North Carolina Business Court’s Recent Opinions on Advancements and Indemnification for Company Officials

Serving as a company official—whether an LLC manager or an officer or director of a corporation—can sometimes be a risky prospect.  Company officials on occasion find themselves at the center of complex litigation solely because of their role as a company official.  Two related—but legally distinct—doctrines help a company official share the risks of litigation with the company they serve. 

The first doctrine is indemnification.  As the North Carolina Business Court has explained, indemnification “is the company's promise to reimburse an official—such as an officer, director, or manager—‘for all out of pocket expenses and losses caused by an underlying claim.’ ”  Vanguard Pai Lung, LLC v. Moody, No. 18 CVS 13891, 2020 WL 4477043, at *2 (N.C. Super. Aug. 4, 2020) (quoting Wheeler v. Wheeler, 2018 NCBC LEXIS 156 at *26 (N.C. Super. Ct. Nov. 15, 2018)).

But this reimbursement only comes after the official successfully defends himself.  In a world where mounting a legal defense is an expensive and drawn-out process, the company's promise to indemnify the official at the end of it all may feel like a meaningless gesture. 

This is where the second doctrine, advancement, comes in.  Advancement allows the company official to be reimbursed by the company for the out-of-pocket costs of his legal defense as those expenses accrue—and before his right to indemnification is established.  If it turns out that the company official is not entitled to indemnification, he must repay the funds.  The right to advancement is distinct from the right to indemnification, meaning that the company official gets advanced the funds even if he is not ultimately entitled to indemnification.

Advancement “provides corporate officials with immediate interim relief from the personal out-of-pocket financial burden of paying the significant on-going expenses inevitably involved with investigations and legal proceedings.”  Vanguard Pai Lung, LLC v. Moody, No. 18 CVS 13891, 2020 WL 4477043, at *2 (N.C. Super. Aug. 4, 2020) (quoting Homestore, Inc. v. Tafeen, 888 A.2d 204, 211 (Del. 2005)).

Sources of a Company Official’s Right to Advancement or Indemnification

Because LLCs and corporations are governed by separate statutory schemes, different default rules apply to indemnification and advancement depending on the legal status of the company. 

By default, under the North Carolina Limited Liability Company Act (N.C. Gen. Stat. Chapter 57D), an LLC must indemnify every member, including any member who is serving as a manager or company official, for expenses incurred by that person in connection with a proceeding to which that person was a party because of their position.  N.C. Gen. Stat. § 57D-3-31.  A member-manager being sued for breach of fiduciary duty, for example, would be entitled to indemnification if he successfully defended himself in the suit.

Similarly, under the default rules of the North Carolina Business Corporation Act (N.C. Gen. Stat. Chapter 55), a corporation must indemnify a director who wholly succeeds in defending himself in a proceeding to which he was a party because he was a director of the corporation.  N.C. Gen. Stat. § 55-8-52.  Additionally and by default, a corporation, may indemnify officers, employees, or agents of the corporation to the same extent as to a director.  N.C. Gen. Stat. § 55-8-56(2).

The LLC Act and Corporation Act differ when it comes to advancement, i.e. paying litigation expenses before conclusion of a case.  The Corporation Act expressly authorizes (but does not mandate) the corporation to advance litigation expenses to indemnitees while the LLC Act does not mention advancement.  Compare N.C.G.S. § 55-8-53 with N.C.G.S. § 57D-3-31.  Despite the LLC Act’s silence on advancement, the North Carolina Business Court recognizes that “[w]ithout question, [a]dvances of expenses may . . . be addressed in an operating agreement.’ ”  Vanguard Pai Lung, LLC v. Moody, No. 18 CVS 13891, 2020 WL 4477043, at *3 (N.C. Super. Aug. 4, 2020) (citation omitted).  There is one consequence of the LLC Act’s silence on advancement: if an LLC’s operating agreement does not address advancement, there is no default rule permitting an LLC official on the wrong side of a lawsuit to recoup his legal expenses during the pendency of the suit.

Application of the Rules to Suits between the Company and its Officials

Ideally, advancement and indemnification work hand in glove to protect company officials from unjustified lawsuits while keeping company officials on the hook for their bad faith conduct.  But in more contentious cases, advancement has the “admittedly maddening aspect” of requiring the company to advance funds to an official who may have intentionally injured the company.  Reddy v. Electronic Data Systems Corp., 2002 WL 1358761 at * 5 (Del. Ch. 2002).

Companies are reluctant to use their funds to defend a reprobate official and they often blitz cases with early, aggressive motions practice in an effort to strip away the company official’s entitlement to advancement. 

Though there is a “dearth of North Carolina appellate authority on the rights to indemnity and advancement[,]”  Clark v. Burnette, No. 19 CVS 8565, 2020 WL 7059336, at *4 (N.C. Super. Dec. 2, 2020), the North Carolina Business Court has provided guidance to company officials and practitioners about the perils and opportunities presented by advancement and indemnification provisions.

Wheeler v. Wheeler

The closely held corporation in Wheeler v. Wheeler erupted in litigation when Gray Wheeler, a minority shareholder and the former president of the corporation, brought claims for breach of fiduciary duty, constructive fraud, and unfair or deceptive trade practices against his father, the majority shareholder of the corporation.  Wheeler v. Wheeler, No. 17 CVS 16248, 2018 WL 6133510, at *2 (N.C. Super. Nov. 15, 2018).  The corporation asserted counterclaims against Gray, alleging that he, as president, secretly increased his compensation without board approval and jeopardized the company’s relationship with its principal supplier.  Id.  The corporation’s bylaws allowed former directors and officers to receive indemnification and advancement, so Gray moved for a preliminary injunction to receive an advancement to defend himself in the suit.  The Court held that Gray had a clear right to advancement under the bylaws, but nevertheless denied Gray’s motion for preliminary injunction because he could not show irreparable harm if he were denied his advancement. 

Gray made a procedural blunder by using a preliminary injunction as the vehicle for his quest for advancement.  Since advancement is really just the payment of money and since an injury is not usually irreparable if it can be compensated with money, failing to advance funds to a company official is generally not an irreparable harm.  Id. at *16.  The Court noted that, in Delaware, well-advised litigants move for summary judgment or other summary proceedings to establish their entitlement to advancement.  Id. at *15.  The Court left the door open for a company official to prevail on a preliminary injunction for advancement if he could show that his missing advancement specifically harmed his litigation strategy.

Vanguard Pai Lung v. Moody

In Vanguard Pai Lung, LLC v. Moody, Vanguard, a North Carolina LLC that makes and sells high-speed circular knitting machines, sued Moody, the former president and CEO of Vanguard.  The LLC accused Moody of “pervasive disloyalty [and] refused to advance his litigation expenses.”  No. 18 CVS 13891, 2020 WL 4477043, at *3 (N.C. Super. Aug. 4, 2020).  Moody counterclaimed for advancement and indemnification and moved for partial judgment on the pleadings on his advancement counterclaims.

The parties disputed whether Moody had been sued “by reason of the fact that” he was an authorized representative of Vanguard, a necessary condition for Moody to receive advancement under the operating agreement.  Relying on the Wheeler decision and Delaware law, Judge Conrad held that the language “by reason of the fact that” merely requires a “nexus” between “the underlying claim and the official’s corporate capacity.”  Id.  Judge Conrad held that Vanguard’s allegations that Moody “used his positions” at Vanguard to commit the alleged misconduct made it “plain as day” that there was a nexus between Vanguard’s claims and Moody’s capacity as a company official. Id. at *4.

The Court swatted down two affirmative defenses that Vanguard raised in an attempt to dodge its advancement obligations:

• Moody materially breached the Operating Agreement, thereby excusing Vanguard from advancing expenses
  • The Court rejected this argument as “not persuasive” and likened advancement provisions to forum selection clauses, which function independent of other promises in a contract and trigger in the event of litigation.
• Moody covered up his misconduct, so his advancement claim is barred by his own unclean hands
  • The Court rejected this argument because “[i]f an official's alleged misconduct amounted to unclean hands, it ‘would turn every advancement case into a trial on the merits of the underlying claims,’ contrary to the nature and purpose of advancement.” Id. at *5 (quoting Reddy, 2002 Del. Ch. LEXIS 69, at *28–29, 2002 WL 1358761).
     

The Court ultimately entered judgment in favor of Moody, awarding him advancement.  The Court noted that the majority of jurisdictions in the country consider “[a]dvancement cases [to be] particularly appropriate for resolution on a paper record. . . .” Id. at *7 (quoting  DeLucca v. KKAT Mgmt., LLC, 2006 Del. Ch. LEXIS 19, at *20, 2006 WL 224058 (Del. Ch. Jan. 23, 2006))

The Business Court has made clear that advancement, where provided by statute or agreement, is not optional for the company.  The company might contend that a determination on entitlement to advancement must wait until the company official successfully defends herself, but the Court’s answer has consistently been that advancement of legal expenses must be made during the course of the litigation for which they are sought.

Finally, it is worth mentioning that, in January 2023, Judge Earp recognized a company official’s right to advancement, although this case applied Delaware law.  Futures Group v. Brosnan, 2023 NCBC 4, 2023 NCBC LEXIS 7, 2023 WL 325113.

Takeaways

Across these cases, some trends emerge:

1. North Carolina courts will construe your advancement provision as it is written.  If you put no constraints on advancement, the Court will not—and indeed cannot—invent constraints to chain down the advancement provision once litigation starts up.

• You can use this fact to your advantage.  Providing advancement in every situation where indemnification is theoretically available may not make sense for every LLC or corporation.  Corporations and LLCs have great latitude to customize their bylaws and operating agreements.
• For example, a company fearing that its company officials are a bad credit risk and may not repay the advanced funds could amend its bylaws or operating agreement to require company officials to put up full security before receiving advancement.
   

2. Advancement and indemnification have an outer limit.  They are limited to defending against claims related to a company official’s conduct as a company official.  However, “defending” can include asserting compulsory counterclaims.  Vanguard Pai Lung, LLC v. Moody, No. 18 CVS 13891, 2020 WL 4477043, at *6 (N.C. Super. Aug. 4, 2020).  If the company official wants to prosecute her own, unrelated counterclaims and get advancements or indemnification for them, then she is out of luck. 
    
3. The LLC act and the Business Corporation Act have different default terms.

• Judge Conrad points out that the North Carolina Business Corporation Act expressly authorizes the corporation to advance litigation expenses to indemnitees while the LLC Act is silent on advancement.  Vanguard Pai Lung, LLC v. Moody, No. 18 CVS 13891, 2020 WL 4477043, at *3 (N.C. Super. Aug. 4, 2020).  Unless the operating agreement permits advancement, LLC officials may not be entitled to it.  Compare N.C.G.S. § 55-8-53 with N.C.G.S. § 57D-3-31.
• Further, the North Carolina Business Corporation act requires the receiving company official to execute an “undertaking . . . to repay such amount” as a condition of receiving an advancement.  N.C.G.S. § 55-8-53.  The LLC Act has no such advancement provision and therefore has no undertaking requirement.
   

4. Companies are frequently reluctant to advance expenses to company officials they accuse of misconduct, even when plain contract language mandates advancement.  Courts are eager to decide advancement disputes in a summary fashion and on a paper record.  Conflating the company official’s entitlement to advancement with the company official’s ultimate entitlement to indemnification is unlikely to succeed.

This article contains general, condensed summaries of actual legal matters, regulations, and opinions for informational purposes. It is not meant to be and should not be construed as legal advice. Readers with particular needs on specific issues should retain the services of competent counsel. For more information, please contact Camden Webb at 919.981.4021 or via email at crwebb@williamsmullen.com or Killian Wyatt at 919.981.4062 or via email at kkwyatt@williamsmullen.com.