Investment funds commonly request and expect that key investment professionals serve as directors on the boards of the portfolio companies in which the funds invest. Fund professionals expect to serve on such boards, provided that they are fully protected with respect to actions taken as board members, and will look not only to the portfolio company for indemnification protection, but also to the fund itself as a backstop in case the portfolio company indemnification provisions do not provide sufficient coverage. Recent case law in Delaware brings to light the need to closely diligence indemnification and expense advancement coverage at the portfolio company-level and ensure that in the attempt to provide comfort to its investment professionals, the fund's indemnification and expense advancement coverage do not inadvertently become primary coverage.

Advancement v. Indemnification Rights

As a preliminary matter, it is important to note that although practitioners commonly use the word "indemnity" to refer to both the right of ultimate indemnification (i.e., reimbursement for any losses, including, generally, expenses and fees, incurred with respect to a claim against such person) and the right to receive an advancement of fees and expenses incurred during the defense of an indemnifiable claim, this broad use of "indemnity" does not always result in expected coverage. For example, a Delaware Chancery Court decision, Schoon v. Troy Corporation1 (discussed in more detail below) serves to reinforce the lesson that the interrelation between indemnification provisions and advancement provisions should not be taken for granted. The Schoon court noted that in the bylaws at issue, "the clear separation of the indemnification and advancement provisions precludes the interpretation" that the advancement provision is simply a subsidiary provision to indemnification, a position that other courts have taken.2 Another more recent case, also discussed in more detail below, Sodano v. American Stock Exchange LLC,3 underscores the need to make sure indemnification provisions are clear and unambiguous with respect to the type of protection afforded. In Sodano, while ultimately holding that the term "indemnity" did encompass advancement rights, the court relied on state contract interpretation provisions to look outside of the indemnity provision at issue and take into consideration the expectations of the parties – a position that many courts will not take. To preempt any controversy, which will likely only surface at the time of litigation, investment funds should make sure that in reviewing their own indemnity provisions and in reviewing portfolio company indemnity provisions, where advancement rights are intended, such rights should be stated clearly.

Portfolio Company Indemnification and Advancement Provisions – Protecting Against Unilateral Changes

Schoon v. Troy. Schoon v. Troy Corporation4 provides several lessons on how to make sure a fund's board nominee is adequately protected by the portfolio company. In Schoon, the court held that a former director, a designee of a major stockholder of the corporation, was not entitled to advancement of legal fees and expenses in defending against an action brought by Troy. Troy had filed fiduciary duty-based claims against both William J. Bohnen, a former director, and Richard W. Schoon, a current director and successor to Bohnen. While Bohnen served as a director, the corporation's bylaws had provided for indemnification rights and advancement rights to current and former directors. After Bohnen's resignation but prior to bringing the claim at issue, the Troy board of directors, other than Schoon, approved amendments to Troy's bylaws that effectively deleted the reference to former directors and provided that only current directors were entitled to advancement rights. The amendments further provided that no advancements would be made in respect of any claims initiated by the indemnitees against the corporation unless otherwise approved by the board.

The issue argued in Schoon was whether Bohnen's rights to advancement vested when he took office, before the adoption of the bylaw amendments, and therefore, as a vested contract right, could not be unilaterally terminated without Bohnen's consent. Contrary to Bohnen's expectations, the court held that the right to advancement vested at the time a person was named in a potentially indemnifiable claim. In Bohnen's case, Bohnen was not named in the claim until after the bylaw amendment was adopted and therefore the amended bylaws controlled and Bohnen was not entitled to advancement of his legal fees and expenses.

The outcome in Schoon was a surprise to boards and their advisers and had many directors reviewing their companies' charters and bylaws to assess their rights of indemnification and advancement of expenses in its aftermath. Recent amendments to the Delaware General Corporation Law have, however, largely mooted Schoon by an amendment to Section 145 (relating to the indemnification of officers, directors, employees and agents) that prohibits the elimination or impairment of a right to indemnification or advancement of expenses arising under the company's charter or bylaws after the occurrence of the act or omission that is the subject of the proceeding for which indemnification or advancement of expenses is sought, unless the provision in effect at the time of such act or omission explicitly authorizes such elimination or impairment after such action or omission has occurred. These amendments became effective August 1, 2009. Note, however, that there is no such similar provision under the Delaware Uniform Limited Partnership Act or the Delaware Limited Liability Company Act.  

Practical Considerations:

  • Identify the document granting the right to indemnification and advancement. If the indemnification and advancement rights appear in the charter of a corporation, those rights will be more difficult to amend (i.e., will likely require a shareholder vote). Note however that if not already included in the charter, such inclusion will be equally difficult to implement.  
  • Make sure the provisions protect the interests of former directors. For example, from and after August 1, 2009, for Delaware corporations, ensure that there is no provision authorizing the company to eliminate or impair indemnification or advancement provisions after the occurrence of an act or omission for which indemnification or advancement of expenses is available. For non-Delaware corporations or other types of entities, make sure that either the governing law provides protection against retroactive unilateral amendments to indemnification or advancement provisions or that such protection is explicit in the entity’s constituent documents.  
  • Request that the portfolio company's constituent documents provide that the time of vesting of indemnification and advancement rights be at the time a director takes office.  
  • For added protection, require a separate agreement between the portfolio company and the director, turning such director's rights to indemnification and advancement into a contractual obligation that cannot be modified without the director's consent.  

Indemnification Provisions at the Fund Level – When Is It Too Much?

"To the Fullest Extent Permitted by Law." Funds recognize that their investment professionals expect to be properly indemnified where they act as portfolio company directors at the request of the fund. Assurance of full protection has long been an accepted inducement for individuals to take on board responsibilities. To make sure investment professionals are granted the indemnification coverage they expect, fund indemnification provisions commonly state that the fund will provide indemnification "to the fullest extent permitted by law." Both the fund and the director generally expect, however, that in a claim against the director for services as a board member of a portfolio company, the portfolio company itself will have the primary obligation to indemnify the board member. To make sure reality matches expectations, the fact that the fund is secondarily liable to the portfolio company's indemnification obligation should be clearly stated such that the fund will be the subrogee to such investment professional's rights to indemnification from the portfolio company. Delaware Chancery court cases Levy v. HLI Operating Company, Inc.5 and Sodano v. American Stock Exchange6 demonstrate the need for these clarifications – each is discussed in turn in more detail below.

Levy v. HLI. In Levy v. HLI Operating Company, Inc., former outside directors sued HLI to obtain indemnification for monies paid in settlement on their behalf by JLL Fund, a stockholder of HLI that had designated the plaintiff directors. In this case, there was no question that the directors were entitled to indemnification by HLI pursuant to HLI's bylaws, personal indemnification agreements and under a bankruptcy reorganization plan. However, HLI argued that because JLL Fund paid the settlement, the directors did not suffer an actual loss – the court agreed, holding that the directors were not real parties-in-interest. Instead, the court held that the appropriate cause of action was by JLL Fund for contribution against the corporation, but only for their equitable share of the amount of indemnification the fund overpaid, i.e., half the monies expended in the settlement on behalf of the plaintiff directors. In addition, HLI argued, and the court agreed, that because the JLL director representatives never had a viable claim for indemnification, advancement of fees and expenses was not appropriate and should be repaid to HLI.7

At issue in Levy was that JLL Fund's partnership agreement provided that JLL Fund would indemnify its director designees "to the fullest extent permitted by applicable law,"8 but did not provide any direction on how the indemnification liabilities on third party board activities would be divided with such third party. The court differentiated the claims between contribution and subrogation, noting that only in a subrogation claim does the subrogee (in this case, JLL Fund) "stand in the shoes" of the subrogor (the plaintiff directors) and may therefore "demand full payment from another party primarily responsible for the loss which the [subrogee] both insured and reimbursed." 9 Critical to bringing a successful claim for subrogation is showing that the subrogee was only secondarily liable for the subrogor's loss, that another party (the portfolio company) bore primary responsibility for the loss and that by discharging the loss, the subrogee simultaneously extinguished the portfolio company's liability to the subrogor.10 The Levy court relied on the opinion in Chamison v. Healthtrust, Inc.,11 where the court observed that the Delaware General Corporation Law did not create a "primary-secondary" hierarchy among indemnitors and therefore "as a general rule, absent of contractual language to the contrary, two insurers who insure the same person for the same risk must share the loss."12

Sodano v. American Stock Exchange. In Sodano v. American Stock Exchange LLC, Salvatore Sodano, the former Chief Executive Officer and chairman of American Stock Exchange LLC ("Amex"), sought advancement of legal expenses from Amex in connection with defending against securities-related claims with respect to his actions during his tenure at Amex. Sodano had been an executive at the National Association of Securities Dealers, Inc. ("NASD"), the parent company of Amex during the time period at issue, and it was at NASD's request that Sodano took office at Amex. Sodano was entitled to indemnification from both NASD and Amex and at issue was whether NASD was only secondarily liable for the advancement of Sodano's legal expenses. The NASD certificate of incorporation provided that any advancement obligations of NASD with respect to any person who is or was serving at its request as a director or officer of another entity was to be reduced by any amounts Sodano collected as indemnification or advancement from such other entity.13 Amex argued that, like in Levy, Amex and NASD were co-indemnitors, each responsible for the advancement of 50% of Sodano's legal expenses. The court, however, disagreed, and held that the express language in NASD's charter "created a hierarchical obligation" such that Amex was primarily liable for advancement obligations.14 The court noted that such language implied "a duty on behalf of Sodano to seek advancement from the Amex and to reduce the NASD's obligations by the amount Sodano may actually collect from the Amex" with the "hierarchical nature of the obligations mirror[ing] the nature of an individual's service." The court noted that "[t]his interpretation therefore captures the relevant business dynamic."15

Practical Considerations:

  • Make sure that the "primary-secondary liability hierarchy" between the portfolio company and the investment fund is clearly delineated. For example, include a proviso in the indemnification provision that the investment professional serving as a portfolio company board member or officer should first look to the portfolio company for portfolio company services-related claims.  
  • Consider including an acknowledgement that if the fund discharges the director's boardrelated claims even though it is only secondarily liable, the director subrogates its rights to claim indemnification from the portfolio company to the fund.
  • For added protection, set forth the "primarysecondary liability hierarchy" as between the portfolio company and the investment fund in a clear, coordinated manner in indemnification contracts at both the portfolio company level and the investment fund level.

Investment funds and their professionals are aligned in their interest to make sure fund professionals are appropriately covered with respect to portfolio company board or officer participation. The expectations are clear – portfolio companies should be primarily liable, with the fund secondarily liable only to ensure that the investment professional has "backstop" coverage. To this end, it is important not only to establish this hierarchical relationship, but also to take steps to prevent a portfolio company from unilaterally changing this relationship.