Private equity funds, and individuals affiliated with fund sponsors, are increasingly being named as defendants in lawsuits involving their portfolio companies.  This litigation risk arises most frequently where a fund controls one or more board seats on the portfolio company, or where an individual affiliated with the fund sponsor serves as a senior executive at the portfolio company.

When a fund sponsor (or an individual affiliated with a fund sponsor) is named as a defendant in a lawsuit involving a portfolio company, the initial assessment of the claims, risks, insurance coverage, and indemnification rights is critical.   Some of the key questions for that early assessment are:

1. What are the board designee’s indemnity rights?  Typically, the board designee has indemnity rights at multiple levels, including the portfolio company level, the fund level, and potentially the management company/sponsor level. The interplay between the rights at different levels, and the priority of the indemnitors’ obligations, requires careful assessment.  Also, it is important to understand that an indemnity right is subject to “credit risk,” as the indemnity is only as strong as the balance sheet of the indemnitor.

2. What insurance policies might cover the board designee? Both the insurance coverage of the portfolio company and the private equity firm should be carefully assessed.  Does the portfolio company have D&O insurance that would apply?  Does the private equity firm have its own insurance policies that might cover the board designee in these circumstances?

3. What are the notification requirements?  Almost every indemnification provision and insurance policy requires written notice to the indemnitor/insurer, otherwise coverage may be void.

4. What rights are included in the coverage?  Is there a duty to defend? Is there a duty to advance legal expenses and defense costs? Is a defendant entitled to independent legal counsel?

5. What are the substantive limits of the indemnity protections and/or insurance coverage?  Indemnification rights and insurance coverage are limited by law and contract.  For example, in almost every instance, coverage ceases if there is a final judgment that the indemnitee (the board designee) breached his or her duty of loyalty to the portfolio company or is liable for other types of breaches or violations of the law, and the defendant would have to repay all of the money that has been advanced to cover legal fees and costs.  A vital component of the early assessment of these cases is determining how these limitations relate to the legal claims and factual allegations asserted against the board designee.

6. What are the specific allegations in the complaint?  How do they differ from the allegations against the other board designees?  The answers will influence the defense strategy, e.g., whether to enter into a joint defense with the other board members (and potentially the portfolio company itself) and, just as important, how long to maintain a joint defense.

7. Who is legal counsel?  In addition to selecting experienced litigation counsel, private equity sponsors and individual defendants should assess whether they should have independent counsel.  Often, the portfolio company will retain one law firm to represent all of the officer and director defendants, as well as the portfolio company.  Director defendants should evaluate carefully whether and when to demand independent counsel.  Consider, for example, whether an individual was or was not a director when the events in question occurred.