Advance Payment, Indemnification, and the Single-Member LLC

The Colorado statues provide that an limited liability company (LLC) member is entitled to be reimbursed for expenses incurred for the company. LLCs can also provide their members, managers, officers, employees, agents, and so on with indemnification for liabilities they incur for the company. While there are limits to the indemnification that can be provided, because LLCs are contractual entities, the indemnification generally has to be granted within the Operating Agreement.

The first thing to keep in mind is that this is a good reason to actually put together an Operating Agreement for an LLC, even if there is only one member.

There are two reasons for this. First, because the entity is separate from the member’s personal capacity, the creation of the indemnification right in the Operating Agreement creates an obligation between the entity and the member. A single member may be tempted to simply indemnify themselves using funds from the company whether there is a written right or not, but this action can itself be used as evidence that the person is simply using the company as their personal instrument instead of as a separate legal entity. The problem is that the limited liability of the member is based on the LLC being a separate entity, distinct from the member. Actions by the member that appear to treat the entity as the same as the member’s personal assets are suspect and run the risk of being evidence that the LLC should not have a limited liability shield.

Second, the creation of such a provision in an Operating Agreement, while creating an advantage for the member, also reinforce that the member and entity are being treated as separate. This actually reinforces the presumption that the entity is separate and that the limited liability should be respected.

The second thing to keep in mind is that an advance payment provision, with an indemnification provision, gives the member or manager a right to receive payments from the company in advance of any determination of ultimate liability when her or she is personally named for liabilities related to the company. Because of the provisions in the Operating Agreement, the member/manager has the right to receive payments from the company to defend him or herself while the claims are being fought, even if the payment of those costs by the company means the company’s assets are being depleted. In other words, the provisions create a known, legitimate liability obligation for the company that benefits the member/manager so the companies available funds can go to the defense of the member/manager while the claim is pending. 

Indemnification and Advance Payment

Reimbursed at the End

Indemnification obligations do not arise until there is some determinable amount that a party is obligated to indemnify. The fact that a party has an indemnification right does not mean they will get reimbursed for their expenses or losses (especially defense costs and attorney fees) until after there is an actual out-of-pocket expense that is found to be covered by the contract language. In other words, you do not get reimbursed until the end.

Example in Corporate Setting

An example might be a corporate officer who is sued by a regulatory agency for violation of some law. Company Articles of Incorporation, Bylaws, and/or state statutes generally include indemnification rights for officers for their liabilities incurred while acting in good faith for the company. This usually means that if the officer meets certain criteria, the company has to cover the cost of the defense and any liability imposed on him or her. However, unless there is an advance payment provision in the indemnification provision (or an equivalent state statutory requirement), the company does not have to pay any amount to the officer until after the officer has the expense and proves their entitlement to the indemnification. This means the indemnitee may have to front all of the costs and expenses of a defense, including any liability. This can be a substantial burden.

Application to Commercial Contracts

The same is true with indemnification provisions in commercial contracts. The party who is obligated to indemnify does not have to reimburse the other party until that party has the expense and proves entitlement to the reimbursement – a proceeding that is usually done after the underlying matter is resolved.

Depending on the language, an advance payment provision states that the party obligated to indemnify may also be obligated to provide the funds in advance of the final resolution of the matter. In short, the advance payment is a loan to the indemnitee over the course of the resolution of the dispute that only has to be paid back if it is determined that the party was not actually entitled to be indemnified.

What the Advance Payment Provision Does

The advance payment provision does two things. First, it mitigates the financial burden of the indemnitee during the time that the claim is being addressed. It does this by requiring that the payment of the fees and costs in the defense, and any ultimate liability, be provided while the expenses are being incurred. The provision can be used to place the obligation of the expense on the party best capable of financing the situation.

Second, the provision can shift the risk of whether the claim is covered by the indemnification provision to the indemnitor because the indemnitor might have to front the costs of the defense if there is a possibility the claim is covered. If it is not covered, it is the indemnitor’s obligation to recover the amount paid from the indemnitee.

Conclusion

Depending on the financial conditions of the parties involved, as well as the roles being played and risks involved, an advance payment provision can be essential in appropriately allocating the risks presented to the parties of a third party claim arising out of the relationship.

One of the areas such a provision can be useful is in the single-member LLC environment. We will discuss this in the next post.

Indemnification versus Defense Obligations

Indemnification is the obligation to pay another for a future liability that might arise. When included in a commercial contract, this usually includes coverage of liability in the form of actual damages or losses such as having to pay a third party. In addition, such provisions often include coverage for liability in the form of defense costs, i.e., the cost of dealing with a third party claim even if there is no ultimate liability to the third party. Notably, in some jurisdictions, attorney fees are not covered unless the provision explicitly states that they are.

Defense Different from Indemnification

It is important to realize that the duty to indemnify for defense costs is not the same as a duty to defend. A duty to defend is different and requires that a party step-up to actually defend the other party from the claim being made. This is taking action in defense of the other party when a third party claim comes up such as opposing the claim, negotiating to resolve the claim, and if necessary, mounting a legal defense in court if a lawsuit is filed, or in arbitration if that is the selected dispute resolution forum.

Insurance Example

Again, insurance policies are a good example. Insurance policies not only provide that the insurer will pay for a covered loss, they also provide that the insurer will defend the insured. This means that the insurer will step in to defend the insured from the claim being made. When the insurance company is notified of the claim, they often try to resolve the matter without litigation, but if this does not work, they hire an attorney to represent the insured in the lawsuit.

How Defense Rights Work

Defense rights often compliment indemnification obligations and can be very valuable. However, these rights pose some different questions. Initially, the idea is that the party who will eventually be obligated to pay the losses or damages incurred has a strong incentive to participate in how the claim is handled before any such liability is determined. That party will want to make sure that the defense is mounted in such a way as to reduce the liability, take advantage of legitimate defenses, and to reduce unnecessary costs of the defense—especially if that party will ultimately be responsible for paying those costs of defense.

Differing Interests and Incentives

This works particularly well when the party obligated to provide the defense is also implicated in the claim. That is, the conduct or activities of that obligated party are an integral part of the situation that gives rise to the claim. In such situations, the obligated party may also have a claim against it, have its own defenses that help with opposing the claim, and the parties are essentially on the same team already so that there is a lot of value to being united in the defense of the claims being made by the third party.

On the flip side, the party obligated to provide a defense may not always have the same incentives to defend as the party who is entitled to the defense. When the obligated party has less risk, or is not named, that party may only be concerned with minimizing the total cost of the process. This can mean that it may not be as concerned about proving the defendant’s innocence as it is with keeping its overall expenditures down. Meanwhile, the party entitled to a defense may be very concerned about its reputation and prefer to fight the claims, even if this might increase the total cost of the process.

The Case for More Specific Terms

Other important factors also need to be addressed with defense rights that relate to the incentives and interests of the parties if a claim is brought. While simply including a defense right may be appropriate, a very simple statement in a provision granting defense rights does not state who selects the counsel, what strategy will be employed, who can approve of a settlement, or whether the party receiving the defense has any right to have a say in the defense. It is often appropriate to include language that explicitly states how counsel will be selected, who manages the defense, and whether a settlement can be entered. Another issue when a party has to provide notice to the party obligated to provide a defense that there is a claim that triggers the obligation. A late notice can be prejudicial to the ability of the defending party to mount an effective defense.

Conclusion

Indemnification provisions provide a basic level of rights by giving a party the obligation to pay for losses that another party may incur because of engaging in the contract. Those rights may include coverage for defense costs, but this is not the same as having a right to require that someone mount a defense for you if that dreaded claim arises.

Both indemnification and defense rights look to the practical reality of what is going to happen if such a claim comes up. As a result, it is important to consider and forecast what the parties really want to have happen. Does the party want to be defended as well as indemnified, or just indemnified? Does the party want to control the defense or have a say in who the counsel will be?

While these issues are important, there is another concern that is practically very important – the question of timing. We will discuss this in the next post.

What is this Indemnification Provision in my Contract?

Definition

Indemnification is the action of protecting (someone) by promising to pay for the cost of possible future damage, loss, or injury. In a contract setting, it is a provision where one party promises to pay the costs of potential future liabilities incurred by the other party as a result of some defined set of circumstances that might occur because of the contractual arrangement.

Examples

The most common example of an indemnification agreement is an insurance policy. In an insurance policy contract, the insurer agrees to pay for certain liabilities that might be incurred by the insured due to accidents or risks such as property damage to a car in a car accident, injuries to a visitor at a retail store, or defamation caused by an advertisement. Insurance policies are generally complicated and include grants of coverage, exceptions, and exceptions to the exceptions. This is because insurance policies are very careful about what type of conduct or risk is being covered.

Although not as elaborate as insurance policies, scaled down indemnification provisions are common in commercial contracts. Commercial contracts provide the parties the opportunity to allocate the risks the parties have when they engage in the relationship.

Often there is a risk that one of the parties could become liable to a third party because of the work they are agreeing to do. For example, a website designer who uses pictures provided by a customer doesn’t know whether the customer has full rights to use those pictures. The pictures might be copyrighted by some third party. The designer can get a representation from the customer that they have the rights, but even with such a representation, if a third party actually has the rights, that third party can assert a claim of infringement against the designer for using the picture without his or her permission. There is a risk. Accordingly, the designer may require that the customer back up their representation with a promise that if the customer is wrong about their rights such that the designer is involved in a lawsuit for some claimed infringement, the customer will take care of the cost of the lawsuit and any damages. This would be an indemnification provision.

Another example is in construction. A homeowner hires a general contractor (GC) to remodel his or her kitchen. The GC then hires subs. The subs are to be paid by the GC who is paid by the owner. But if the GC fails to pay the subs, the subs have the right to put a mechanic’s lien on the property as security for the work they did and the materials they supplied. The owner may then have defend against the lien, or might decide it is best to pay the subs directly to remove the lien. The owner is well advised to make sure that his or her contract with the GC includes a promise by the GC to take care of any damages the owner has because of the GC’s failure, including any legal fees and costs in defending against a mechanic’s lien.

Important, But There is More

Indemnification provisions are an important tool for the parties to allocate the risk of losses that might arise out of the relationships in the contract. However, indemnification provisions vary and it is extremely important that they be tailored to the situation. Otherwise, they can be overbroad, or uselessly narrow. In addition, indemnification rights are a specific kind of right to get paid for damages incurred and are therefore somewhat narrower than what a party may actually want when the problem arises. We will discuss this more in the next posts regarding defense rights and advance payment.

The Griess Law Firm, LLC has moved!!

The Griess Law Firm, LLC is pleased to announce that it has moved locations. The new address is:

750 W Hampden Ave, Suite 520

Englewood, CO  80110

All of the firm’s other contact information remains the same.

After a fruitful office sharing relationship with Cooper Clough, PC, and then with Brown Kaplan Gold, LLC, in downtown Denver for the past 4 years, the firm has relocated to Englewood to share office space with Atkinson | Boyle, PLLC. In addition to sharing space and resources, Douglas Griess is also “of Counsel” with Atkinson | Boyle.

Mr. Griess continues to focus on transactional work including business law, contracts, business succession planning, real estate, intellectual property, and owner relations, while Atkinson | Boyle focuses on litigation including both personal injury and commercial disputes.