With the increase in private securities, derivative and bankruptcy-related litigation against portfolio companies, private equity firms need to maximize the protections for the private equity firm, the funds they organize and the individuals who agree to serve as their representatives on portfolio company boards. Ironically, however, a private equity firm’s effort to provide “more” protection to its director-representatives may be far more expensive than the firm expects or intends.

Typically, private equity firms and the funds they organize grant their representatives serving on portfolio company boards broad indemnification rights—“to the fullest extent permitted by law.” Typically, too, private equity firms and their funds require that their portfolio companies provide “fullest extent of the law” protections to these same directors. Each of the firm, the fund and the portfolio company likely will have separate insurance policies to satisfy their respective indemnification obligations. Optimally, the firm and the fund will be entitled to indemnification rights from the portfolio company pursuant to the terms of a management services agreement.

Absent thoughtful drafting, however, the broader the indemnification rights provided by the private equity firm or its fund to the individual director, the more likely it is that the firm or its fund will be liable for a disproportionate share of defense and settlement costs incurred by the director in litigation involving the portfolio company and the less likely that such costs can be fully recovered from the portfolio company or its insurer. Moreover, the broader the terms of the insurance provided by the private equity firm, the greater the chances that the portfolio company’s insurers will resist paying out the full proceeds of the portfolio company’s policy before other sources of insurance are tapped.

Often times, the allocation of responsibility for indemnification and advancement obligations as between the portfolio company and the private equity firm and the fund that holds the investment in the portfolio company are not considered until after litigation has been filed. The same holds true with respect to the terms and amount of available insurance, especially at the portfolio company level.

As the foregoing suggests, there are a number of issues that every private equity firm that designates directors on its portfolio companies’ boards must consider to maximize protection against liability to plaintiff shareholders (or trustees in bankruptcy) and minimize the risk of paying the cost of defending against such claims.

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