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Broad indemnification rights for directors, officers, members, managers and employees are common in large companies. Should small businesses also provide this indemnification? In many cases, the answer is no.

Indemnification is one of the most difficult legal areas most small businesses need to deal with.  It comes up regularly in contracts and agreements.  It is also an important consideration when forming a small business entity.

Important Tip Most form companies and lawyers will automatically insert broad indemnification rights in your governing documents. Think before including these rights or you may end up paying when someone has harmed your small business.

Colorado law, like many other states, provides that corporations and limited liability companies may indemnify directors, officers, members, managers and employees. Almost every public company has a clause in its articles of incorporation or by-laws providing for the indemnification of directors and officers, and sometimes other employees, to the fullest extent provided by law.  Are these clauses also appropriate for small businesses?  

We believe that for most small businesses the answer is no. 

What is Indemnification?

In connection with an entity like a corporation or limited liability company, indemnification is an obligation by the company to protect a director, officer or employee of the company against liabilities incurred by reason of his or her duties on behalf of the company.  So, for example, if an officer is sued for her work on behalf of the company, the company would agree to pay any liabilities (including expenses, in some cases) from the lawsuit against the officer.

 The Law of Indemnification

Most every state will have laws regarding indemnification of officers, directors, managers and employees of corporations and limited liability companies.  In Colorado, for example, these provisions provide for automatic indemnification of a director or an officer if he was wholly successful in legal proceedings (unless provided otherwise in the governing documents of the entity).  The law also provides that indemnification may be made in the case of employees as well, although this is not automatic.  In addition, the law provides for the advancement of expenses to officers and directors to defend them selves and also provides the opportunity to provide indemnification in many cases even if the person being sued loses the lawsuit.

Most large companies will provide for the company to indemnify directors, officers and employees to the fullest extent permitted by the law.

In limited liability companies, Colorado law provides that the limited liability company shall reimburse and indemnify members and managers for payments and liabilities incurred in the ordinary conduct of business.  

Insurance

Director’s and officers insurance is also available to provide the same coverage as is allowed under the law for indemnification.  For most small businesses, this insurance would be an unnecessary expense. When owners serve as the officers and directors of a small business, their interests should be aligned with the best interests of the company.

Limitations on Indemnification

In Colorado, in order to be entitled to indemnification, a person must be acting in good faith and in the best interests of the company.  In the case of a criminal proceeding, the person must have had no reasonable cause to believe his conduct was unlawful.  In addition, there are other limitations associated with employee benefit plans and lawsuits brought by a company.

Small Business Considerations

In many cases, indemnification is required by law (unless modified in the articles of incorporation) and is appropriate for many small businesses.  

In a wholly owned small business, the small business owner should be able to make decisions as to indemnification on a case by case basis, rather than needing a broad rule requiring indemnification in almost all instances.  A small business owner should not be in a position to be forced to indemnify an officer or employee and should not expand indemnification rights in the governing documents of the small business.

Similarly, in a small business owned by very few owners, in most cases, the interests of the small business owners should be the same.  It would be likely that all the owners or directors of the small business would be sued in most cases if one of them were sued.

Only in cases where professional outside directors, officers or managers are used, or the roles of the owners are significantly different (not all of them serve on the Board of Directors or, for example, one of the owners serves as a chief financial officer for the company having different responsibilities than the other owners), would indemnification begin to be an important consideration for a small business.  In these cases, standards should be adopted by the small business providing more certainty and direction to all involved.

Additional Information
Important Tip: 
Most form companies and lawyers will automatically insert broad indemnification rights in your governing documents. Think before including these rights or you may end up paying when someone has harmed your small business.
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