Now that portfolio company bankruptcy has gone from a worst case scenario to a fairly common occurrence, GPs may want to consider reexamining their directors & officers liability insurance, as well as the legal contracts that govern indemnification.
Generally, when a manager from a private equity firm agrees to sit on the board of a portfolio company, it is the portfolio company that’s responsible for buying insurance to cover any damages if that manager is sued for any actions or omissions he commits in his capacity as a director. The private equity fund that invests in the company will also purchase its own coverage, to protect the director in the event that the company has no assets with which to indemnify the director.
But recent court cases have shown a number of areas where the GP should take care to avoid finding itself on the hook for damages.
First of all, in the event of a bankruptcy, the existing coverage may simply prove insufficient. In the case of Stockman v. Heartland Industrial Partners, LP, decided in Delaware Chancery Court this July, two directors sued their fund for the advancement of legal fess and indemnification because they had exhausted their insurance coverage in the lawsuits that followed a portfolio company bankruptcy.
“Because bankruptcies suits can generate such significant losses, companies carrying minimal limits of D&O coverage could quickly erode the coverage on defense costs alone,” says Nancy Rodrigues, a managing director in the private equity group of insurance broker Marsh. “Hourly rates at large firms can range from $500 – $1000 for a partner, so it’s easy to see how you can quickly exhaust D&O limits on defence alone.”
Determining just the right level of coverage to purchase takes a bit of work. For private companies, Marsh tends to use peer benchmarking, or will examine the amount of debt the portfolio company in question is taking on, and reconcile that debt with the appropriate Moody’s recovery rates.
Once a minimum threshold has been found, it’s also important that funds are diligent about requiring their portfolio companies to purchase the right amount of coverage, Rodrigues says.
“Most private equity clients understand, appreciate, and want their portfolio companies carry D&O,”she says. “The level of proactive involvement in looking at limits, terms and conditions is a different story and varies by firm.”
A private equity firm may want to consider purchasing Side A Difference In Condition insurance as well, which is designed to protect directors and officers in non-indemnifiable situations. These include when the company is unable or refuses to indemnify the directors, the most common instance of which is bankruptcy.
“In a bankruptcy, a DIC policy will not deemed an 'asset' of the company; it is there just for the directors and officers,” Rodrigues says. “With increasing frequency our private equity clients are requiring that their portfolio companies purchase some form of DIC, whether it’s on a standalone basis for each company, or they’ll get creative and structure an 'umbrella' programme that sits over a number of companies, thereby reducing the cost associated with buying the DIC program.”
Contractual obligations
Apart from the structure and amount of coverage, GPs should also scrutinise the D&O-related terms of contracts between the fund and the directors, the portfolio companies and the directors, and the fund and the portfolio companies – several other court cases have demonstrated that these contracts aren’t always as airtight as they were designed to be.
In 2008, Schoon v. Troy, a portfolio company sued a past director for a breach in fiduciary duty. But before the company sued him, it voted to amend its bylaws so that it would be required to indemnify only current directors, not past directors. The Delaware Chancery Court decided that the company was fully within its rights to do this.
Fortunately for private equity directors, that case has been made moot because Delaware’s general corporation law was changed effective 1 September, setting down a new default provision which says a corporation can’t change or eliminate the right of indemnification or advancement of expenses after the occurrence of the act or mission for which a claim for indemnification is brought. Companies must now explicitly preserve the right in their bylaws, or it will not be upheld in court.
Still, the case highlights a need to make sure that a portfolio company has not preserved the right to amend its indemnification obligations. It might also be a good idea to draw up a contract between the director and the portfolio company guaranteeing indemnification in certain events, because contracts require mutual consent to revise.
Still another alarming case is Levy v. HLI. In this case, decided in 2007, a portfolio company filed for bankruptcy, and a number of lawsuits ensued. Four of the company’s directors were employees of the private equity fund that owned shares of the firm. The fund indemnified the directors, then sought reimbursement from the company. The company argued that because the directors never suffered an actual loss, the company was not responsible for making them whole. The court decided in favor of the company, which was a “surprising” result, says Yvonne Chan, a partner at law firm Paul, Weiss, Rifkind, Wharton & Garrison.
“The court said that there is no primary/secondary liability hierarchy amongst who should actually be footing the bill for indemnification where you have a claim for contribution,” she says. “Therefore absent any contractual provisions between the fund and the portfolio company, if the fund wants to make a claim against the portfolio company, they have equal liability. The fund really could only sue and get back half of what it paid out of pocket.”
The way to prevent this situation is to clearly state in contractual agreements between the portfolio company and the fund which party is responsible for what, and what hierarchy applies to indemnification, she says.
Or again, it would be helpful to establish a direct contractual relation between the company and the director, in which the company agrees to the fullest extent permitted by the law that it will indemnify the director for its acts or omissions in its capacity as a director of the board. A GP could go further and include a provision that if the fund actually does advance money to the director or set aside an indemnification claim, that the fund can then step into the shoes of the director and then seek that money from the portfolio company, a concept known as subrogation.
Finally, it is important to distinguish in all these contracts whether the directors are entitled to just indemnification (compensation for damages incurred) or indemnification and advancement (compensation for fees incurred by lawyers or other service providers in connection with a lawsuit). Given how quickly legal fees can mount in some cases, a director doesn’t want to find himself unexpectedly on the hook.
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