Delaware Chancery Court Ruling May Alter Indemnification Expectations for Private Equity Funds

In Levy v. HLI Operating Co., Inc [1]., the Delaware Court of Chancery held that a private equity fund and its portfolio company will be jointly liable for indemnifying directors appointed by the fund. Following this reasoning, a fund that advances settlement amounts and defense costs to its director representatives would be able to maintain an action for contribution against the portfolio company for only a portion of the indemnification amounts advanced, absent a provision for relative priority of indemnification responsibility.

Sponsors of private equity funds and certain other funds[2] should review their agreements with portfolio companies, as well as their fund limited partnership agreements, and consider making revisions to clarify that portfolio companies will have the primary liability for any indemnification obligations of fund representatives who serve as portfolio company directors, as was the assumption prior to Levy.

Opinion

The case arose from a typical request for the payment of indemnification costs from defendant directors. Security holders of HLI Operating Company, Inc. (HLI) filed a lawsuit against HLI and its directors, including the director representatives of Joseph Littlejohn & Levy Fund II, L.P. (JLL), following a restatement of HLI’s financials. After a settlement was reached, JLL’s representatives requested—and were denied—indemnification from HLI under HLI’s bylaws and indemnification agreements. JLL’s representatives then sued HLI for indemnification. In the interim, JLL paid its representatives’ settlement and defense expenses relating to the security holder litigation pursuant to an indemnification provision in JLL’s limited partnership agreement.

The court held, inter alia, that JLL’s representatives did not have a cause of action because their right to receive indemnification from HLI was extinguished by JLL’s payments, but JLL could sue HLI for equitable contribution and recover some of the cost of indemnification for the directors. The court ruled that when a fund and a portfolio company both make fullest-extent-of-the-law commitments to indemnify the directors without contractual language that establishes priority of payment, those agreements create a joint and several obligation to an indemnitee. Therefore, if an indemnitee proceeds against only one indemnitor, that indemnitor would not be entitled to a full recovery of its advance under subrogation (a suit by a person against a person that caused a loss, to obtain reimbursement of the amount of the loss), but could only sue the other indemnitor for a contribution of its portion of the amounts paid.

Potential Solutions

Funds may attempt to overcome the ruling in the Levy decision by contract. The clearest method for overcoming the ruling is to enter into an indemnification contract with a portfolio company that stipulates that the portfolio company is primarily liable for indemnification obligations to directors appointed by a fund. A fund may also be able to mitigate the consequences of the decision by amending its limited partnership agreement to expressly state that any indemnification that a fund would provide to persons serving as directors of a portfolio company at its request would be secondary. Similarly, fund sponsors should consider clarifying indemnification provisions in their upper tier documentation to establish order of priority in relation to their funds with respect to fund matters, as presumably the same principle could apply in respect of advances made by a general partner or fund manager properly reimbursable by the fund.


[1]924 A.2d 210 (Del Ch. 2007)

[2] The above indemnification issue may be relevant to activist hedge funds that nominate directors for the boards of their portfolio companies.

 

CONTACT INFORMATION

If you have any questions regarding this alert, please contact-



Mark H. Barth

mbarth@akingump.com 212.872.1065 New York
David M. Billings dbillings@akingump.com 44.20.7012.9620 London
J.P. Bruynes jpbruynes@akingump.com 212.872.7457 New York
James A. Deeken jdeeken@akingump.com 214.969.4788 Dallas
Christopher M. Gorman-Evans cgorman-evans@akingump.com 44.20.7012.9656   London

Barry Y. Greenberg

bgreenberg@akingump.com 214.969.2707 Dallas
Robert M. Griffin Jr. bgriffin@akingump.com 44.20.7012.9676 London
Leon B. Hirth lhirth@akingump.com 212.872.1059 New York
Ira P. Kustin ikustin@akingump.com 212.872.1021 New York
Arina Lekhel alekhel@akingump.com 212.872.8018 New York
Burke A. McDavid bmcdavid@akingump.com 212.872.1083 New York
Prakash H. Mehta pmehta@akingump.com 202.887.4248 Washington, D.C.
Lisa A. Peterson lpeterson@akingump.com 817.886.5070 Dallas
Eliot D. Raffkind eraffkind@akingump.com 214.969.4667 Dallas
Fadi G. Samman fsamman@akingump.com 202.887.4317 Washington, D.C.
William L. Sturman wsturman@akingump.com 212.872.1035 New York
Ann E. Tadajweski atadajweski@akingump.com 212.872.1087 New York
Simon Thomas swthomas@akingump.com 44.20.7012.9627 London
Stephen M. Vine svine@akingump.com 212.872.1030 New York