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Generally, indemnification refers to a situation in which one party (the “indemnifying” party) agrees or is required to cover the costs, losses and/or expenses experienced by another party (the “indemnified” party).
In the context of business organizations, a limited liability company or corporation will often indemnify its officers and directors, covering their expenses (including legal fees) and judgment amounts incurred by such persons as a result of their service to the entity.
Indemnification is a key protection for officers, directors and key employees, and the scope of an LLC’s or corporation’s indemnity provisions demands close attention.
In an LLC, indemnification is completely discretionary and the scope of indemnification, if any, can be defined in the LLC’s Operating Agreement. Often, an Operating Agreement will provide broad indemnification, providing that indemnification, subject to the exceptions discussed below, will cover losses, damages and fines such as legal fees that are a result of an officer’s, director’s or employee’s service to the LLC.
In a corporation, the scope of indemnification can vary, depending upon the terms of the corporation’s charter and bylaws, but only within certain parameters prescribed by the Delaware corporate law and judicial precedent.
Although Delaware corporate law generally provides corporations with the power, but not the obligation, to indemnify directors and officers, there are certain circumstances where indemnification is mandatory. Section 145 of the Delaware General Corporation Law states that:
“[…] to the extent that a present or former director or officer of a corporation has been successful on the merits or otherwise in defense of any action, suit or proceeding… or in defense of any claim, issue or matter therein, such person shall be indemnified against expenses (including attorneys' fees) actually and reasonably incurred by such person in connection therewith.”
Indemnification amounts are generally paid out as the loss, cost or expense is incurred. For example, legal fees in defending against a claim are generally paid out as they are incurred so that the director or officer is not out of pocket those amounts, which can be sizable.
Ordinarily, an indemnified person will be required—as a condition of such an advance of expenses—to agree to return amounts provided it is determined that the indemnified party was not entitled to indemnification. The practicality of such a requirement is dubious in many circumstances, as the indemnified person may be unable to repay amounts after a judgment against him or her.
Indemnification is generally qualified by certain standards of conduct. For example, many LLC Operating Agreements and corporate documents provide that indemnification will apply to the fullest extent permitted by law, but that no indemnification will be provided where the action of the potential indemnitee constitutes fraud, gross negligence or willful misconduct.
Often, under the terms of an LLC or corporation’s indemnification provisions, only a final, non-appealable judgment of a court can determine whether an indemnified person’s conduct constituted fraud, gross negligence or willful misconduct.
Given the importance of an entity’s indemnification provisions, great care should be taken in setting the scope of and exceptions to indemnification, and in drafting the actual language, as variations in language can have a significant impact on a court’s interpretation of an indemnification clause.
If you incorporate with us, the Certificate of Incorporation we provide includes indemnification language for your new corporation.
*Disclaimer*: Harvard Business Services, Inc. is neither a law firm nor an accounting firm and, even in cases where the author is an attorney, or a tax professional, nothing in this article constitutes legal or tax advice. This article provides general commentary on, and analysis of, the subject addressed. We strongly advise that you consult an attorney or tax professional to receive legal or tax guidance tailored to your specific circumstances. Any action taken or not taken based on this article is at your own risk. If an article cites or provides a link to third-party sources or websites, Harvard Business Services, Inc. is not responsible for and makes no representations regarding such source’s content or accuracy. Opinions expressed in this article do not necessarily reflect those of Harvard Business Services, Inc.