Alert September 08, 2008

Levy Decision Clarifies Responsibility for Indemnification Obligations

Last year’s decision by the Delaware Chancery Court in Levy v. HLI Operating Company, Inc. has resulted in a re-thinking of indemnification arrangements by companies and their private equity and venture capital investors. The Levy case addressed the relative responsibility for indemnification obligations when an investment fund general partner is entitled to indemnification both from the portfolio company on whose board the partner sits and from his or her investment fund. The court ruled that, absent an agreement to the contrary, the fund and the portfolio company have to share liability for any indemnity claims required to be paid. Before this case, many practitioners believed that under applicable law the portfolio company would be fully-responsible for any claims in the first instance, and that the fund would only be liable to the extent the portfolio company was unable to pay (including through any available director and officer insurance). Most indemnification arrangements between fund-appointed directors and portfolio companies, and between the companies and the investment funds themselves, have been based on this concept.

Goodwin Procter and a number of other leading law firms, working under the auspices of the National Venture Capital Association, have proposed revisions to the NVCA Model Indemnification Agreement to provide for primary indemnification liability on the part of portfolio companies, and thus to preclude outcomes like the outcome in the Levy case. The revised agreement has been posted on the NVCA’s website. Because the concept of portfolio companies having primary liability was largely assumed to be the case before the Levy decision, modification of existing indemnity arrangements should not be controversial for investors and companies. We also believe that inclusion of these provisions will emerge as a best practice standard for new investments.

The Levy case may also have broader implications that investment funds and their sponsors should address. For example, the formation documents for most families of funds, including those for the related general partner and management company entities, typically contain similar indemnification obligations. It may not be clear in those documents what the order of liability sharing is which may lead to unintended results in the event of an indemnification claim. In addition, partners serving on boards of directors and sponsors acting as general partners of funds have fiduciary duty issues to consider when dealing with these claims in light of Levy (e.g., whether they have a duty to assert a claim for contribution against their own fund on behalf of a portfolio company that pays a claim pursuant to an agreement that does not contain a provision addressing the Levy case). Others who typically obtain contractual indemnification from their clients and customers, such as commercial and investment banks and other financial intermediaries, should also consider the application of the Levy case to their indemnification arrangements.