Drafting Advancement and Indemnification Provisions in Limited Partnership Agreements
A July ruling by the Court of Chancery holds important lessons for how Delaware courts interpret advancement and indemnification provisions in limited partnership agreements. In J. Michael Stepp v. Heartland Industrial Partners, L.P., two former officers and directors of the defunct Collins & Aikman Corporation sought advancement of legal fees and indemnification from the company’s majority investor, Heartland Industrial Partners, L.P. After C&A disclosed historical accounting irregularities, J. Michael Stepp and David A. Stockman incurred hefty expenses resulting from civil and criminal proceedings brought against them in connection with their roles at the portfolio company. Heartland rebuffed the directors’ request, insisting that (i) the general partner of the private equity fund had the discretion to refuse their advancement application and (ii) the directors failed to satisfy the requirements of the partnership agreement’s indemnification clause. The Court of Chancery disagreed and chastised Heartland for relying on ambiguous contractual language to shirk its obligations.
Contractual Ambiguity Resolved Against General Partner
In his opinion, Vice Chancellor Strine drew on general principles of Delaware contract law. Confronted with a partnership agreement marred by slipshod drafting, Strine emphasized the public policy considerations behind Delaware courts’ approach to interpreting the foundational documents of business entities.
Delaware courts resolve ambiguities in governing instruments in order to provide uniform, predictable interpretations of the documents that officers, investors, and other constituencies who provide benefits to the entity rely on in making their decisions about whether to participate in the entity’s activities. This principle of interpretation protects the participants’ reasonable expectations, which in turn benefits the entity by encouraging participants to provide their capital, be it human or financial, at a lower cost than they would if they faced greater uncertainty.
Directors, officers, and employees of limited partnerships, Strine observed, generally do not take part in the negotiation of the partnership’s organizational documents. Consequently, when deciding whether to work for a limited partnership, they must rely on the plain meaning of the terms of the partnership agreement in order to understand their rights and obligations. To protect the reasonable expectations of people who join a partnership after its formation, Strine reasoned, Delaware courts construe ambiguous terms against the drafter of the governing instrument.
Advancement of Legal Fees & Expenses
The court granted the directors’ motion for summary judgment that they had a mandatory right to the advancement of legal fees and expenses under the limited partnership agreement. After finding themselves defendants in half a dozen civil actions, Stepp and Stockman first applied for advancement of legal fees and expenses to C&A’s and Heartland’s insurance carriers. Once they exhausted the insurance policies, the directors turned to Heartland itself. Heartland’s general partner refused to authorize their petition.
The relevant section of the partnership agreement read: “[e]xpenses reasonably incurred by an Indemnitee shall be advanced by the Partnership,” but “[n]o advances shall be made by the Partnership. . . without the prior written approval of the General Partner.” Heartland claimed that the prior written approval requirement granted the general partner sole discretion to decide whether to accept or deny an application for advancement. The court rebuked Heartland for its strained interpretation of the written approval requirement because it eviscerated the mandatory advancement language. Strine instead construed the requirement as performing the ministerial function of ensuring the directors’ request for an advancement of expenses was reasonable. According to the court, the general partner did not have the power to withhold its written approval merely to block the directors’ contractual rights to mandatory advancement.
Indemnification of Legal Fees & Expenses
Stepp and Stockman sought indemnification for expenses related to their defense against criminal charges, all of which were dismissed without prejudice by a federal court. The partnership agreement contained expansive indemnification rights by promising the directors restitution for “any and all claims. . .of any nature whatsoever.” But the partnership agreement subjected this broad indemnity to certain qualifications. In its motion to dismiss, Heartland maintained that the partnership agreement required the directors to demonstrate good faith, lawfulness, and the absence of any willful or knowing misconduct.
The partnership agreement was silent with respect to the rights of indemnitees who were successful in proceedings brought against them. As a result, the court held that the terms of the agreement did not clearly require an indemnitee to prove good faith, lawfulness, or lack of willful misconduct where, as occurred in the case of Stepp and Stockman, the indemnitee emerged victorious in the underlying proceeding. In support of its construction, the court cited recent Delaware case law mandating an award of indemnification after the dismissal of a case without prejudice.
Indemnification decisions, the court explained, should be made on a case-by-case basis. Otherwise, directors who are defendants in lawsuits would have to wait until all proceedings against them have been dropped or resolved. To apply Heartland’s interpretation of the agreement would contravene Delaware’s “strong public policy interest in promoting indemnification. . . to encourage capable people to serve as directors.” Given the agreement’s mandatory indemnification provision and the directors’ successful defense against the criminal charges brought against them, the court observed that Heartland bore the burden of proof that Stepp and Stockman did not satisfy the indemnification requirements. The court accordingly rejected Heartland’s motion to dismiss the directors’ claims for reimbursement.
Freedom of Contract & Delaware’s Limited Partnership Act
Vice Chancellor Strine noted that Section 17-108 of Delaware’s Limited Partnership Act affords limited partnerships greater freedom to draft their own indemnification plans than is available to corporations under Section 145 of Delaware’s General Corporation Law. In the case of Heartland, the court remarked that “drafters of the Partnership Agreement used their contractual freedom to craft an approach to indemnification that employs language drawn from § 145, but in a selective way that creates some room for confusion.”
When drafting indemnification provisions in limited partnership agreements, general partners should focus on clarity and not rely on boilerplate or statutory language adapted from other sources of law. Freedom of contract does not come without substantial responsibilities. Bespoke partnership agreements need to be tailored to the specific circumstances of the contracting parties and any potential third-party beneficiaries. Populating a limited partnership agreement with a farrago of provisos and exceptions does not give a general partner the right to break its explicit contractual promises.
