NVCA Today

By Pamela W. Mason, AAI

When asked to identify the sources of defense against directors and officers litigation, most VC's who sit on portfolio company Boards would reply:

1. Indemnification from the portfolio company
2. Directors & Officers Liability at the portfolio company
3. Venture Capital General Partnership / Professional Liability (if purchased)
4. Indemnification from the Fund or Management Company

Until recently, even experienced corporate counsel would not have challenged this line-up. But two rulings by the Delaware Court of Chancery have dispelled all previous assumptions relative to indemnification provided to VC's by a portfolio company.

Levy v. HLI Operating Company, Inc.

In Levy v. HLI Operating Company, Inc., Joseph Littlejohn & Levy Fund II, LP (JLL) sued its portfolio company, HLI Operating Company, Inc. after HLI denied a request for indemnification to its four VC board representatives.

Following financial difficulties and a restatement, HLI filed for Chapter 11. Given its bankruptcy protection status, HLI was unable to indemnify its management or outside board in the ensuing securities litigation. JLL paid nearly $5M on behalf of its four board members, while two other independent board members spent over $1M of their own money.

After HLI emerged from bankruptcy, outside board members sought recovery from HLI for reimbursement of their expenses under their indemnification rights as outlined in HLI's bylaws. Litigation ensued when HLI denied the request to indemnify and, specific to JLL, cited that the JLL board representatives had suffered no loss. JLL disputed HLI's position on the basis that they were subrogated to the indemnification rights of their directors sitting on HLI's board.

The Court sided with HLI agreeing that the JLL directors suffered no direct financial loss and therefore had no claim for indemnification. In addition, The Court stated that there was no clear, contractual basis to establish which party's indemnification took precedent over the other. Instead it relied upon other Delaware law and ruled that the initial basis of indemnification between parties should be contributory in equal proportions.

Schoon v. Troy Corporation

The Court's ruling in the Schoon created indemnification concerns in a different area. In the Schoon case, a board member who was subject to litigation learned that his rights to indemnification had been removed without his consent.

Following litigation brought against it by a board member, Troy Corporation quietly made amendment to its by-laws by removing the word "former" from the definition of directors who were entitled to indemnification. Subsequent to this change, a former board member sought advancement for defense costs from Troy for litigation brought against him. It was only then that the director became aware that Troy had changed its by-laws. He argued that his rights as a former director had vested prior to the time that Troy made the change, and therefore he was entitled to advancement of defense expenses.

The Court ruled that the rights of a former director vest at the time a claim is made against him, not at the time he was appointed as a director. As such, the director was not entitled to advancement by Troy.

Indemnification and Insurance

In light of The Court's rulings in these two cases, it is important to understand the direct correlation between contractual indemnification provisions at the portfolio company level and Directors & Officers (D&O) Liability insurance coverage. Specifically, most D&O insurance policy contains a "Presumptive Indemnification" provision, which states that the charter and/or by-laws of the portfolio company must provide indemnification to the director to the greatest extent permissible or required by law. One exception to this would be the portfolio company's inability to indemnify due to its financial insolvency. Barring this exception, if the portfolio company refuses to indemnify, coverage under the portfolio company's D&O policy would be subject to the policy's "indemnifiable loss" coverage deductible. This could equate to a rather large out of pocket expense for an individual director.

The Levy and Schoon cases create quite a predicament surrounding presumptive indemnification and D&O coverage for VC's sitting on portfolio company boards. At a minimum, it creates significant uncertainty in the assumption of sources of defenses outlined at the beginning of this article. It also raises the question of what solutions are available to mitigate this potential crisis.

At a minimum, VC's should review existing Director Indemnification Agreements with outside counsel to determine the adequacy of the existing language. The content of the language should be amended to tighten the original intent of the indemnification provisions, principally to delineate that the portfolio company's indemnification is "primary" to any other sources. In addition, ensure that such Agreements cannot be changed without an individual director's consent.

Amending the "Presumptive Indemnification" provision of a D&O policy is another option, but isn't easily accomplished. D&O insurers rely on presumptive indemnification to dissuade insureds from wrongfully denying indemnification and therefore are reluctant to make changes here. Consideration should be given to supplementing a portfolio company's D&O program with the purchase of dedicated "A‑Side" insurance to better address the needs of individual directors. Differing from a traditional D&O policy that provides coverage for 1) non-indemnifiable loss of insured persons 2) reimbursement to the corporate entity for monies it expends to indemnify it's D's and O's, and 3) coverage for claims made against the corporate entity directly, an "A-Side" policy limits coverage to non-indemnifiable loss of insured persons. In addition, most "A-Side" policies do not contain "Presumptive Indemnification" provisions. Therefore, "A-Side" coverage is typically viewed as the best personal asset protection available to directors sitting on portfolio company boards.

The continual changes emanating from litigation create an on-going need to assess exposures to risk. The review contracts and the potential ability to transfer or mitigate risk are a solid starting point.