Warning: If You Want Legal Fee Advancement or Indemnification, You May Need to Amend Your Partnership, Shareholder, or Operating Agreement
October 24, 2022
The universe works in mysterious ways. Four days ago, when I sat down to write this article, my plan was to feature a decision from Manhattan Commercial Division Justice Andrea J. Masley denying dismissal of a closely-held business owner’s complaint challenging his co-owner’s contractual indemnification under a pair of LLC operating agreements for $2.5 million in legal fees defending a separate lawsuit the same plaintiff brought and mostly lost in Delaware Chancery Court.
The Mehra Case
In the decision, Mehra v Teller (Decision and Order, Index No. 657027/2020 [Sup Ct, NY County Oct. 17, 2022]), Justice Masley held that it was not “unmistakably clear” from the language of two exceedingly broadly worded indemnification provisions that the parties intended to indemnify one another for disputes between the contracting parties (so-called “intra-party” disputes or “direct actions”), as opposed to claims by non-parties to the contract (so called “third-party” claims).
In Crossroads, the Court ruled that where closely-held business owners “use highly inclusive language in their indemnification provision, which they chose not to limit by listing the types of proceedings for which indemnification would be required” – in Crossroads, the contract said “any and all claims, demands, actions, suits or proceedings” – the indemnification provision must be read not to “preclude intra-party claims,” entitling the parties to advancement or indemnification of legal fees in disputes between themselves.
As best I can tell, there are now exactly seven appeals court decisions from three of the four Departments of the Appellate Division explicitly adopting this rule of construction of contract indemnification provisions to cover intra-party disputes unless otherwise specified in the agreement:
Sure enough, just as I was about to start writing my article, Peter Mahler passed along a brand new decision from New York’s highest court, the Court of Appeals, issued three days after Justice Masley decided Mehra, overruling the line of case law I planned to make the focus of my article. Back to the drawing board.
In 2006, Robert Liss (“Liss”), a co-partner with Sage of a general partnership named S-L Properties (the “Partnership”), sued to dissolve the Partnership. After three years of litigation, Manhattan Supreme Court Justice Debra A. James dismissed Liss’ dissolution proceeding, holding that Liss had “unclean hands” and lacked “any evidence” to warrant dissolution.
In 2010, Sage sued Liss, alleging in its complaint a single cause of action for recovery of its legal fees defending against Liss’ unsuccessful dissolution proceeding under Section 13.02 (b) of a partnership agreement providing, in broad language:
The Partnership and the other Partners shall be indemnified and held harmless by each Partner from and against any and all claims, demands, liabilities, costs, damages, expenses and causes of action of any nature whatsoever arising out of or incidental to any act performed by a Partner which is not performed in good faith or is not reasonably believed by such Partner to be in the best interests of the Partnership . . . . (emphasis added).
A decade later, Manhattan Supreme Court Justice Barbara Jaffe, relying in her decision upon Crossroads, Crown Wisteria, WSA Group, and Healthnow, held that the indemnity provision did not “limit the types of proceedings covered by it,” and, therefore, “applies to direct claims between the partners.”
The Appellate Division affirmed, ruling in just two terse sentences, citing Crown Wisteria, that the indemnity agreement’s “broad language encompasses the recovery or attorneys’ fees” and is “not limited to third-party claims.”
The Court of Appeals Decision
Sage moved for, and was granted, permission to appeal to the Court of Appeals. Those interested can read the parties’ merits briefs here, here, and here. You can also watch the oral argument at this link.
In Sage, the Court began with a familiar principle victorious litigants love to hate: “Under the American Rule, a prevailing party” in a breach of contract dispute “may not recover attorneys’ fees from the losing party” unless the agreement contains “express language or indicia of the parties’ ‘unmistakably clear’ intent to indemnify each other for attorneys’ fees in an action between them on the contract” (quoting Hooper Assoc., Ltd. v AGS Computers, Inc., 74 NY2d 487 ).
The Court noted that while the American Rule is “straightforward enough,” in the “context of private agreements” courts must often “determine the intent of vague fee-shifting language and broad indemnification provisions that do not explicitly allow for the prevailing party in an action between contracting parties to collect attorneys’ fees.”
Overturning the nearly decade-old, common-law default rule of Crossroads and its progeny that broad contract indemnification provisions apply to intra-party disputes “in the absence of limiting language” (In re Part 60 RMBS Put – Back Litig.), the Court held:
To the extent that some of these decisions presume that broadly worded indemnification provisions by their nature are intended to cover attorneys’ fees in direct party actions, they deviate from this Court’s exacting standard that the agreement must contain “unmistakably clear” language of the parties’ intent to encompass such actions.
After announcing its abrogation of the Crossroads line of cases, the Court found that “the indemnification provision makes no explicit mention that partners may recoup attorneys’ fees in an action on the contract” and “nothing in the provision nor the agreement as a whole makes ‘unmistakably clear’ that the partners intended to permit recovery for attorneys’ fees in an action between them on the contract.”
As a result, the Court reversed the lower courts’ award of attorneys’ fees and dismissed Sage’s complaint.
Business Owners, Controllers and Corporate Transactional Lawyers Take Heed
Sage is an abrupt wake-up call to closely-held business owners and controllers, and especially to the lawyers who draft their partnership, shareholder, or operating agreements that the answer may be “no.”
No longer may they rely on a generic, broadly-worded indemnification provisions to recover advancement or indemnification of legal fees they incur defending against “intra-party” disputes a/k/a “direct actions” by another party to the contract.
But hope is not lost. A relatively quick fix for the pitfall created by Sage is to amend existing partnership, shareholder, or operating agreements to include language that the right to advancement or indemnity shall include “disputes arising out of or related to this agreement between or among the parties hereto,” or words to that effect, and to explicitly provide for “attorneys’ fees” to the prevailing party. A variety of phrases like this should do the trick.
The Court of Appeals alluded to this drafting solution in Sage, writing at the end of its opinion that “inclusion of clear language stating that the prevailing party is entitled to recover attorneys’ fees in an action between the parties would avoid potential litigation on the issue.”
The problem, of course, is that many business owners, controllers, and their lawyers barely know what’s in their contracts, nor consider amending them, until litigation ensues and it’s far too late. I suspect Sage will come as a bitter pill to many litigants in the years to come, who presumed – wrongly – that a broad indemnification provision in a closely-held entity’s agreement would provide for recovery of legal fees in a dispute under the contract.
Special thanks to my former adversary, Chris Raimondi, for discussing the case and sending me the appeal briefs in Sage.