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.[1] 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.[2] 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.[3] 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.[4]
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.[5] 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.
- 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 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.[6] 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.
- 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.
For example, if the LLC’s operating agreement does not provide a carefully drawn definition of what a “manager” means, i.e., a manager of the LLC, a potential claimant who was a “manager” of a specific department or division of LLC, but not of the LLC itself, may seek advancement of his or fees and costs when that was not the LLC’s intent when drafting the operating agreement.[7] Thus, it is important that the operating agreement clearly define, and narrowly tailor, key terms so as not to unintentionally broaden who qualifies as a “covered person.”
- The operating agreement should exclude reimbursement for first-party claims
In Florida, indemnity provisions generally apply only to third-party claims, i.e., when a party outside of the LLC bring a lawsuit.[8] Florida law further cautions that broad indemnity language in an operating agreement that may encompass first-party claims could enable a former manager who acted in bad faith towards the LLC to use its indemnity clause to exculpate himself from liability to the LLC.[9]
For example, in a situation where the LLC has sued its former manager for breach of fiduciary duty for usurping corporate opportunities or self-dealing, the LLC might be required to reimburse the former manager for his attorney’s fees and costs to defend the very lawsuit that the LLC has brought against him for damages. And while indemnity provisions are generally limited to third-party claims unless a contract “clearly and unambiguously shows an intent to extend indemnity to first-party claims,” certain broad language in a reimbursement provision likely would trigger a duty to indemnify a first-party claim such as: “No Covered Person shall be liable to the Company or any other Covered Person for any losses, damage or claims incurred by reason of any act or omission performed or omitted by such Covered Person.”[10] This is because it provides, without any limitation, that a covered person shall not be liable to the LLC for any damages, including those that the covered person himself caused the LLC to suffer.[11]
- The operating agreement should expressly disallow recovery for “fees on fees” for litigating the issue of advancement.
The general rule in Florida is that a prevailing party may recover its attorney’s fees for litigating entitlement to attorney’s fees, but not for litigating the amount of attorney’s fees owed.[12] Florida law also provides an exception that where the parties’ contract is so broad that it contemplates that a prevailing party shall be entitled to recover attorney’s fees for litigating the amount of fees the non-prevailing party owes, i.e., “fees on fees,” a court’s award of such fees to the prevailing party is proper.[13]
Therefore, it is important for the LLC to include language in its operating agreement’s reimbursement provisions that provides, in the event the LLC were to reject a demand for advancement from a former manager, the LLC shall not be required to reimburse the former manager for her attorney’s fees incurred in pursuing her claim against the LLC for advancement. In other words, the operating agreement should expressly provide that the former manager is not entitled to “fees on fees” for pursuing her advancement claim against the LLC.
- The operating agreement should require a party who seeks advancement to pledge security to protect the LLC if it seeks repayment of the advanced funds
One of the more significant threats that a claim for advancement presents is that the LLC may be required to advance the attorney’s fees and costs in favor of a former manager, later prove at the trial on the merits that the former manager was not entitled to advancement or indemnification, but the LLC would have no means to recover the unsecured “loan” it advanced in favor of the former manager.[14] In other words, absent the operating agreement provision that for a party to be entitled to advancement of attorney’s fees and costs to defend a lawsuit, the party seeking advancement must “undertake” a pledge of adequate security in favor of the LLC. This undertaking is particularly important because absent the former manager’s provision of adequate security for the loan, the LLC is left with a mere unsecured claim against the former manager to recover the advanced funds and no ability to recoup such funds if the former manager is judgment proof.
Conclusion
Because an advancement claim asserted by a former manager may present a formidable threat and financial burden to an LLC, it is critical that the LLC’s new management take the time to review and understand the reimbursement provisions set forth in the LLC’s operating agreement. Taking the time up front to conduct a proactive review of the operating agreement, before an issue or claim for advancement arises, will better enable the LLC to adjust any unfavorable language that may have unintended and significant financial consequences for the LLC.
[1] See MVW Mgmt., LLC v. Regalia Beach Dev. LLC, 230 So. 3d 108, 111 (Fla. 3d DCA 2017).
[2] See id.
[3] See id.
[4] See id.
[5] See Order, Regalia Beach Dev. LLC v. MVW Mgmt. LLC, Case No.16-3753 CA 22 (Fla. 11th Cir. June 30, 2016) (Hanzman, J.) (requiring indemnity to be settled prior to consideration of a request for advancement of expenses “would eviscerate any right to advancement at all, as the merits of the case would have to be decided before” any reimbursement of expenses could occur) (citing DeLucca v. KKAT Mgmt., L.L.C., CIV.A. 1384-N, 2006 WL 224058 (Del. Ch. 2006)).
[6] See § 605.0408(3), Fla. Stat. (“In the ordinary course of its activities and affairs, [an LLC] may advance reasonable expenses, including attorney fees and costs, incurred by a person in connection with a claim or demand . . . .”)
[7] See MVW Mgmt., LLC, 230 So. 3d at 110 (denying MVW’s argument that it was a “covered person,” in part, because it was “a manager of the construction, sales, and operations of the condominium” under a separate management agreement).
[8] See id. at 112.
[9] See id.
[10] Id. at 113.
[11] See In re Villas of Windmill Point II Prop. Owners Ass’n, Inc., No. 19-20400, 2021 WL 814118, at *5 (S.D. Fla. Bkrtcy. March 2, 2021) (citing Wendt v. La Costa Beach Resort Condo. Ass’n, Inc., 64 So. 3d 1228, 1230-31 (Fla. 2011); MVW Mgmt., LLC, 230 So. 3d at 112-13) (“. . . Florida courts have permitted indemnification for first-party claims in a similar factual context.”).
[12] See, e.g., State Farm Fire & Cas. Co. v. Palma, 629 So. 3d 830, 833 (Fla. 1993).
[13] See Waverly at Las Olas Condo. Ass’n, Inc. v. Waverly Las Olas, LLC, 88 So. 3d 386) (Fla. 4th DCA 2012) (awarding fees on fees based upon the following clause: “In the event of any litigation between the parties under this Agreement, the prevailing party shall be entitled to reasonable attorneys’ . . . fees . . . .”) (emphasis added).
[14] See MVW Mgmt., LLC, 230 So. 3d at 111.
