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By Ryan M. Billings
Kohner, Mann & Kailas, S.C.
Milwaukee, Wisconsin

Owners of corporations and limited liability companies can have statutory and contractual obligations to indemnify officers, directors, managers, and members for legal fees incurred in defending litigation. Ryan M. Billings discusses equity holders' exposure to legal fees when a company brings suit against its former officers, directors, managers, or members.

While the articles of incorporation may alter these duties, Wisconsin law requires a corporation to indemnify a director or officer (D/O) for all reasonable expenses incurred in defending a lawsuit when:

  • the D/O was a party in the suit because he or she was a D/O of the corporation and
  • the D/O was successful on the merits or noneof the following applies:
    1. the D/O willfully failed to treat the corporation fairly in a transaction in which the D/O had a material conflict of interest;
    2. the D/O’s conduct was in violation of criminal law, unless the D/O had reasonable cause to believe the conduct in question was lawful or no reasonable cause to believe the conduct unlawful;
    3. the D/O derived an improper personal profit; or
    4. the D/O engaged in willful misconduct.1

Further, unless otherwise provided in the articles of incorporation, the directors of a corporation are immune from liability for breach of any duty resulting solely from their status as directors, unless any of 1-4 above apply.2 This is Wisconsin’s codification of the business judgment rule.

Similarly, while the operating agreement may alter these duties, Wisconsin law requires a limited liability company to indemnify a member or manager (M/M) for all reasonable expenses incurred in defending a lawsuit:

  • when the M/M was sued in his or her capacity as an M/M of the limited liability company, and
  • the M/M was either successful on the merits, or
  • none of 1-4 above applies.3

(D/Os and M/Ms are collectively referred to as DOMM).

Consider then the following scenario: a corporation or LLC terminates a DOMM for wrongdoing and sues the terminated DOMM to recover damages stemming from the misconduct. Unless the corporation or LLC both prevails on the merits and shows that the DOMM engaged in self-dealing or knowingly committed wrongdoing, the corporation or LLC will wind up having to pay the DOMM’s attorneys’ fees.

The Why of Mandatory Indemnification

These rules were created by the legislature “because directors often were sued for actions taken on behalf of corporations and that litigation was causing directors to resign and to refuse to serve on boards of directors.”4

Without mandatory indemnification, the theory goes, good leaders would not be willing to lead Wisconsin companies. The consequence in a misbehaving DOMM scenario is that a company that pursues a former leader for wrongdoing risks exposure to paying the former leader’s legal fees. And since civil litigation is largely driven by economic incentives, this exposure can influence a company’s decision whether to sue a former DOMM for losses it believes were caused by the former DOMM’s misdeeds.

In cases where the wrongdoing is at all debatable, it could be rational for a company to let the DOMM escape liability rather than risk further losses to the equity holders in the form of mandatory indemnification of attorneys’ fees and costs.

Moreover, unless otherwise provided in the articles of incorporation, a D/O seeking indemnification gets to choose which of the following entities decides whether the corporation must indemnify them:

  1. the board of directors;
  2. independent legal counsel;
  3. a panel of 3 arbitrators;
  4. the shareholders;
  5. the court; or
  6. any other legal method provided for in the articles of incorporation, bylaws, by contract, or by resolution of the board.5

As counsel and arbitrators are normally paid by the hour, the D/O’s selection of options B or C above can impose additional costs on the corporation, and thus operate as a further disincentive to pursue wrongdoing.

Regardless of who decides and what the articles of incorporation say, a corporation may not indemnify a D/O unless it determines that the D/O did not breach any of the duties specified in Wis. Stat. section 180.0841(2)(a) (i.e., the four criteria outlined above).6

Case Law and Indemnification

Case law on indemnification under these statutes is relatively thin.

In Merge Healthcare, Inc. v. Linden,7 the court determined that a D/O could be “successful” on the merits even if the fact-finder determined that the D/O broke a law. Further, the court of appeals has held that determination of whether a D/O was sued because of acts undertaken in their capacity as a D/O is not controlled by the allegations of the complaint, but can take into account the focus of the litigation.8

So, success is not clear cut, and whether a D/O was pursued for acts as a D/O cannot always be conclusively established at the start of litigation. This uncertainty is a further disincentive for a corporation to pursue DOMM wrongdoing.

For LLCs, the determination whether an M/M is to be indemnified is made by a majority vote of the members or managers who are not parties to the proceedings (or by a straight majority vote if all members are parties), although this can be altered by the operating agreement.9

However, regardless of the language in the operating agreement, an LLC like a corporation may not indemnify an M/M unless it affirmatively determines that the M/M did not violate any of the four duties outlined above.10

Only one reported case discusses indemnification of an M/M under Wisconsin law, and that was a disciplinary proceeding that provides little insight into how courts will view either the default statutory rules or an LLC’s ability to tinker with them.11 Uncertainty is expensive, but in theory clear language in the operating agreement or articles of incorporation ex ante can provide at least some guidance when a dispute arises ex post.

The Disincentive to Pursue Litigation

The possibility of paying “double” attorneys’ fees (one’s own and the other side’s) is a tool often used by the Wisconsin legislature to encourage plaintiffs (and plaintiffs’ attorneys) to bring certain kinds of litigation deemed to be beneficial to society.

Mandatory indemnification, however, has the opposite effect when it comes a company pursuing the misdeeds of former leaders. It seems likely that the Wisconsin legislature was motivated by concerns of frivolous nitpicking lawsuits when it decided to adopt mandatory indemnification of DOMM. But, in the context of actions brought by a company against a former DOMM terminated for wrongdoing, the incentives created by mandatory indemnification are arguably perverse.12

This is something to be considered when forming a Wisconsin corporation or LLC – both corporations and LLCs can address this concern by careful language in their articles of incorporation or operating agreement.

This article was originally published on the State Bar of Wisconsin’s Business Law Blog. Visit the State Bar sections or the Business Law Section web pages to learn more about the benefits of section membership.

Endnotes

1 Wis. Stat. §§ 180.0851(1), (2)(a), 180.0852.

2 Wis. Stat. § 180.0828(1)-(2).

3 Wis. Stat. §§ 183.0403(2), (3), (5)(a), 183.0402.

4 Data Key Partners v. Permira Advisers LLC, 2014 WI 86, ¶ 55 (citing A Comprehensive Approach: Director and Officer Indemnification in Wisconsin, 71 Marq. L. Rev. 407, 411 n.23 (1988)).

5 Wis. Stat. § 180.0855.

6 Wis. Stat. § 180.0858(2).

7 Merge Healthcare, Inc. v. Linden, No. 10-CV-82, 2010 WL 4065588, at *2-3 (E.D. Wis. Oct. 15, 2010).

8 Ehlinger v. Hauser, 2008 WI App 123, ¶ 47, aff’d as modified and remanded, 2010 WI 54.

9 Wis. Stat. § 183.0403(5)(b).

10 Wis. Stat. § 183.0402.

11 See In re Disciplinary Proceedings Against Reitz, 2005 WI 39, ¶ 29.

12 Cf. Jesse v. Four-Wheel Drive Auto Co., 177 Wis. 627, 189 N.W. 276, 279 (1922) (noting the uneven battle of plaintiff shareholders “fighting before the breastworks” against defendant directors fighting “from behind the breastworks,” and the inequity in forcing the plaintiffs “to assist the tort feasant directors in their defense” by paying the directors’ legal fees).