A recent Delaware Court of Chancery decision, Freeman Family LLC v. Park Avenue Landing, LLC, C.A. No. 2018-0683-TMR, 2019 Del. Ch. LEXIS 149 (Del Ch. Apr. 30, 2019), touches on two topics that are familiar to private equity sponsors: (1) Delaware limited liability companies (“LLCs”) and (2) indemnification. LLCs, rather than corporations, are often used in transaction structures because of LLCs’ nearly complete flexibility, particularly with respect to governance and tax treatment. Indemnification is important because (a) private equity professionals often serve as officers and directors of portfolio companies and (b) plaintiffs will sometimes attempt to join private equity sponsors into litigation against portfolio companies. Consistent with their inherently flexible nature, there is greater freedom to tailor the indemnification provisions with respect to an LLC than a corporation. However, eschewing such freedom, the indemnification provisions of a corporation’s organizational documents are sometimes imported into LLCs. This case addresses the (potentially unintended) consequences of incorporating “corporate” indemnification provisions into an LLC operating agreement.
The members of Park Avenue Landing LLC (“Park Ave” or the “Company”) include, among others, Freeman Family LLC (“Freeman Family”) and Hugo Neu Corporation (“Hugo Neu”). The operating agreement of Park Ave (the “Operating Agreement”) contains call rights that permit Hugo Neu to buy back Freeman Family’s equity under certain circumstances. Hugo Neu commenced an action against Freeman Family to enforce its call rights. In turn, Freeman Family commenced this separate case against the Company seeking advancement of legal fees under the Operating Agreement.
The indemnification provision (which underlies the advancement provision) in the Operating Agreement reads:
“[t]he Company shall indemnify any person (each, an “Indemnitee”) who was or is a party or is threatened to be made a party to any threatened, pending or completed action . . . by reason of the fact that such Indemnitee is or was a Managing Member, Member or an officer of the Company.”
Sections 145(a) and (b) of the Delaware General Corporation Law (the “DGCL”) state that:
“[a] corporation shall have power to indemnify any person who was or is a party or is threatened to be made a party to any threatened, pending or completed action . . . by reason of the fact that the person is or was a director, officer, employee or agent of the corporation.”
Freeman Family argued that corporate case law should not be used to interpret the indemnification provisions in the Operating Agreement. On the other hand, the Company took the position that (i) corporate case law is applicable and (ii) under corporate case law, indemnification, and therefore advancement, do not apply to claims relating to personal obligations such as the call rights.
The Delaware Court of Chancery concluded that (i) as a general matter, the freedom of contract underlying LLCs permits the parties to adopt corporate case law in LLC operating agreements and (ii) in this particular case, “the parties intended to import corporate case law as indicated by their decision to use contractual language that mirrors [the DGCL].” And though it disagreed with Freeman Family on the applicability of corporate case law, the Delaware Court of Chancery held that Freeman Family is entitled to advancement because the call rights were not merely personal obligations and the corporate case law requirement of “by reason of the fact” is satisfied.
The limitations on indemnification under the DGCL did not ultimately prevent Freeman Family from receiving advancement. However, the question of whether such limitations apply in the first place could have been avoided if the Operating Agreement had taken advantage of the greater flexibility permitted by the Delaware Limited Liability Company Act (the “DLLCA”), which provides that an LLC may indemnify any person from “any and all claims and demands whatsoever.” Had the indemnification provisions been expressly expanded beyond the typical language designed for corporations, the Delaware courts would have been broadly deferential to the terms of the Operating Agreement. But instead, the Delaware Court of Chancery had to use corporate case law to interpret the Operating Agreement.
The lesson from this case is that
importing provisions of the DGCL (or Delaware law applicable to partnerships)
into LLC operating agreements may also import the case law applicable to
corporations (or partnerships). Doing so may be desirable in some cases because,
as the Delaware Court of Chancery points out, the parties may want “to import a
predictable and well-defined rule from corporate statutory and case law.”
However, if the goal is to provide private equity professionals with the broadest
indemnification possible, it is best to avoid using words from the DGCL and
expressly include more expansive indemnification provisions in the LLC