How Boilerplate Agreement Advancement Clauses Can Transform Ownership Disputes

Previously, we explored the purposes of indemnification and advancement clauses, which are staples in foundational business and fiduciary documents, such as limited liability company (LLC) operating agreements, partnership agreements, and shareholder agreements.[1] Simply put, indemnification determines who will ultimately bear the financial burden for legal liabilities, whether they be monetary damages or legal fees and costs post-judgment.

While indemnification shields a fiduciary from ultimate legal liability, it generally does not cover the ongoing legal expenses incurred in defending against that liability, which can be substantial. In contrast, advancement provides interim contractual protection and typically requires a company to cover its fiduciary’s legal expenses as they arise during an ongoing dispute.

If a covered individual (such as a manager of an LLC) faces potential liability for which they may eventually be entitled to indemnification, an advancement clause typically mandates that the company advance their legal expenses as they occur, even if the potential liability arises from claims (or counterclaims) by the company against the covered individual. An advancement clause can be a formidable tool that might affect whether a party can afford to sustain litigation or be compelled to settle.

An Advancement Clause Can Be Dispositive

Consider a hypothetical scenario involving a member-managed, three-member LLC embroiled in a dispute. Members A and B bring a lawsuit on behalf of the company against Member C. The complaint alleges that Member C steered valuable business opportunities to a competitor that was founded by Member C’s children, costing the company millions in annual earnings.

Member C’s lawyer believes Member C has strong defenses, but Member C fears that she will not be able to cover the legal expenses necessary to prevail. If the company’s operating agreement contains a mandatory indemnification clause, Member C may be able to require the company to pay her attorneys’ fees.

Unfortunately for Member C, the indemnification clause requires the company to pay her legal expenses only if she ultimately obtains a final judicial ruling in her favor. In the meantime, Member C must cover her own defense costs throughout the litigation, and the financial burden of litigation may force Member C to agree to a settlement.

In contrast, if the operating agreement also contains an advancement clause, Member C may be able to require the company to pay her legal expenses as she incurs them. In these circumstances, Member C will have the resources necessary to mount a strong defense and will not have a strong incentive to accept unfavorable settlement terms.

An Advancement Clause May Deter Claims or Counterclaims

Consider a variation of the prior scenario. In response to the claims brought by Members A and B against her on behalf of the company, Member C considers bringing counterclaims against Members A and B for various breaches of the operating agreement. Member C believes her counterclaims will cause Members A and B to devote significant resources to their own legal defense, which would give Members A and B a strong incentive to accept a compromise settlement proposed by Member C.

In deciding whether to file counterclaims, Member C should assess whether Members A and B would have to fund their legal expenses in defending against the counterclaims. If the operating agreement contains an advancement clause that covers the legal expenses of Members A and B, the counterclaims that Member C is contemplating may not be worth bringing. This is because Members A and B could obtain company funds to reimburse their costs of defense as incurred.

Additional Considerations

An advancement clause can be broad or narrow in scope, and, as illustrated by the above scenarios, the breadth of the clause can significantly alter the litigation landscape. If an operating agreement contains a mandatory advancement clause, the company must pay the legal expenses incurred by a manager who is sued for actions taken on behalf of the company within the scope of that clause. The company may regret making advancement mandatory, rather than discretionary.

For example, even if the company brings claims against a former manager for intentional wrongdoing that harmed the company (such as fraud or embezzlement), the company may be required to pay the attorneys’ fees that the former manager incurs in defending against the company’s claims if the advancement clause is mandatory and without limitation. In contrast, if the advancement clause is discretionary, such as subject to the approval of a corporation’s board of directors or an LLC’s manager, the company may be able to reject the former manager’s demand for advancement. As a middle ground, even a mandatory advancement clause can be limited to certain circumstances, such as in defense of claims brought by a third party (and not by the company or its members).

The broader the advancement clause, the more likely it is that the company must spend its funds to pay attorneys’ fees in disputes among its owners. This financial burden may threaten the company’s other financial priorities or even drive the company to insolvency, which makes advancement a powerful tool in ownership disputes.