Indemnification for Investment Professionals by Their Funds

collins-aikman

A recent case decided some 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 their portfolio companies. Stockman v. Heartland Industrial Partners, L.P., (July 14, 2009), Delaware Chancery Court.

David A. Stockman and J. Michael Stepp were investment professionals at Heartland Industrial Partners, L.P. (“Heartland”). They also served as officers and directors of Collins & Aikman Corporation (“C&A”), and joined C&A at the direction of Heartland.

C&A got itself into some accounting trouble. That also got Stockman and Stepp involved in civil and criminal proceedings in connection with their roles at C&A. Stockman and Stepp sought advancement of legal fees and indemnification from C&A, and when C&A’s insurance was exhausted, they sought advancement of legal fees and indemnification from Heartland. Heartland refused to advance legal expenses to Stockman or Stepp unless they agreed to additional conditions not written in the Partnership Agreement.

Stockman and Stepp argued that both advancement and indemnification to them are mandatory under Heartland’s Partnership Agreement.

Heartland took the position that the Partnership Agreement granted it the discretion to impose additional conditions beacuse of the requirement in the advancement provision that Heartland’s General Partner give prior approval. Heartland contended that advancement is not mandatory when its General Partner has refused to provide written approval. Also, Heartland argued that indemnification is not mandatory because Stockman and Stepp must prove that the conduct giving rise to the underlying dismissed criminal action met three requirements set forth in the Partnership Agreement. Heartland asserted that it is Stockman and Stepp’s burden to demonstrate that they i) did not breach their duties to the partnership; ii) did not knowingly violate applicable law; and iii) did not act with scienter.

The court found in favor of Stockman and Stepp on both their advancement and indemnification claims “because the plain language of the Partnership Agreement does not unambiguously support Heartland’s reading of that document.” To the extent there is any ambiguity in the Partnership Agreement regarding advancement, that ambiguity must be resolved against the partnership in favor of the officers.

The Partnership Agreement contains a broad indemnification provision:

To the fullest extent permitted by law, the Partnership agrees to indemnify and save harmless each of the Indemnitees from and against any and all claims, liabilities, damages, losses, costs and expenses . . . of any nature whatsoever, known or unknown, liquidated or unliquidated, that are incurred by any Indemnitee and or to which such Indemnitee may be subject by reason of its activities on behalf of the Partnership or in furtherance of the interest of the Partnership or otherwise arising out of or in connection with the affairs of the Partnership, its Portfolio Companies or any Alternative Vehicle . . . provided, that: (i) an Indemnitee shall be entitled to indemnification hereunder only to the extent that such Indemnitee’s conduct (A) was in or was not opposed to the best interests of the Partnership, (B) in the case of a criminal action or proceeding, the Indemnitee had no reasonable cause to believe his conduct was unlawful, or (C) did not constitute fraud, bad faith, willful misconduct, gross negligence, a violation of applicable securities laws or any material breach of the Agreement or the Advisory Agreement . . .

and advancement rights under certain conditions:

Expenses reasonably incurred by an Indemnitee in defense or settlement of any claim that may be subject to a right of indemnification hereunder shall be advanced by the Partnership prior to the final disposition thereof upon receipt of an undertaking by or on behalf of the Indemnitee to repay such amount to the extent that it shall be determined ultimately that such Indemnitee is not entitled to be indemnified hereunder. No advances shall be made by the Partnership under this Section 4.4(b)(i) without the prior written approval of the General Partner or (ii) in connection with an action brought against an Indemnitee by a Majority in Interest of the Limited Partners.

So, advancement of expenses to Heartland Indemnitees is mandatory under the Partnership Agreement, subject to the requirement of prior written approval from the General Partner.

You may want to check the indemnification and advancement provisions of your partnership agreements to see how well they work on the basis of this decision.

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