"Defensive Measures--
Three statues govern whether a law firm must indemnify a partner or shareholder against a third-party lawsuit." by Richard S. Rosenberg and Sherrie Lipsky Sheldon

Law firms, sued together with one or more of their attorneys for sexual harassment or similar intentional misconduct, invariably find themselves caught in a strategic conundrum: how to respond to the accused's immediate request for a defense and indemnification without appearing as though the firm is ratifying the offending behavior. Three independent statutory sources implicate whether the firm may (or must) indemnify an associate, partner or shareholder for costs (including attorneys fees) and liability for a judgment or settlement. They are California Labor Code Section 2802 and California Corporations Code Sections 317 and 16,401(c). The form of the business and the status of the accused will determine which of these statute(s) applies.

Labor Code Section 2802 obligates California employers to indemnify an employee for all expenditures and losses "necessarily incurred in direct consequence of the discharge of [the employee's] duties." State and Federal courts in California have interpreted Section 2802 to require indemnification of an employee's legal fees and costs when sued by a third person, as a consequence of conduct which the employee engaged in when discharging his duties. Douglas v. Los Angeles Herald-Examiner, 50 Cal.App.3d 449 (1975); Los Angeles Police Protective League v. City of Los Angeles, 27 Cal.App.4th 168 (1994) (Section 2802 "has been interpreted to require employers in general to pay defense costs incurred by employees when defending unfounded third party civil actions challenging the employees' conduct within the course and scope of their employment"); O'Hara v. Teamsters Union Local No. 856, 151 F.3d 11 52 (9th Cir. 1998.) Notably, the statute does not require the employer to provide the employee with a separate defense. Grissom v. Vons Companies, Inc., 1 Cal.App.4th 52 (1991) ("The word 'defend' does not appear in Section 2802. The statute merely requires that the employer indemnify the employee for all that the employee necessarily expends in direct consequence of the discharge of the employee's duties.") See also O'Hara. Nor does the statute dictate the timing of such indemnification. The employer may want to see what the discovery process reveals, or even await judgment before making the financial commitment. If the underlying lawsuit was brought "solely and exclusively because of acts performed for, at the direction of and with the authorization and approval of [the Firm]," or the acts were "specifically ratified and approved by [the Firm]" then the employee is entitled to indemnity under Section 2802. See Douglas, O'Hara.

However, this obligation is not unlimited, and the contours of this obligation have not been clearly defined in the context of claims of illegal behavior such as sexual harassment. Long before the proliferation of sexual harassment and other workplace misconduct claims, at least one court stated that "an employer does not have a duty to defend an employee who was sued solely because he was off on a frolic of his own not within the scope of his employment and not in obedience to the direction of his employer." Douglas.

Notably, courts grappling to draw the line have distinguished between the term "course and scope of employment" and the more specific statutory term "in the discharge of his duties" in Section 2802. One recent court stated that to have been acting "in the discharge of his duties," under Section 2802, the employee must have acted both "within the course and scope of employment" and the action against the employee must have been "unfounded." Devereaux v. Latham & Watkins, 32 Cal.App.4th 1571 (1995) (indemnification disallowed). Accord. O'Hara ('California's policy decision to broadly construe "within the scope of employment' to create a friendly environment for third party plaintiffs does not require employers to indemnify employees for costs incurred in defending well founded claims levied against them by those third parties,") The 2802 standard for indemnity is, thus, significantly narrower than the principles of respondeat superior and/or vicarious liability. The standard under those doctrines has been defined as "whether the conduct was so unusual or startling that it would be unfair to include the loss as a cost of the employer's doing business." See Devereaux.

Section 2802's narrower standard takes on increased significance in light of three recent California Supreme Court rulings. In Reno v. Baird, 18 Cal.4th 640 (1998), the California Supreme Court distinguished between accusations of "discrimination" and "harassment' when evaluating whether a supervisory employee may be held individually liable. Discrimination involves "the making and implementation of business or personnel management decisions which are inherently necessary to the performance of a supervisor's job duties" (no individual liability attaches for such decisions); whereas harassment, (where there is individual liability) consists "of conduct outside the scope of necessary job performance, conduct presumably engaged in for personal gratification, because of meanness or bigotry or for other personal motives ... not conduct of a type which is necessary for management of the employer's business or performance of the supervisory employee's job." Cf. Lisa M. v. Henry Mayo Newhall Memorial Hospital, 12 Cal.4th 291 (1995) (Employer not liable for employee's sexual assault of a patient because sexual assault is not motivated by desire to serve employer's interest); Farmers Ins. Group v. County of Santa Clara, 11 Cal.4th 992 (1995) (insurer not liable to indemnify sexual harassment by deputy sheriff because conduct was not within scope of employment.) With the narrow interpretation given to the term "discharge of his duties" in Section 2802, and the Supreme Court's rulings in Reno, Lisa M. and Farmers, it is unlikely that a firm would be required to indemnify an employee who engaged in "harassment" or other illegal behavior which the firm did not ratify.

A law firm which adopts a corporate form, must comply with California Corporation Code Section 317(d) and Section 2802 because corporate officers and shareholders are employees as well. Corporations Code Section 317(d) governs mandatory indemnification by corporations of corporate officers, directors and agents for "expenses, judgments, fines, settlements and other amounts actually and reasonably incurred." Section 317(d) mandates indemnification only to the extent that the prospective indemnitee: (1) was sued because he/she is or was an agent of the corporation, (2) acted in good faith and in a manner believed to be in the best interests of the corporation in the conduct giving rise to the suit and (3) was successful on the merits in the proceeding. Corp. Code. ? 317(d). Bancorp v. 7horton Grant 26 Cal.App.4th 926 (1994); Branson v. Sun-Diamond Growers 24 Cal.App.4th 327 (1994). The "success on the merits" requirement renders a determination of the indemnity issue premature until a final and favorable termination of the proceedings on the merits. Dalaney v. American Pacific Holding Corp. 42 Cal.App.4th 822 (1996) (equating the Section 317(d) "success on the merits" requirement" with the "favorable termination on the merits" requirement for maintenance of malicious prosecution actions.)

Corporations Code Section 16,401(c) is the governing indemnification provision applicable to California partnerships and unincorporated associations (other than limited liability companies). Absent a contrary express contractual provision, Section 16,401(c) requires a partnership to reimburse a partner for payments made and indemnify the partner for liabilities incurred by the partner "in the ordinary course of the business of the partnership or for the preservation of its business or property." An act outside the ordinary course of the business of a partnership may be taken only with the consent of all of the partners. Corp.Code ? 16,401. The statute itself, acknowledges that the obligations of a partner to third persons under Section 16,301 ( governing a partner's acts deemed to be made in the ordinary course of the business of the partnership or with apparent authority) may be broader than those determined by the partnership to be in the ordinary course of its business. Corp. Code. ? 16,301. Unfortunately, there are no reported decisions under Section 16,401 nor its predecessor Section 15,018(b), specifically on point. However, the logic and reasoning in Section 317(d) decisions suggest a similar outcome.

Most law firm partners (particularly rainmakers) are not going to want to fund their own litigation expense, particularly if the partner may require separate counsel due to a conflict of interest. Section 317(b) permits indemnification only if there is a determination that the director, officer or agent seeking it has acted (1) in good faith and (2) in a manner reasonably believed to be in the best interests of the corporation (3) with regard to the conduct giving rise to the suit in which the evidence establishes he engaged. Bancorp. See also Plate v. Sun-Diamond Growers 225 Cal.App.3d 11 15 (1990). "[T]he conduct of the agent which gives rise to the claim against him must have been performed in connection with his corporate functions and not with respect to purely personal matters .... Where personal motives, not the corporate good, are predominant in a transaction giving rise to an action, indemnification is not warranted." Plate. Accord: Branson (corporate officers sued for establishing business for their personal benefit, independent of their employer, not entitled to indemnification.) In light of Reno's holding that harassment, by definition, is "conduct for the personal benefit or gratification of the employee" and "outside the scope of employment," a California law corporation ought not indemnify a partner/shareholder in an action wherein the partner/shareholder is found to have engaged in harassment or similar conduct. The same would appear to be true with regard to a California law partnership.

Advancement of fees and costs may be a tool available to the firm who nevertheless wishes to financially support the accused partner/shareholder. Any such arrangement should be pursuant to a prior written undertaking to reimburse the firm unless and until there is a determination that the partner/shareholder is entitled to be indemnified under applicable statutes. See Corp. Code ?? 317(f), 16,401(j). Advancement (subject to the repayment undertaking) also allows the firm to avoid the appearance of taking action which later could be construed as ratification of the alleged misconduct.

In the end, strategic considerations often drive the indemnity decision, especially where the firm will be responsible legally for the accused's behavior (such as in a sexual harassment claim). Applicable sex harassment law obligates the firm to investigate and remedy any harassment. Yet, if the partner is dismissed and left to fend for himself, it may be difficult to secure the partner's absolute cooperation in the firm's defense. Of course, divisiveness on the defense side may signal to the accuser that the firm believes the accused engaged in the offending behavior. Indeed, the firm also may wish to have the accused enter into a joint defense agreement. These immensely important matters of legal compliance and strategy must be carefully reviewed with defense counsel before adopting any indemnity strategy.