In last week’s New York Business Divorce, we wrote about an important decision from New York’s highest court, Sage Sys., Inc. v Liss (___ NY3d ___, 2022 NY Slip Op 05918 [Ct App Oct. 20, 2022]).
In Sage, the Court of Appeals overturned a line of case law starting with Crossroads ABL LLC v Canaras Capital Mgt., LLC (105 AD3d 645 [1st Dept 2013]). Crossroads announced a judge-made presumption that in the absence of language in an LLC operating agreement expressly “limiting” an indemnity provision to third-party claims, an otherwise broadly-worded indemnification provision applies to all claims, including those between the parties to the agreement itself (so-called “direct actions” or “intra-party” disputes).
Jettisoning the presumption of Crossroads, Sage announced the opposite presumption: in the absence of express language that an indemnity agreement applies to disputes between the contracting parties, the indemnity agreement applies only to third-party claims.
The Kao Case
Continuing our exploration of the law of advancement and indemnification, we consider this week a recent decision from Manhattan Commercial Division Justice Margaret Chan, Kao v Onyx Renewable Partners L.P. (2022 NY Slip Op 33117[U] [Sup Ct, NY County Sept. 15, 2022]).
In Kao, Justice Chan resolved an executive / minority owner’s motion for court-ordered advancement and indemnification under a contract with Delaware choice-of-law and New York choice-of-venue provisions. Inverse of the partnership agreement in Sage, the employment agreement in Kao provided indemnification only for disputes between the parties to the contract.
The Three Questions
In Kao, the central issues were threefold.
First, whether Delaware law permits an implied right to advancement of legal fees where the contract is silent as to advancement, addressing only indemnification.
Second, whether Delaware law permits a party entitled to contractual indemnification to recover indemnification prosecuting claims — as opposed to defending them — including statutory claims for gender-based discrimination.
Third, whether Delaware law permits recovery of “fees on fees” — legal fees proving one’s legal right to advancement or indemnification.
The Facts of Kao
According to the complaint, Onyx Renewable Partners L.P. (“Onyx”) is a renewable energy firm focusing on the development and financing of commercial, industrial, and small-scale utility solar photovoltaic energy generation funded primarily by investment giant Blackstone Group Inc. (“Blackstone”).
From 2008 to 2015, Kau was an investment banker at Blackstone, leading the renewable energy investment banking practice. In 2015, Blackstone recruited Kau to join Onyx as its President. Later, she became its Chief Executive Officer, as well as a member of its board.
Kau had multiple contracts, one of which was an employment agreement, section 22 of which provided:
Section 22. Litigation; Legal Fees.
The parties acknowledge and agree that in connection with any dispute [sic] any of this Agreement, the Partnership Agreement or the MLP LLC Agreement, the Company shall pay all costs and expenses of the parties to this Agreement, including, without limitation, all legal fees and expenses of the Executive.
The Employment Agreement included restrictive covenants, a provision addressing termination or resignation for “good reason,” and the right to receive severance and other compensation in the event of a “good reason” cessation of employment.
In 2021, Kau submitted a notice of resignation, suing a few months later. Her complaint alleged eight causes of action – all but one of them seeking enforcement of her contracts, including for declaratory judgments and damages for breach. Counts four and six sought advancement and indemnification of her legal fees under section 22 of the employment agreement. Kao’s one conceptually distinct claim was count eight for gender-based discrimination under the New York City and New York State Human Rights Law. Onyx counterclaimed alleging, among other claims, breach of fiduciary duty.
Roughly six months into the litigation, Kao moved by order to show cause for advancement by Onyx of her legal fees pending the litigation, submitting a short affidavit explaining her intent at the time of drafting the employment agreement’s fee-shifting provision and a memorandum of law. Onyx opposed with a lengthy memorandum of law.
Advancement Versus Indemnification
Though Justice Chan did not question Kao’s right to eventual potential indemnification from Onyx for most of her claims, she ruled that section 22 of the employment agreement “cannot be interpreted to require Onyx to pay legal fees and expenses prior to the resolution of the action.”
Section 22, the Court held, lacked any language permitting advancement of fees:
[A]bsent from section 22 is language such as the fees will be paid ‘in advance’ or ‘as incurred’ which would support a finding that Onyx must pay the fees before the end of the litigation (see Majowski v Am. Imaging Mgt. Servs., LLC, 913 A2d 572, 575, 578 [Del Ch 2006] [holding that plaintiff officer of defendant did not have a right to advancement of attorneys’ fees under subject agreements which promised to indemnify and hold harmless defendant’s officers but did not mention the word ‘advancement,’ and noting the contrast with other agreements which clearly provide for the payment of plaintiff’s ‘legal expenses as they are incurred’]; cf. Martinez v. Regions Fin. Corp., 2009 WL 2413858, at *13-14 [Del Ch Aug. 6, 2009] [finding advancement rights where the agreement in question stated that “the Company agrees to pay as incurred . . . all legal fees and expenses”]).
Does Delaware law require any particular magic words for advancement? Not necessarily. Under a line of Delaware cases, a provision that the entity shall indemnify an owner, officer, or director “to the fullest extent permitted by law” provides a right of advancement by implication (Davis v EMSI Holding Co., No. 12854-VCS [Del Ch May 3, 2017]). Unfortunately for Kao, her contract lacked any equivalent language, so the Court denied advancement.
Defensive Versus Offensive Claims
On the question of whether Kao may recover her legal fees prosecuting the lawsuit – as opposed to defending one – some Delaware cases hold that claims “must be responsive or defensive in nature to give rise to an advancement right” (Donohue v Corning, 949 A2d 574, 579 [Del Ch 2008]). But, generally speaking, the question is one of contract: “corporations retain the contractual freedom to explicitly carve-out all counterclaims or offensive claims from advancement” (Zaman v Amedeo Holdings, Inc., No. 3115-VCS [Del Ch May 23, 2008]). In Zaman, the Court adopted a test where “the costs of prosecuting a counterclaim should be subject to advancement if the counterclaim would qualify as a compulsory counterclaim under the traditional counterclaim test used by both Delaware and federal civil procedure” (id.).
The Court did not seem to bat an eye at the notion Kao could potentially recover fees prosecuting her claims, likely because the indemnity provision made no distinction between offensive or defensive legal fees, referring broadly to fees “in connection with any dispute.” The Court also ruled that Onyx’s fiduciary duty counterclaim against Kao fell within the indemnity provision.
The discrimination claim, though, stood on a different footing:
[W]hile Onyx’s obligation to pay attorney’s fees and expenses under section 22 ‘in connection with any dispute’ must be broadly construed, the court finds that such obligation . . . is limited to any dispute relating to the Employment and other agreement referenced in section 22. Thus, Onyx is not obligated to pay attorney’s fees and expenses incurred by plaintiff in pursuing the discrimination and retaliation claims as these claims are not disputes related to the agreements but, instead, arise from alleged violations of New York State Human Rights Law and New York City Human Rights Laws (citation omitted).
I suspect reasonable people could disagree about the Court’s discrimination holding.
One might argue that it’s difficult to imagine how alleged acts of employment discrimination could not be considered “in connection” with a dispute under the employment agreement, particularly since the complaint alleged that her “gender” was a “motivating factor in both Defendants’ adverse employment actions and response to Mrs. Kao’s resignation for Good Cause.”
On the other hand, the employment agreement did not include the “by reason of the fact” language found in many advancement and indemnification enabling statutes, which provide coverage wherever “a ‘nexus or causal connection’ exists between the underlying proceeding and the official’s ‘corporate capacity’” (Kerbs v Bioness Inc., No. 2021-0128-SG [Del Ch Aug. 15, 2022]).
Fees on Fees
Lastly, Kao highlighted a major difference between New York and Delaware law.
In New York, under Baker v Health Mgt. Sys., Inc. (98 NY2d 80 ), closely-held business owners and controllers are not entitled to recover legal fees litigating the right to advancement or indemnification itself – coveted “fees on fees” – unless the entity’s organizational documents or contracts explicitly permit it.
The opposite presumption applies in Delaware: fees on fees are the default rule, but the parties may opt out “to exclude ‘fees on fees,’ if that is a desirable goal” (Stifel Fin. Corp. v Cochran, 809 A2d 555 [Del 2002]). In Stifel, the Delaware Supreme Court wrote that establishing fees on fees as the default rule “gives recognition to the reality that the corporation itself is responsible for putting the director through the process of litigation” and “prevents a corporation from using its ‘deep pockets’ to wear down a former director, with a valid claim to indemnification, through expensive litigation.”
Based upon this case law, Justice Chan ruled that Kau is “potentially entitled to ‘fees on fees,’” but “because Onyx is not required to pay the fees in advance,” deferred ruling conclusively on the question “without prejudice to renewal upon conclusion of this litigation.”