Fund General Partner Exculpation and Indemnification

A fund’s partnership agreement customarily provides that unless managers and their employees (“covered parties”) are guilty of misconduct, they will (a) not be liable to any partner or the fund for any claims, liabilities, damages, loss or expenses (e.g., legal fees, judgments and settlements) which may arise out of, or incidental to, the business of the fund (i.e., the covered party is “exculpated” under the partnership agreement), and (b) be indemnified by the fund for losses suffered in connection with the fund’s business. The definition and types of misconduct that are not subject to indemnification and exculpation varies in fund agreements, but generally include conduct constituting gross negligence or willful misconduct, or conduct otherwise determined to have been made in bad faith. Other common carve-outs to indemnification and exculpation include violations of securities laws, breaches of the fund’s partnership agreement (sometimes limited by materiality), the commission of a felony, disputes among members of the fund’s management team, and disputes brought against management by a majority of investors.

Investors often seek to reduce a fund’s indemnification obligations in several other ways. For example, managers may seek to limit the definition of misconduct to that which has been determined by a court to fall within the carve-outs in the partnership agreement. Investors often prefer instead that a majority of investors have the ability to determine whether such misconduct has occurred and to remove the general partner in such circumstances. Additionally, a partnership agreement should require a covered person to seek indemnification from any other available sources before looking to the fund (i.e., portfolio companies and insurance policies). A recent Delaware court case ruled that unless an order of priority is provided in a fund’s partnership agreement, the fund’s managers are not required to seek indemnification from other sources before seeking indemnification from the fund. Finally, while covered parties generally will be permitted to have their legal fees and other expenses advanced prior to any determination that such party is entitled to indemnification; investors should prohibit such advances in the event of a claim brought by a sufficient number of investors.

Sources of indemnification proceeds include investment proceeds, capital commitments, and what is often referred to as a “limited partner clawback.” Fund agreements frequently require partners to return distributions to cover indemnification obligations for a period of two years from the date of distribution and up to a maximum of 25% of total capital commitments. The partnership agreement should require the general partner to share in the clawback obligation by unwinding the most recent distributions, including any carry distributions, such that the parties would be placed in the same position as if such returned distributions had never been made.

Ultimately, the consequence of the typical exculpation and indemnification clause is to move the standard of liability from ordinary negligence to gross negligence (a higher standard involving reckless indifference rather than simply carelessness), and to limit the general partner’s liability with respect to such matters as selection and allocation of investment opportunities and dedication of time to the express restrictions set forth in the partnership agreement. Securities laws – in particular a registered investment adviser’s fiduciary duties to its clients – may require a higher standard of conduct than gross negligence, but investors may not be provided a private right of action under such laws.

Jeffrey Hart is the founder of Triangle Funds. At Robinson Bradshaw, his primary areas of practice include private fund formation, private investment transactions, joint ventures and other business transactions.