved third parties, but should coverage extend to actions initiated by the entity itself against a wrongdoing agent or to a counterclaim made against the entity by the alleged wrongdoer defending that action? Courts enforce indemnification as written. In one case where a former officer was both indicted and sued civilly because of his actions which the company claimed, “were motivated by personal greed that resulted in his receipt of $1.5 million,” the officer’s claim for advancement of expenses was nevertheless granted because of the broad language adopted by the corporation in its documents.

What about the agent that is not sued but is the plaintiff suing the entity?

D. A Modest Proposal

What future legal actions may be brought by whom for whatever reasons against which entity agents are unknown. Owners and investors, at the very least, will want their decision makers to enjoy the security of indemnification. Beyond that, could it not be left to the decision makers to decide whom to indemnify for what as the situation arises? Would not the purpose of indemnification be served by (i) providing full permissive indemnification to the governing body (directors, managers, members) against direct and derivative actions by investors and claims by third parties, but not against claims made by the entity itself, and (ii) authorizing the governing body to indemnify officers, employees, and other agents by contract or resolution as the situation arises?