Individuals affiliated with private fund managers are increasingly being named as defendants in lawsuits involving fund portfolio companies, particularly where the fund controls one or more seats on the portfolio company’s board, or where an individual affiliated with the fund sponsor serves as a senior executive at the portfolio company.

When an individual affiliated with a fund manager is named as a defendant in a lawsuit involving a portfolio company, some important questions should be addressed from the outset:

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

2. What are the board designee’s indemnity rights?  Typically, the board designee has indemnity rights on multiple levels, including the portfolio company level, the fund level, and potentially the management company/sponsor level.  These rights, and particularly the priority of the parties providing these indemnities, require careful assessment.  It also is critical to consider the “credit risk” of a particular indemnitor, as the quality of the indemnity is only as strong as the balance sheet of the indemnitor.

It is also essential in both the indemnity and insurance contexts to check the applicable notification requirements.  Virtually every indemnification provision and insurance policy requires written notice to the indemnitor/insurer, otherwise coverage may be void.

3. What rights do the indemnity or insurance coverage confer on the board designee?  Is there a duty for the indemnitor or insurer to defend?  Is there a duty to advance legal expenses and defense costs?  Is the defendant entitled to independent legal counsel?

4. 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 violations of the law or contractual breaches, meaning the defendant would have to repay all of the money that has been advanced to cover legal fees and costs (pursuant to a written undertaking).  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.

5. What are the specific allegations in the complaint?  Does the complaint include substantively different allegations against different board members?  The answers to these questions 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.

6. Who is legal counsel, and whom do they represent?  In addition to selecting experienced litigation counsel, fund managers 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.  For example, independent counsel is most appropriate when the interests of an individual director (or group of directors) diverge from the other defendants.  Independent counsel may also be appropriate where the directors relied on the advice of the company’s counsel in connection with a particular transaction that is the subject of the dispute.