Double-check indemnity

A recent case in Delaware highlights the need for private equity and venture capital firms to go over the indemnification provisions in their partnership agreements in order to avoid getting hit with a costly judgment.

Private equity and venture capital funds should make sure their partnership agreements are sufficiently clear regarding indemnification in the wake of a recent decision handed down by a Delaware court.

The issue arose from a failed investment by private equity firm Heartland Industrial Partners in automotive manufacturer Collins & Aikman, which filed for bankruptcy and was liquidated in 2007 after certain accounting errors were disclosed. Heartland co-founder David Stockman and managing director Michael Stepp, who also served as officers and directors at C&A following the investment, were subsequently indicted by the US Attorney in Manhattan for allegedly defrauding C&A’s investors and lenders, while the SEC brought a parallel civil suit against the pair.

Both Stockman and Stepp first sought advancement of legal fees and indemnification from C&A’s insurance carriers, and when those policies were exhausted they turned to Heartland for advancement pursuant to the indemnity under its partnership agreement. However, Heartland refused to advance any funds unless the two agreed to additional conditions not written in the partnership agreement, including a cap on the total amount of fees that would be advanced.

Stockman and Stepp argued that advancement and indemnification to them were mandatory under the partnership agreement, while Heartland argued that a requirement in the agreement that its general partner approve all advances of expenses allowed it to impose additional conditions. Jonathan Axelrad, a partner in Goodwin Procter’s private investment funds practice, said such conditions essentially made it impossible for the two to be indemnified.

The court last month ruled in favour of the plaintiffs, and in doing so established several principles that private equity firms will have to keep in mind in the future. Most importantly, it said the “plain language of the Partnership Agreement does not unambiguously support Heartland’s reading of the document”, which means that in future cases, ambiguity in the partnership agreement will likely result in a verdict against the partnership in favour of the officers.

“The indemnification provisions of the governing partnership agreement were ambiguous, which had a major impact on the court's approach,” Axelrad said. “Specifically, the court asked, 'Who should suffer from the ambiguity', and concluded based on Delaware public policy that the ambiguity should be resolved in favour of the indemnified person. In essence, the court ruled that, if there is ambiguity in an indemnification provision, the tie goes to the indemnified person.”

He adds that the court did note that that the parties could have drafted around this issue. If the agreement had clearly said that Stockman and Stepp were not entitled to indemnification due to their legal troubles, the court indicated that it would have upheld the language of the agreement.

“The lesson from this case is twofold,” Axelrad said. “One, if the indemnification provision is unclear the ambiguity will be resolved in favor of the indemnified person, and two, if you want to deny someone indemnification you had best make sure that your indemnification provision is clear.”

In light of this, it may be a good time for private equity and venture capital firms to go back over their agreements again to make sure they are sufficiently clear, as another investment funds attorney says he has seen many poorly drafted agreements cross his desk that would receive similar treatment from the Delaware court if they went to trial.