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Chancery Awards Advancement to Member Under Operating Agreement Provision

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May 25, 2019
By: Albert H. Manwaring IV
Delaware Business Court Insider

Delaware corporate law allows for a corporation to agree in its organizational documents or contracts to advance legal fees and expenses in defense of actions, arising from a person’s service to the company. To encourage quality leadership of companies, the policy under Delaware law is to broadly construe indemnity and advancement provisions in favor of permitting advancement. In its recent decision in Freeman Family v. Park Avenue Landing, C.A. No. 2018-0683-TMR (Del. Ch. April 30, 2019), the Delaware Court of Chancery determined whether a member of a limited liability company was entitled to advancement under the indemnity and advancement provisions of its operating agreement. The operating agreement imposed a duty on the plaintiff to use its best efforts in its capacity as member to either exchange certain real property or have it developed. In the underlying New Jersey suit, for which advancement was sought, the defendant company challenged the plaintiff member’s call rights based on the member’s alleged failure to use its best efforts concerning the property under the operating agreement.

In contrast to the general corporation law context, the fundamental principle underlying an LLC relationship in an operating agreement under the Delaware LLC Act is the freedom of contract—where members are free to arrange their duties and governance as they choose. Overlaying the principle of freedom of contract in the LLC context, however, is the concept that if the parties adopt provisions from the general corporation law, the Court of Chancery may rely on its general corporate law precedent to interpret these provisions.

In Freeman Family, the Court of Chancery emphasized that “parties are free to contract into corporate case law (or not) when they create LLCs, and courts will respect that choice.” Adhering to this principle, the court found that because the “by reason of the fact” language in the operating agreement’s indemnity and advancement provisions was “nearly identical” to the language found in the indemnity and advancement provisions of Section 145 of the Delaware General Corporation Law, that the members intended to import general corporation law principles, and thus utilized Section 145 to guide its interpretation of the indemnity and advancement provisions in the operating agreement. Under Section 145 precedent, addressing whether suit is brought against a party “by reason of the fact” that the party was acting in an official capacity on the company’s behalf, the “by reason of the fact” language is interpreted broadly, and requires only a nexus or casual connection between the party’s official capacity and the underlying suit. Here, because the underlying action challenged the plaintiff member’s call rights based on its failure to perform its member duty to use best efforts concerning certain property under the operating agreement, the suit directly implicated the member’s performance of its official duties under the operating agreement. Accordingly, advancement was appropriate.

Practice Point

If LLC practitioners import the language of Section 145 of the Delaware General Corporation Law into indemnity and advancement provisions of an operating agreement, the Court of Chancery will look to its Section 145 precedent to interpret the indemnity and advancement provisions, even in the LLC context, where freedom of contract rules.

Delaware Business Court Insider l May 22, 2019

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