Private equity firms and the funds they organize frequently place individuals on their portfolio companies’ boards. However, all too frequently, it is not until a claim has arisen that the various entities consider how the potentially implicated indemnities and insurance will interact. Unanticipated interactions sometimes can produce unintended consequences, particularly from the perspective of the private equity firm.
A March 19, 2009 article by the Latham & Watkins firm on the Harvard Law School Corporate Governance Forum blog entitled "Indemnification of Director-representatives by PE Firms" (here) takes a closer look at these issues.
Among other things, the authors note that "the allocation of responsibility for indemnification and advancement obligations … are not considered until after litigation has been filed" and the same "holds true with respect to the amount of available insurance, especially at the portfolio company level."
The authors offer a number of excellent practical suggestions.
First, they suggest that the contractual arrangements between the private equity firm and the individuals serving on the portfolio company boards "provide clearly that the private equity firm’s indemnification and advancement obligations to its director-representatives are secondary to the indemnification and advancement obligations of the portfolio company." Otherwise, courts may consider the private equity firm and the portfolio company to be "co-equally liable," which could prove very costly for the private equity firm if it advances costs in the first instance and later seeks reimbursement from the portfolio company.
Second, the authors suggest that if the indemnification documents with the director-representative cannot be modified, the private equity firm "should seek an assignment of the director-representative’s rights to indemnification and advancement from the portfolio company prior to the fund paying out defense or settlement costs on their director-designees’ behalf."
Third, the authors point out that advancement rights are distinct from indemnification rights, and they suggest that the portfolio company’s advancement commitments "should be examined to be certain that advancement is contractually required and that any advancement obligations owed by the private equity firm or its fund are secondary to the obligations of the portfolio firm."
The authors’ final observations relate to insurance. They comment that typically "neither the director nor the private equity firm will look at the portfolio company’s D&O insurance policies until after the director needs to defend/or settle such claims."
The authors correctly note that the private equity firm should review the portfolio company’s policies to ensure that the policies are "adequate to protect their director-representatives." The authors also suggest a review of the provisions that will determine how the portfolio company’s policies and the private equity firm’s policies will interact in order to "prevent a battle of the insurance companies."
The authors cite the interaction between the portfolio company’s D&O insurance policy and the private equity firm’s policy as a potential concern. These insurance issues become particularly critical if the portfolio company goes bankrupt, in which case portfolio company indemnity issues drop out of the picture and the portfolio company’s insurance can becomes critical.
Bankruptcy often has a way of demonstrating the insufficiency of the limits of insurance that the portfolio company purchased. Moreover, bankruptcy also has a way of demonstrating –after the fact – the need for auxiliary insurance structures (such as Side A/DIC insurance or independent director insurance) to protect individuals in the event of complex claims while the portfolio company is bankrupt.
The authors are correct that the the various potentially implicated insurance policies terms and prospective insurance interactions all too often go unexamined. However, looking at the terms alone is not enough. Limits selection and program structure should also be carefully considered. Private equity firms should take steps to ensure that the portfolio company’s insurance program will sufficiently protect the director-representatives in all contingencies, even bankruptcy—or, rather, especially in bankruptcy.
I disagree with the article’s authors on one point. The authors state that "private equity firms should also strongly consider having the same carrier write the primary policies at both the firm and at each of its portfolio companies." The authors suggest this approach avoids the "other guy’s" policy coverage dodge.
The authors are correct that this would avoid the "not my problem" dodge. But it could be a terrible insurance solution in every other respect, both for the private equity firm and for the portfolio companies. First, from the private equity firm’s perspective, there are relatively few carriers willing to write those kinds of risks in the first place, and within that small group, the available terms and conditions vary dramatically. The private equity firm should focus first on placing the optimal insurance solution for its own risks and needs, without being forced to accept a suboptimal solution out of an artificial effort to try to match carriers with its portfolio companies.
By the same token, the portfolio companies are unlikely to have uniform exposures and interests. Given the incredible diversity of potential insurance alternatives available in the marketplace, it is very unlikely that the same carrier would provide the best insurance solution for each of the various portfolio companies. And by the same token, the portfolio companies should not have their range of potential D&O insurers restricted only to the relatively few carriers that also will write private equity firm D&O insurance.
In short, trying to cram all of the various insured entities under a single carrier’s umbrella could address one single issue but create a host of potentially more significant problems as a result. The preferred approach is exactly the one the authors otherwise recommend, which is to consider policy interaction issues in connection with the insurance placement process – a process that should in the first instance be addressed to providing the best solutions for each respective entity.
The authors’ interesting article highlights the need for private equity firms to enlist knowledgeable and experienced insurance professionals in connection with their insurance placement and in connection with their consideration of the issues discussed above. Insurance can sometime appear like a peripheral or relatively unimportant matter– unless things go seriously wrong, in which case insurance can turn out to be the most important thing. At the point that things have gone seriously wrong it a very poor time to discover that critical insurance issues were insufficiently considered.
Break in the Action: The D&O Diary is taking its act overseas, and so the publication schedule will be disrupted for the next few days. Regular publication will resume the week of March 30.