Tuesday, October 14, 2008

Indemnification Agreements: When Trouble Hits, Who Picks up the Tab?

(Warning: Technical post about to unfold here. Why wade through it? you may well ask. One answer: I’ve been slaving over a hot printout of the decision all day; would it kill you to show some appreciation and take a look at what I think about it? Another thought: you should make sure that you understand when your company needs to pay any director’s fees and expenses, and when you may be able to switch tactics to lessen the cost to your company.)

What happens when your board is threatened with a lawsuit? Does the company pick up the tab, or is each director on his own? The answer used to be clear, but now, thanks to a recent Delaware court decisions, waters are being muddied.

There are multiple layers of paper that protect VCs (or any private equity investor, for that matter) from any liability as a director of a portfolio company. First, there is the indemnity provided by the portfolio company to the VC-director. This can reside in a shareholders agreement or, as I suggested in a previous post, it will now increasingly be part of a separate indemnification agreement between a company and each individual director.

VCs also will have received similar protection from their own fund, in the form of yet another indemnity agreement. How do these various indemnities work together when trouble strikes? VC funds often assume that they would be liable for the legal costs of their director nominees only if the portfolio company was unable to pay. However, in the Levy v. HLI Operating Company, Inc., the Delaware Chancery court established that, unless otherwise agreed, liability should be shared between the portfolio company and the fund.

In Levy, the directors had entered into indemnification agreements with the company (HLI), containing the usual broad indemnification covenants by HLI. The indemnification agreements provided that HLI would advance expenses in connection with any indemnity claim, regardless of whether the directors prevailed in such litigation. Directors on the HLI board who were serving as nominees of the private equity fund that had invested in HLI had separate indemnification agreements with the fund as well.

The board was hit with a securities fraud lawsuit. The private equity fund had its nominee directors settle claims against them for $4.8 million, which amount was paid by the fund. The directors then tried to recover the amount paid by the fund from HLI, relying on the provisions of the indemnification agreement each had signed with HLI. HLI refused to reimburse them, and the directors (and their fund) sued.

The court sided with HLI, saying that there was no indemnifiable loss to the directors; their obligations had been paid in full by the private equity fund. Further, the fund was not entitled to be fully reimbursed by HLI; the court held that the fund only could seek reimbursement only for a portion share of the $4.8 million payment—a far cry from being made whole.

The takeaway? Companies need to think tactically before actually making indemnification payments on behalf of their directors who are fund representatives. It may not be your obligation alone. And, of course, the same applies to VCs.

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