July 29, 2009

New Delaware Case Favors Indemnity for Investment Professionals

A recent case from the Delaware Chancery Court, Stockman v. Heartland Industrial Partners, L.P. (July 14, 2009), decided important issues relating to the indemnification of private equity and venture capital professionals by their affiliated funds in connection with their service as directors and officers of the funds’ portfolio companies. The decision was largely in favor of the investment professionals and will likely result in their prevailing on their claims to be indemnified by the fund. Like any of the cases involving the critical issue of indemnification, this one both provides new guidance and confirms the importance of carefully applying existing rules of the road when crafting investment partnership agreements.

The case arose from a failed investment by Heartland Industrial Partners, L.P. (“Heartland”) in Collins & Aikman Corp. (“C&A”), a Detroit-based manufacturer of automotive interior components. David Stockman, a co-founder of Heartland, and Michael Stepp, a Heartland managing director, served as officers and directors of C&A. In March 2005, C&A publicly disclosed and corrected certain accounting errors that it said were revealed during an internal management review. Two months later, C&A filed for bankruptcy protection and was liquidated in 2007.

In March 2007, Stockman and Stepp were indicted by the U.S. Attorney in Manhattan for defrauding C&A’s investors and lenders, and the SEC brought a parallel civil suit against them. Stockman and Stepp were also the subjects of numerous other civil actions. They proceeded to engage counsel to defend themselves and began submitting advancement claims to C&A’s insurance carriers for their legal expenses. These claims were paid until C&A’s policies were exhausted. Stockman and Stepp then submitted claims to Heartland’s insurers until those policies were also exhausted.

With the various suits against them still proceeding, Stockman and Stepp then turned to Heartland itself for advancement and indemnification pursuant to the indemnity under Heartland’s partnership agreement. Heartland refused to advance funds unless Stockman and Stepp agreed to certain conditions including, principally, a cap on the total amount of fees that would be advanced. Heartland took the position that a requirement in the partnership agreement that the general partner approve all advances of expenses allowed it to impose conditions on providing those advances.

Heartland also took the position that no indemnification was available in respect of the criminal prosecution by the U.S. Attorney unless Stockman and Stepp proved in court that their actions that led to the bringing of the criminal complaint did not contravene any of the three exceptions to their entitlement to indemnity set forth in the partnership agreement (i.e., their actions were not opposed to the best interests of the partnership, they had no reasonable cause to believe their conduct was unlawful and their actions did not constitute fraud, bad faith, willful misconduct, gross negligence, a violation of applicable securities laws, or a material breach of the partnership agreement or related advisory agreement).

In deciding the case in favor of Stockman and Stepp, the court established some important principles that will apply in future cases. First, the court noted that it is fundamentally important that the terms of organizing documents (like partnership agreements) be construed uniformly and predictably so that those who rely on them (such as future officers and directors) can be assured of the benefits on which they relied when they joined. This principle furthers the public policy of Delaware, which generally favors indemnification of officers and directors, enabling business entities to attract qualified people to join their enterprises. Applying that principle in cases like this causes the court to decide any ambiguities in favor of the party seeking indemnification.

Second, the court denied Heartland’s claim that the general partner had broad discretion to add conditions to the advancement of expenses merely because it was entitled to consent to such advancements. The court noted that, while in a number of other sections of the partnership agreement the general partner’s right to consent to certain matters was expressly permitted to be in its “sole discretion” or “sole and absolute discretion,” that was not the case as to the expense advancement provision. The court concluded that the general partner consent requirement as to advancement should be read only to permit the general partner to ensure that the prerequisites to advancement set forth in the agreement had been met (i.e., that the expenses were reasonably incurred and the indemnitee undertook to repay non-indemnifiable expenses) and not to allow the general partner to add other conditions or otherwise exercise discretion.

Third, the court resolved the previously unsettled issue whether a dismissal without prejudice (meaning, in theory, the case could be brought again in the future within the statute of limitations) should be considered a “success” by the director or officer seeking indemnification. That issue is crucial since under Delaware corporate law and many investment fund partnership agreements success on the underlying claim generally results in automatic indemnification. Again on this issue, the court found in favor of those seeking indemnification by concluding that dismissals without prejudice do count as success and that indemnitees cannot be made to wait until all related proceedings (e.g., concurrent civil actions) are resolved to receive indemnification in respect of a particular claim on which the indemnitee was successful.

The court’s resolution of the dismissal without prejudice question was important in this case because in January 2009 the U.S. District Court for the Southern District of New York dismissed its case against Stockman and Stepp at the request of the U.S. Attorney. The Heartland partnership agreement, however, did not contain a provision like the Delaware corporate statute which would require mandatory indemnification in a case, like here, in which the indemnitee succeeded. Heartland argued that the absence of the provision indicated the drafters’ intention to exclude the concept of automatic indemnification for successful indemnitees and, therefore, the claims against it should be dismissed. The court, though, concluded that silence alone is not sufficient to preclude an important indemnification right that is consistent with Delaware public policy. That is so particularly when that the drafters of the agreement could have explicitly denied automatic indemnification, but did not.  Perhaps to spur the parties toward a settlement, the court went on to suggest strongly that if the case proceeds beyond the motion to dismiss stage, it would likely read a prevailing indemnitee provision into the agreement.

Some limited partners may focus on the several places in this case where the court noted that partnerships have more freedom to tailor their indemnification arrangements than do corporations under Delaware law. Many of the conclusions in this case favoring Stockman and Stepp could be reversed through simple drafting changes to standard indemnification provisions. However, doing so would create a risk of potential personal financial ruin for investment professionals that would likely prevent many of them from joining partnerships that did not offer standard, fulsome indemnity. A provision reversing the Stockman case would, for example, deny indemnification to an individual who was swept into the investigation of a portfolio company by an over-zealous prosecutor who later concludes the individual is not culpable. Defending oneself from a federal prosecution, even for a short period of time, can result in very substantial legal fees, potentially exhausting the assets of even wealthy individuals.

In light of this case and the other guidance from Delaware on this issue, investment professionals and limited partners who invest in funds should focus on the following when establishing indemnification arrangements:

  • Draft with foresight and be sure your indemnity will pay when you expect it to and be denied only in circumstances intended by both sides
  • Be clear who the gatekeeper is on the critical issue of advancement of expenses and what, if any, discretion can be applied in the granting or denying of advancement
  • Ensure any indemnification comes first from the underlying portfolio company (see our September 8, 2008 client alert, “Levy Decision Clarifies Responsibility for Indemnification Obligations”)
  • Draft any intended limitations on indemnity rights clearly, explicitly and unambiguously, understanding that any lack of clarity will be resolved in favor of the indemnitee
  • Consider carefully the recruiting implications of providing narrower indemnity rights than in the Stockman case; doing so would result in substantially weaker indemnity than directors and officers get from corporate portfolio companies
  • Reconsider the amount of director and officer insurance carried by the fund since the issues in this case only became relevant after the insurance was exhausted

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We would be happy to discuss any of these issues with you in more detail.