Buyer Required to Advance Expenses of Former Target Officers & Directors (that are also Selling Stockholders) for Defending Claims Brought by Buyer against the Selling Stockholders for Breach of Target Company’s Representations and Warranties.

Advancement and indemnification may be related concepts, but to borrow from Sesame Street, neither of these things is like the other. As has been noted in a previous blog posting on Weil’s Global Private Equity Insights, “[t]here is both a distinction and a definite difference between an advancement obligation and an indemnification obligation under Delaware corporate law.” In fact, in Homestore, Inc. v. Tafeen, 888 A.3d 204, 214 (Del. 2005), the Delaware Supreme Court held that “[a]lthough the right to indemnification and advancement are correlative, they are separate and distinct legal actions” and “[t]he right to advancement is not dependent on the right to indemnification.” Indeed, there may be an obligation to advance expenses for a matter that may not ultimately be indemnifiable because “corporations may confer a right to advancement that is greater than the right to indemnification.” Appreciating that distinction and definite difference is obviously important in putting into effect indemnification and advancement provisions in favor of the officers and directors of private equity portfolio companies. But as can be seen from this recent Delaware Court of Chancery decision, Hyatt v. Al Jazeera America Holdings II, LLC, C.A. 11465-VCG (Del. Ch. March 31, 2016), recognizing this distinction and difference can be even more important in negotiating the acquisition of a target company by a private equity firm.

Unless representation & warranty insurance is being used, in a typical transaction involving the acquisition of target company by a private equity buyer, the selling stockholders agree to indemnify the buyer from an agreed escrow fund, subject to a specified cap and deductible, for any breach of the target company’s representations and warranties. And regardless of the source of recourse for breach of the specified representations and warranties of the target company, it is also not uncommon for the buyer to agree to continue to provide indemnification and advancement of expenses to the former officers and directors of the target company, who will be leaving as part of the closing of the acquisition, to the same extent as they would have been entitled under the terms of the target’s existing formation documents. But what happens when the buyer asserts claims against the escrow funds, the selling stockholders, or the stockholder’s representative, for indemnification under the purchase or merger agreement for alleged breaches of the target company’s representations and warranties, and a dispute arises with respect to the buyer’s entitlement to all or some portion of the escrow? Can the former officers and directors of the target company, who are also selling stockholders and therefore financially interested in the proceeds of the escrow funds, seek advancement from the buyer for the expenses they incur defending the claims the buyer is making against the escrowed funds?

Well, according to Vice Chancellor Glasscock in the recent Hyatt decision, the answer depends on whether the defense of the underlying claims against the escrow funds involves the former officers and directors (whether or not they are also selling stockholders) “defend[ing] their actions as former officers and directors.” And whether a claim involves a former officer or director defending their actions as a former officer or director is dependent upon whether “a ‘nexus or causal connection’ exists between the underlying proceedings and the defendant’s ‘official corporate capacity.’”

In this case, the buyer’s claims for indemnification for breach of the target company’s representations and warranties were solely recoverable from the escrow funds to which the selling shareholders would otherwise be entitled—and the buyer conceded in court that they were not seeking to hold any of the selling shareholders individually liable for the alleged breaches of the representations and warranties. Moreover, the acquisition agreement provided that any attorney’s fees incurred by the prevailing party in any disputed claim between the selling stockholders and the buyer would be payable by the non-prevailing party. But the named selling shareholders, which included the selling shareholder’s representative, argued that, as former officers and directors of the target company, they were entitled to advancement of expenses under a separate provision whereby the buyer had assumed the target company’s officer and director indemnification and advancement obligations. The target company’s indemnification and advancement provisions provided that the former officers and directors were entitled to be (a) indemnified for any action in which such former officer or director was involved “by reason of the fact that he, or a Person of who he is the legal representative is or was a member of the Board of Directors or officer of [Target],” and (b) “paid or reimbursed by [Target] the reasonable expenses [they] incurred in a Proceeding in advance of the final disposition of the Proceeding and without any determination as to the Person’s ultimate entitlement to indemnification.” Thus, regardless of the fact that the former officers and directors were being sued as selling shareholders for indemnification from the escrow funds related to alleged breaches of the target company’s representations and warranties, to the extent the underlying claims involved actions that they had taken while they were officers and directors on behalf of the target company, they were entitled to have their expenses of defending those claims advanced to them by the buyer even though they may ultimately not be entitled to be indemnified for an adverse determination against them on those claims.

Because the claimed breach of the representations and warranties made by the target company necessarily involved the actions of the former officers and directors in exercising their “decision-making authority on behalf of the corporation,” the buyer’s claims against the named selling shareholders to recover the escrow funds “require[d] them to defend their actions as former officers and directors,” even though “they do not face liability in their capacity as officers and directors” with respect to such claims. So, the buyers have to advance the legal fees of the very persons they are suing, to the extent those fees are attributable to the defense by the selling stockholders of the buyer’s claims for breach of representations and warranties made by the target company.

As a buyer you can avoid this outcome by either (a) negotiating a complete waiver and release of all continuing target company indemnification and advancement obligations to former officers and directors who are selling stockholders, or (b) specifically carve out any proceedings against the escrow funds by buyer from the continuation of advancement and indemnification obligations by the target company. But from the sell-side, selling stockholders who are also officers and directors, will would want to be careful that such a carve out did not deprive the officers and directors of advancement and indemnification for third party claims that might have given rise to the buyer’s claims for breach of the representations and warranties, or be otherwise comfortable that the tail officer’s and director’s policy will cover such claims. Moreover, the selling stockholders representative will want to ensure that there is separate fund set aside from the proceeds of the sale to fund expenses of any dispute with the buyer regarding entitlement to the escrow funds on behalf of the selling stockholders.