Private Equity Law Review : New York Private Equity Lawyer & Attorney : Geoffrey Parnass : Corporate & Business Law

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.

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In my last post, I said that indemnification is:

• a promise
• by one person
• to make good
• certain losses
• suffered by another person

I'd like to explore this here.

The "promise" of indemnification is contained in an agreement that is primarily concerned with something else. For example, in a contract to develop a website, the party that performs the development service will be asked to provide certain assurances and indemnifications to the customer.  The promise of indemnification is in addition to the assurances about the services that are contained in the contract.  For example, the website developer will promise to make good any losses suffered by the customer in case a third party claims that the website infringes a copyright, or in case the website does not meet specifications.

In some respects, a promise of indemnification is redundant.  If the website developer represents in the contract that her work will not infringe a copyright, and it does, then the customer has a right to sue for breach of contract.  A separate promise to indemnify the customer against a claim of infringement is not really necessary, at least as to a claim brought by one contract party against another.  For this reason, some indemnification claims cover only claims by “third parties,” that is, people who are not parties to the contract. In general, it is accepted practice to ask and receive broad indemnification language, even though redundant.   

The "person" who makes the promise to indemnify is someone who has, in consideration of some payment or benefit, undertaken some kind of action, such as building a website.  The action, however, is one that has some risk or uncertainty associated with it.  For example, the finished website may infringe the copyright of someone else or may not meet specifications. The possibility of infringement may not be immediately apparent from an inspection of the website at the time it is delivered.  The possibility may only becomes apparent over time, hence the risk.

The promise to make good backs up some kind of assurance that the person made. The assurance is usually about something specific, such as “this website does not infringe any copyright” or “this website will meet specifications.” The “make good” includes the promise to “indemnify, defend and hold harmless”.  It is a promise to put the injured person back in her original condition, before the covered injury took place. In our example, that might include fixing the website to eliminate the infringing material, meeting the required specifications, refunding the payment if infringement cannot be cured or “defending” any legal costs, for example if the copyright holder sues for infringement.

The promise to make good covers only certain losses, namely, those losses arising out of a breach of the assurance. If an assurance is given that the website will not infringe a copyright, then the losses covered are only those that arise out of the infringement. Thus, before there can be a claim for indemnification, there has to be a loss; and for there to be a loss, there has to be a breach of some specific assurance. Often, where the loss is based on a third party claim, the loss has been established before the claim for indemnification is made. Where the loss is based on the character of the service itself, such as the specifications, then the loss will have to be established at the same time as the claim for indemnification.

The losses covered by indemnification include the costs and expenses of defending or pursuing a claim in court.  the biggest cost here is attorney fees.  In the American legal system, each party has to pay its own legal expenses.  Including attorneys fees in "losses" shifts this burden to the party who is providing the indemnification. 

Indemnification only covers losses "suffered by" the person to whom the assurances were made.  The suffering person is often expanded to include, in the case of a corporation, its officers, directors, shareholders and affiliates.  The losses cannot be speculative and must actually be incurred or suffered.

Related Posts:  What is Indemnification? -- Part 1

                         Indemnification Provisions of a Purchase Agreement

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When the topic of "indemnification" is reached during contract negotiations, the principals often grow silent and wait for their lawyers to speak.  The topic seems taboo, mysterious, off grounds to any but the intrepid legal specialist. 

But this is wrong, for indemnification is simply a promise by one person to make good certain losses that may be suffered by another person.  It is akin to a policy of insurance.  It is given where one person wants to back up or support an assurance made to another person. The word itself -- indemnification -- has the ring of insurance.  In fact, real insurance companies, like The National Indemnity Company, use a form of the word in their names.  I will discuss here the section of a business contract (usually near the end) in which one party, or both, agree to provide indemnification.

To illustrate this discussion, assume that a website developer has been hired to create a new website. The customer wants and receives written assurances that the website will not infringe any copyright, and that the website will function according to specifications.  The contract contains these assurances, along with the following simple, mutual indemnification clause:

“Each party shall indemnify, defend and hold harmless the other party (including such other party’s affiliates, partners, officers, directors, employees, agents, and representatives) against any claims and/or liabilities of any nature, including reasonable attorneys’ fees, arising out of or relating to any breach of the warranties made by such party in this Agreement.”

As I mentioned above, indemnification is simply a promise by one person to make good certain losses that may be suffered by another person.  To those like me who love bullet points, indemnification is:

• a promise
• by one person
• to make good
• certain losses
• suffered by another person

In my next post, I will discuss each of these elements in detail.

Related Posts:  What is Indemnification? -- Part 2

                          Indemnification Provisions of Purchase Agreements

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In a recent case from Delaware’s chancery court, the clear language in a merger agreement, controlling dispute resolution matters, was enforced by the court even where the method specified wasn’t the best way to resolve the dispute. The case underscores the importance of thinking carefully about the implications of arbitration clauses, and especially how two or more arbitration schemes relate to each other.

Matria Healthcare entered into an agreement to acquire CorSolutions Medical for $445 million. Both companies were engaged in the disease management business. Nearly 5% of the purchase price ($20.3 million) was set aside in an escrow account to satisfy claims that the closing net working capital of CorSolutions fell short of a minimum target. The escrow account was also available to satisfy claims under the indemnification provisions, including breaches of representations and warranties.

Whether a claim fell under the working capital adjustment or the indemnification claim was critically important, as indemnification claims were subject to a threshold of $4.45 million, while claims for a working capital adjustment were not subject to any threshold. There was an important procedural difference as well. Claims concerning the closing net working capital were to be resolved solely by a specific accounting firm. Indemnification claims were to be resolved in accordance with the Commercial Arbitration Rules of the American Arbitration Association, which give the parties the ability to challenge and investigate claims.  

The parties saw ahead of time that disputes involving, for example, misrepresentations could fit within both arbitration schemes. They decided that any matter relating to the closing working capital had to be resolved by the accounting firm mechanism, even though the matter could also be raised as a misrepresentation under the AAA procedure.

Shortly after the closing, a messy dispute arose involving a customer of CorSolutions. The customer instituted an audit of a CorSolutions disease management program. Matria dealt with the matter after the closing by negotiating a resolution with the client that involved, among other things, a cash payment of $1.5 million and amendments to the customer contract. Matria applied the $1.5 million payment as a debit to the closing working capital and asserted a claim against the escrow account.

The dispute could have been raised as both a working capital adjustment and a claim for indemnification. CorSolutions thought the working capital arbitration was too narrow a context to allow a full airing of the issues, and it asserted that the AAA was the only proper place to hear the dispute. It also, of course, wanted the claim to be subject to the $4.45 million threshold for indemnification claims.

The court agreed in substance with CorSolutions, but ruled in favor of Matria, on the strength of the clear hierarchy of arbitration contained in the merger agreement. Even though the dispute was one that typically would be subject to an indemnification threshold, the clear hierarchy of arbitration procedures forced the claim into the working capital adjustment, for which there was no threshold. Clever drafting by Matria’s attorneys.

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The indemnification provisions of a purchase agreement function like an insurance policy. Each party (buyer and seller) stands behind its warranties and agrees to make the other party whole if there is a loss that is attributable to or covered by the misstatement or broken promise. 

In some cases, the indemnification may take the form of protection against the claim of a third party. For example, if the seller warrants that the business may be conducted without infringing the intellectual property of any third party, and that proves not to be true, then the seller must hold the buyer harmless against the claim made by the third party. In other cases, the indemnified matter may be a direct loss suffered because the quality of the assets transferred is not as represented. For example, if the seller’s receivables are warranted to be collectible in full, and there is a shortfall in collection, the buyer can recover the shortfall from the seller.

Like an insurance policy, the first question is how long the coverage lasts. The indemnification sections will say how long the representations and promises will remain in effect. This is generally a year or two after the closing, although certain representations, such as those covering taxes, employee benefits and environmental laws, will last longer as the laws they cover carry exposures that may last many years.

Next, like an insurance policy, the indemnification clause will usually have a threshold or deductible for making any claims at all, on the theory that small or minor claims do not warrant invoking the indemnification process. The size of the deductible will generally vary according to what is considered material in the transaction. A small deal may have a deductible of $10,000 while large deals can have deductibles of $100,000 and more. This issue is usually negotiated in the term sheet. Finally, an indemnification clause may have a cap on the total value of claims that can be made for indemnification, usually expressed as a percentage of the purchase price.

In an asset purchase transaction, the indemnification protection that a buyer gets will cover three events: a misrepresentation or breach of a warranty made by seller; a breach of any covenant or agreement made by the seller; and any liability that seller agreed to retain. For the seller, the indemnification covers the first two items and any liability that buyer agreed to assume but was nonetheless imposed on seller. Indemnification extends to any costs or expenses (including reasonable attorneys fees) that the protected party incurs as a result of the claim or loss, such as the costs of defending against a third party claim and the cost of asserting a claim against the other party to the deal. In fact, the only legal liability added by the indemnification clause is this obligation to pick up costs and expenses, since in the absence of the clause, the aggrieved party would still have a claim for breach of contract in case the other party breaches a warranty or covenant.

The procedures for exercising indemnification claims involve giving the other party notice of the claim and the opportunity to take over the defense of the claim, in the case of a third party liability. The party providing the indemnification generally has the right to settle the matter and both parties must assist in the defense of third party claims.

Related Posts:  What is Indemnification? Part 1 and Part 2

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