LLC Operating Agreements: Indemnity, Arbitration, and Equity
LLC operating agreements frequently provide for indemnity to the LLC’s manager. This is consistent with the statutory default rule embodied by California Corporations Code section 17704.08(a), which provides for indemnity for any “debt, obligation, or other liability” incurred by the manager in the course of the manager’s activities on behalf of the LLC, so long as the manager complied with his/her fiduciary duties.
The easy-to-grasp concept underlying most operating agreement indemnity provisions is that if the LLC’s manager is sued by some third party who has done business with the LLC, the manager should be indemnified by the LLC.
But some indemnity provisions are written very broadly, and the manager’s indemnity rights can be unclear in the context of expenses incurred in lawsuits filed by the LLC’s members against the manager.
An opinion recently published by California’s Fourth Appellate District — Starr v. Mayhew (order for publication here) — addressed this issue in the context of a dispute between an LLC manager and its members decided in arbitration.
Facts: LLC dispute regarding membership interests and manager fiduciary duties; manager claims right to indemnity for attorney fees
Defendant Jeffrey Mayhew and Plaintiffs David Starr and Thomas Hunt formed Strata Tustin, LLC in 2003 to develop and operate a shopping center in Tustin, California. Starr and Hunt owned a collective 50% membership interest and contributed $500,000 in initial capital. Mayhew, who owned the remaining 50% ownership interest, contributed “sweat equity” and was designated the LLC’s manager.
The shopping center’s business declined in 2008, and Mayhew requested additional capital contributions from Starr and Hunt to keep the business afloat. Starr and Hunt opposed the capital call unless Mayhew also contributed. Eventually, Starr and Hunt contributed approximately $100,000 in additional capital. Mayhew forgave $100,000 of the debt the LLC owed him and represented to Starr and Hunt that he had made his contribution.
The business eventually turned around, and the LLC sold the shopping center in 2018 for a profit of roughly $7.8 million. The parties disputed their proportionate share of entitlement to profits. Mayhew claimed that the history of contributions allowed him to “unilaterally increase his ownership” of the LLC beyond the 50% interest set forth in the LLC’s records.
Starr and Hunt filed arbitration claims pursuant to the operating agreement’s arbitration provisions, seeking a declaration that Mayhew held only a 50% ownership interest, and seeking damages against Mayhew for various alleged instances of misconduct and breaches of fiduciary duty.
Arbitration award: manager entitled to only limited indemnification; anything more would be inequitable
In the early stages of the arbitration proceedings, Mayhew requested that the arbitrator authorize an advance of his attorney fees under the LLC operating agreement’s indemnity clause. The indemnity clause provided that the LLC’s manager “shall not be liable for and shall be indemnified and held harmless … from any loss or damage incurred … in connection with the business of the Company, including costs and attorneys’ fees … resulting from any act or omission performed or omitted in good faith, which shall not constitute gross negligence of willful malfeasance … to promote the interests of the Company.”
The arbitrator granted Mayhew $250,000 in advanced indemnity. Mayhew requested additional indemnity during the arbitration proceedings.
In the final award, the arbitrator found for Starr and Hunt on the ownership issue, holding Mayhew owned only a 50% interest. The arbitrator also awarded $53,384 in damages against Mayhew, and awarded Starr and Hunt nearly $500,000 in prevailing party attorney fees and costs. As to the indemnity issue, the arbitrator denied Mayhew’s request for additional indemnity for the attorney fees he incurred during the arbitration, but also rejected Starr and Hunt’s argument that Mayhew should refund the initial $250,000 in advanced indemnity.
After the final award, Mayhew sought clarification as to whether he was entitled to indemnity for the damages and fees awarded against him in the final award. The arbitrator rejected Mayhew’s position, holding: “all attorneys’ fees and damages awarded against Mr. Mayhew are his personal obligation and the company is not required to indemnify him for such fees and damages.” The arbitrator explained that additional indemnity for attorney fees would be unreasonable due to Mayhew’s poor management, including a “borderline” violation of fiduciary duty. Specifically, the arbitrator found “there were numerous problems with recordkeeping, contemporaneous invoicing of expenses, sloppy bank reconciliation and commingling of funds from other projects.”
The superior court confirmed the arbitration award as a judgment. Mayhew appealed.
Court of Appeal: affirmed
The Court of Appeal affirmed the trial court’s order confirming the arbitration award.
The court rejected Mayhew’s argument that the language of the operating agreement (manager “shall be indemnified”) required the arbitrator to grant him indemnity against all of the damages and fees awarded against him on Starr and Hunt’s claims. The court observed the wide discretion afforded to arbitrators: “Arbitrators also have wide latitude in crafting awards. They are not bound to award on principles of dry law, but may decide on principles of equity and good conscience, and make their award ex aequo et bono [according to what is just and good].”
Applying those principles, the court held: “Nothing in the operating agreement prevented the arbitrator from limiting the amount of his indemnity based on equitable principles.” Noting that Mayhew had breached his fiduciary duties, the court concluded that “any additional award of indemnity to Mayhew would be inequitable due to his conduct.”
Lesson
Under the holding of Starr v. Mayhew, even if an operating agreement contains a broad indemnity provision in favor of the manager, indemnity can be limited on equitable grounds, especially within the context of arbitration proceedings. Arbitrators have wide discretion in their rulings and are not necessarily required to follow the law, so the impact of this case is probably limited.