Delaware Business Litigation Report

Advancement Denied to Board Chair Following LLC's Conversion

 Authored by Lewis H. Lazarus
This article was originally published in the Delaware Business Court Insider | January 29, 2013

Advancement rights assure directors and officers that if they are sued for conduct arising out of their company service, the company will pay their attorney fees and costs as they are incurred. Without advancement rights, many people would not serve out of fear that their personal assets would be depleted in defending suits based on their conduct as directors or officers. For that reason, Delaware courts regularly enforce advancement rights, even after a finding of criminal guilt at the trial level, until the judgment is final and all appeals are exhausted. Nonetheless, mandatory advancement rights apply only if provided by charter, bylaw or contract. The recent case of Grace v. Ashbridge LLC, C.A. No. 8348-VCN (Del. Ch. Dec. 31, 2013), provides a cautionary tale that advancement rights that may have existed when the entity was a corporation do not necessarily survive intact when the entity converts to a limited liability company.

Background

Plaintiff Charles Grace was the co-trustee of a family trust that held shares of a Delaware corporation that converted into defendant Ashbridge Partners LLC, a Delaware limited liability company. Defendant Ashbridge Partners LLC changed its name to Ashbridge LLC. Grace also served as chair, a member of the governing boards and a member or shareholder of Ashbridge LLC and its predecessor, Ashbridge Corp. Upon the filing of an accounting in a Pennsylvania court by the trustees of the family trust, beneficiaries of that trust filed objections to that accounting based upon alleged breach of fiduciary duty and diminution in the value of the trust due to imprudent investments, improper loans and self-dealing. The Court of Chancery noted that the beneficiaries' objections to the accounting did not refer to any act taken by Ashbridge LLC. Grace nonetheless asserted entitlement to advancement from Ashbridge LLC for his expenses in responding to the objections to the accounting, a failed mediation, and his Court of Chancery action seeking advancement.

Court of Chancery Rejects Advancement Claim

The primary ground upon which the court rejected Grace's claim for advancement was that the plaintiff failed to demonstrate that the advancement provision in the Ashbridge LLC operating agreement applied retroactively to acts that occurred prior to the formation of Ashbridge LLC. The court so held for three reasons:

(1) The plain language of the operating agreement defining "company" "function[ed] prospectively as of the date on which the agreement was executed," and the predicate acts for which Grace sought advancement pre-dated the formation of the LLC.

(2) The plaintiff pleaded no facts in his complaint that related to Ashbridge LLC.

(3) The court viewed the 2008 conversion of the predecessor corporation into Ashbridge LLC as a "fundamental change in control" due to the important ways in which limited liability companies and corporations differ, including the absence of mandatory statutory indemnification for managers of limited liability companies who successfully defend themselves. The court thus held that it would not "impose retroactive obligations on a limited liability company when the plain language of its operating agreement would not permit predecessor or affiliate liability and when the indemnification schemes of the predecessor corporation and successor limited liability company differ."

Lesson Learned

It is important to note that the court was not required to address whether a successor entity could be liable for advancement based upon the language of a predecessor's bylaws or operating agreement because the court found that the plaintiff failed to make well-pleaded allegations that he was entitled to advancement and indemnification under the predecessor corporation's bylaws. For practitioners and the directors and officers they represent, this case demonstrates that parties should not assume that upon conversion of a corporation into a limited liability company the directors and officers who become managers are automatically entitled to advancement by the successor entity for acts taken on behalf of the predecessor corporation. A court is more likely to find advancement rights in these circumstances if the terms of advancement and indemnification in the governing documents of the successor entity are identical to the terms in the predecessor corporation. Even then, a plaintiff must plead specific facts that he or she complied with the advancement provisions of the predecessor entity. If a plaintiff cannot so plead, a Delaware court will not find a right to advancement where, under the governing language of the relevant advancement provisions, no clear right exists.

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