A Private Fund Manager’s Right to Indemnification: The “Finally Adjudicated Clause”

08.05.2014

The governing documents of most institutional private funds bar indemnification or exculpation of the fund sponsor and its affiliates for some combination of willful misconduct, fraud and/or gross negligence (or similar formulations) by such persons. 

Where we see variation is in who gets to decide whether a “bad act” of this sort has occurred.  Often fund governing documents express the bad act exclusion in objective terms—if the bad act occurred, then indemnification is not permitted (the “objective conduct standard”).  In contrast, governing documents of some funds require a court of competent jurisdiction to finally determine, in a final, non-appealable decision, that a bad act occurred before indemnification is barred.  In such instances, a typical “finally adjudicated” clause might read as follows:

“The Partnership shall, to the fullest extent permitted by applicable law, indemnify and hold harmless each Indemnified Person against any losses, claims, damages, liabilities, costs or expenses (including legal fees, judgments and amounts paid in settlement) to which such Indemnified Person may become subject … in connection with any matter arising out of or in connection with this Agreement or the Partnership’s business or affairs, unless … a court of competent jurisdiction, in a judgment that has become final and that is no longer subject to appeal or review, determines that any such loss, claim, damage, liability, cost or expense is primarily attributable to such Indemnified Person’s willful misconduct, fraud or gross negligence….”

Why does this difference matter?  On the one hand, the “finally adjudicated” language gives a fund sponsor the ability to avoid making difficult decisions about its own conduct or the conduct of a related party that could involve significant conflicts of interest.  Equally important, however, is that the “finally adjudicated” phrasing gives the fund sponsor the ability to manage third-party claims (i.e., claims by parties other than fund investors) so as to maximize the manager’s chances for indemnification.  

Consider, for example, a situation in which a purchaser of a private equity fund’s portfolio company sues the fund sponsor for fraud in connection with the sale.  The suit is settled before going to trial, with no admission of liability by the fund sponsor.  Is indemnification of the fund sponsor permitted under the fund’s governing documents?  Is it required?  For a fund with governing documents using the objective conduct standard (i.e., that do not require a final judicial determination of fraud on the part of the fund sponsor or its personnel), the answer is unclear—which isn’t particularly comforting either to fund sponsors or to their investors.  The fund arguably would still have a duty to determine whether fraud occurred in order to determine whether indemnification would be proper. 

However, the fund sponsor faces a conflict of interest regarding this decision, which could result in the fund sponsor’s being forced to turn over the determination (with potentially significant financial consequences for the fund sponsor) to the fund’s limited partner advisory committee or another disinterested decision maker.  Even if the fund sponsor is authorized to make this decision on its own, the fund sponsor may subject itself to breach of fiduciary duty claims by investors if it determines that indemnification is proper—meaning, again, that the fund sponsor would be well advised to consider turning over this decision to independent counsel or an arbitrator. 

By contrast, however, if the fund’s governing documents provide for indemnification so long as there has been no final adjudication that fraud occurred, the picture becomes clearer—indemnification is compelled because the litigation was settled without an admission of bad acts that would trigger the exclusion by the fund sponsor (i.e., without a final adjudication regarding fraud), regardless of any actual bad acts by the fraud sponsor or its personnel.

Use of a “finally adjudicated” clause helps create a bright line so that fund sponsors can easily make indemnification determinations.  However, given where the line is drawn, fund sponsors and their personnel will rarely be denied indemnification for third-party claims. 

Fund investors who have negotiating leverage may wish to demand that the objective conduct standard be used in fund governance documents rather than the sponsor-friendly “finally adjudicated” provision.  We have also seen the following alternative approach used in some fund governing documents using the “finally adjudicated” clause.  If the general partner expects to advance a certain threshold amount of legal costs (for example, $1 million) for conduct that may be indemnifiable by the fund, a majority in interest of the limited partners may appoint a representative to initiate an arbitration as to whether the advance of legal costs should be authorized.  The arbitrator is charged with determining whether it is more likely than not that the person receiving the advance of legal costs met the standard of conduct necessary for indemnification.  The arbitrator’s finding is generally not admissible in the court proceeding that will ultimately determine the right to indemnification.  The benefit of this approach is that it allows the general partner to avoid the conflict of interest problems with the objective conduct standard.  At the same time, this approach affords the limited partners a means to protect themselves from depletion of fund assets for legal expenses arising from litigation that is settled before an ultimate decision on the right to indemnification is made.