The Stockman Decision: An Expansion of Indemnification and Advancement Rights in Limited PartnershipsAug 03, 2009
Michael E. Horowitz is a litigation partner and member of the Business Fraud and Complex Litigation Group at Cadwalader, Wickersham & Taft LLP (“Cadwalader”), where April Oliver is a Senior Associate and Joseph Jay is an Associate. Research assistance was additionally provided by Alyssa Kate Ogawa, a student at University of Chicago, the Law School and 2009 Summer Associate.
As the economic collapse spawns a wave of complex white collar prosecutions, and as the volume of documents in such cases grows exponentially, an executive’s ability to defend himself or herself adequately requires substantial financial resources. In most cases, the right of officers and directors to indemnification and advancement of attorney’s fees is critical to their ability to avoid financial ruin while mounting a sufficient defense. In a key decision rendered on July 14, 2009, the Delaware Chancery Court expanded and clarified indemnification rights for principals involved in limited partnerships.1 The case centers on David Stockman (“Stockman”), the Reagan-era White House budget director, and his colleague, J. Michael Stepp (“Stepp”), both of whom served as officers in Heartland Industrial Partners L.P. (“Heartland”).2 Grounding its decision in contract law and public policy concerns, the Delaware Chancery Court held that Stockman and Stepp should receive full indemnification and advancement of fees under a somewhat ambiguous partnership agreement.3 The decision has important implications for individual defendants who prevail in criminal proceedings but nonetheless have indemnification and advancement of fees withheld.
Stockman earned fame at an early age, coming to Washington as a young congressman and then serving as the youthful wunderkind driving the Reagan revolution.4 In 1985, after leaving the White House Office of Management and Budget, Stockman transformed himself into a successful investment banker. In 1999, Stockman started his own private equity fund, Heartland, based in Greenwich, Connecticut, where Stepp served as Senior Managing Director.5 Just as Detroit tottered on the precipice of another recession, Stockman made the pivotal decision to invest heavily in American automobile parts. In 2001, Heartland invested extensively in the interior auto parts manufacturer, Collins & Aikman Corporation (“C&A”). Stockman joined C&A’s Board, eventually becoming its Chairman and CEO.6
In 2005, C&A publicly disclosed certain accounting errors and, like many companies, restated its financials in order to correct the irregularities.7 Soon after, C&A filed for bankruptcy, eventually dissolving in 2007.8 Amidst the debris, the high-profile Stockman, as well as other C&A officers and directors, became targets for government investigations and investor suits.9
After a protracted criminal investigation, Stockman and Stepp were charged in 2007 in a sixty-five page indictment that accused them of (among other things) conspiracy, securities fraud, wire fraud, and bank fraud.10 The charges, brought forth in the Southern District of New York, described a complex accounting scheme related to revenue recognition for rebates, and other managed earnings issues.11 The government essentially alleged that Stockman, in his position as senior Managing Director, manipulated C&A’s earnings to mask its financial woes.
Stockman vigorously defended himself, maintaining that his actions were not fraudulent, but simple acts of bad timing as the auto industry turned sour.12 He publicly stressed the significant personal risk that he took by investing substantial sums in C&A.13
This past January, Stockman was vindicated when, in a surprise move, all charges against both him and Stepp were dropped without prejudice by the government, who asked the Court for a nolle prosequi order.14 In a written statement abandoning the criminal claims against Stockman and Stepp, the U.S. Attorney for the Southern District of New York stated that “[a]fter a renewed assessment of the evidence,” further prosecution “would not be in the interests of justice.”15
Speculation abounded about the reasons behind the dismissal. Some legal commentators noted the complex accounting issues at the heart of the case, and the extensive work of the defense team to explain them to prosecutors.16 Despite the nolle prosequi order, however, several civil actions remain pending against Stockman and Stepp, including the civil suit by the U.S. Securities and Exchange Commission (“SEC”).17
The combination of the criminal investigation and prosecution, SEC charges, bankruptcy proceedings, and investor suits had one certain outcome for Stockman and Stepp — mounting legal bills. Unfortunately, the likelihood of having to address numerous matters in multiple jurisdictions is becoming more and more routine for corporate officers and directors involved with companies facing accounting irregularities or other complex legal issues. The outcome of the Stockman prosecution serves as a prime example of the importance of having the financial resources to mount a robust defense in such situations – it was the defense, after all, that pulled together the evidence which demonstrated to the government that its criminal charges were erroneously filed. Given the extraordinarily high conviction rate in the federal system, and that a conviction in this case could have resulted in Stockman spending most, if not all, of his life in jail, the stakes for Stockman and the defense team could not have been greater. However, more and more frequently, insurance companies and employers are balking at paying the legal fees that are necessary to ensure an adequate defense in complex, document-intensive cases that revolve around complicated legal and/or factual issues, such as the minutiae of accounting rules.
This was the predicament facing Stockman and Stepp, who found themselves awash in legal proceedings. As litigation mounted, Stockman and Stepp submitted claims to C&A’s insurance carriers, which were paid until the company’s policy was exhausted.18 After C&A’s coverage ran out, they turned to Heartland’s insurance coverage, which by late 2008, was also depleted. Stockman and Stepp then turned to Heartland itself. Heartland declined to advance legal expenses directly.19 Stockman and Stepp, in separate actions, filed claims against Heartland, which were later consolidated.
Summary of Key Holdings
Corporate indemnification and rights to the advancement of legal fees for the defense of a corporate director or officer have traditionally been vigorously enforced under Delaware law.20 Courts recognize that well-established public policy in the corporate context promotes indemnification in order to encourage capable people to serve as directors and/or officers.21 However, until last week, the extent of indemnification for principals in a partnership, such as Heartland, was uncertain.22
In a forty-one page decision, Vice Chancellor Strine found in favor of Stockman and Stepp on both their advancement and indemnification claims and granted their motions for partial summary judgment on the advancement claims.23 Furthermore, in dicta, the Court suggested that a strongly similar result would be compelled on indemnification if a summary judgment motion were brought on that issue.24
Closely reading the partnership agreement, Strine held that the payment of indemnification fees by Heartland was mandatory.25 Moreover, Stine reasoned that any ambiguity in the agreement should be construed against Heartland.26 He rejected Heartland’s interpretation that the indemnitees’ rights under the agreement were more limited, and that the advancement of legal fees required the written approval of the General Partner.27 Strine held that Heartland was wrong to require an indemnitee to demonstrate good faith, lawfulness and a lack of scienter in order to earn indemnification rights.28 He reasoned that when a criminal defendant prevails in an underlying proceeding, any such burden is satisfied.29
The Partnership Agreement
The Court closely scrutinized the broad indemnification provision in Heartland’s partnership agreement.30 Both parties agreed that Stockman and Stepp were indemnitees, but disagreed as to the scope of the indemnification coverage.31
The partnership agreement contained fairly boilerplate language that the indemnitees should be indemnified against claims “[t]o the fullest extent permitted by law . . . known or unknown, liquidated or unliquidated, incurred by any Indemnitee . . . on behalf of the Partnership or in furtherance of the interest of the Partnership, its Portfolio Companies [i.e. C&A] or any Alternative Vehicle . . . . ”32 The partnership agreement also granted generous advancement rights for “[e]xpenses reasonably incurred by an Indemnitee in defense or settlement of any claim . . . .”33
Heartland’s argument relied on a caveat in the indemnification provision that focused on conduct. The provision allowed Heartland to withhold indemnification when the indemnitee’s conduct was not in the best interest of the Partnership, unlawful, fraudulent, or in bad faith.34 Heartland’s case further relied on language stipulating that advancement of legal fees should not occur without the prior written approval of the General Partner.35
Stockman and Stepp alleged that when they approached Heartland for direct coverage, Heartland attempted to force additional limitations on coverage that were not reflected in the Partnership Agreement. The limitations proposed by Heartland purportedly included caps on legal fees, the submission of monthly litigation budgets, and a requirement that Stockman and Stepp provide security in case repayment was required.36 Without such concessions, Heartland declined advancement of legal fees. Heartland also refused to indemnify Stockman and Stepp for costs relating to the failed criminal proceedings – even though the case was dismissed in its entirety more than six months earlier.37 Heartland contended that, as long as civil proceedings existed, inappropriate conduct by the Indemnitees still might be found.38
Legal Analysis of Advancement Claim
The Court largely viewed the case as a traditional contract dispute, peppered with public policy considerations. In rendering its opinion, the Court parsed the plain language of the partnership agreement’s requirement stating that “[n]o advances shall be made by the Partnership…without the prior written approval of the General Partner.”39
Interestingly, when performing this analysis, the Court opted to treat both Stockman and Stepp uniformly, in applying the concept of contra proferentum (a canon of contract interpretation which construes an ambiguous term in the contract against the party who imposed the ambiguous term).40 The Court applied the principle, even though Stockman was a co-founder of Heartland, and thus was privy to the drafting and negotiation of the agreement. The Court reasoned that any inconsistent application would risk the “bizarre outcome of concluding the same language of the Partnership Agreement means different things as applied to two persons who are both Indemnitees . . . .”41
Both sides rested their arguments to some degree on interpretation of the plain language of the agreement. Stockman and Stepp asserted that the agreement unambiguously stated that the fees “shall be advanced” and argued that the later condition requiring written approval from the General Partner was largely ministerial.42 In contrast, Heartland placed greater weight on the clause requiring written approval, asserting that without allowing the General Partner to exercise discretion over fee advancement, such a clause would be rendered meaningless.43
In deciding the issue of advancement, Strine acknowledged tension existed in the language of the partnership agreement.44 In applying basic principles of contract interpretation, including the canon of interpretation requiring that the agreement be read as a whole to harmonize conflicting terms, Strine reasoned that Stockman and Stepp must prevail. He stated that “Heartland’s interpretation of the Partnership Agreement strains the plain meaning of the relevant language when it is read in its full context, as it must be. In contrast, Stockman and Stepp’s interpretation of the Partnership Agreement is reasonable and supports a finding that Stockman and Stepp are entitled to judgment as a matter of law.”45
The Court opined that the language “shall be advanced” required advancement because “giv[ing] the General Partner unfettered discretion to deny an advancement request would, in essence, convert the Advancement Provision to a permissive rather than a mandatory term, in contravention of its plain language.”46 The Court reasoned that while the approval role of the General Partner under the Advancement Provision did allow it to examine requests for advancement related to certain issues, such as whether an indemnitee’s official capacity was truly implicated, or whether some other entity’s coverage applies, the provision did not allow the blanket discretion to deny any or all claims.47
Finally, Strine stated that the plain language as written provided indemnitees with “reasonable expectations” of protection, which “in turn benefits the entity by encouraging participants to provide their capital, be it human or financial, at a lower cost than they would if they faced greater uncertainty.” In short, the Court embraced the public policy precept that advancement encourages talented people, such as Stockman, to serve as officers and directors, partners, or principals.
Legal Analysis of Indemnification Claims
The procedural posture of the indemnification dispute was somewhat less developed, as the Court was rendering a decision on a motion to dismiss, not summary judgment. Nonetheless, the Court forcefully articulated its views that indemnification was required in this context.
In parsing the indemnification dispute, the Court acknowledged that Delaware law provides limited partnerships more latitude to craft indemnification schemes than is allowed within a corporate context.48 The Court noted, however, that the partnership agreement in dispute explicitly adopted language and concepts from Delaware corporate law, including § 145 of the Delaware General Corporation Law (“DGCL”) standard of good faith and lawful conduct.49 The Court sharply criticized the drafters of the partnership agreement for staying silent about “the effect of a disposition of the underlying proceeding in favor of the Indemnitee” as in a situation such as Stockman and Stepp, who had prevailed in the underlying criminal proceeding.50
The Court scrutinized § 145 of the DGCL in some depth, as all parties appealed to its precepts, noting that the embedded purpose of the statutory limits of indemnifiable conduct is to ensure that “corporate officials do not evade the consequences of their own misconduct in such a way that they are rewarded for or encouraged to violate applicable laws and to breach their fiduciary duties to the corporation.”51 Noting this important policy goal, the Court elaborated that when there is no conviction or similar fine then “the corporation may not inquire into the good faith and lawfulness of its indemnitees.”52 Thus, in a corporate context, when criminal defendants avoid conviction, indemnification and mandatory advancement would naturally be assumed.53
In the case at hand, the Court chose to apply the same standards embedded in Delaware corporate law to limited partnerships, holding that indemnification was proper, despite ongoing civil litigations in several forums. The Court relied on recent precedent allowing indemnification for fees related to a settled class action, despite an ongoing SEC investigation arising from the same underlying conduct.54 Quoting the earlier precedent, Strine emphasized that requiring a party to wait for all possible causes of action to be disposed prior to indemnification “eviscerate[s] the important right of indemnification on which Delaware corporations rely to secure qualified people to serve on their boards.”55 For Strine, the dismissal of the S.D.N.Y. criminal proceeding against Stockman and Stepp was sufficient to permit indemnification.56
Again, the Court harkened to the plain language of the agreement to justify its conclusions, noting that the indemnification provision stressed indemnification “[t]o the fullest extent permitted by law.”57 The Court reasoned that, given such language, Stockman and Stepp were not required to plead anything about their conduct because the mandatory language of the indemnification provision shifts the burden onto Heartland to prove that Stockman and Stepp’s conduct was inappropriate.58
While only a motion to dismiss was before him, Strine left little doubt as to how he would decide such a summary judgment motion. Strine indicated that he did not find it reasonable to litigate the substance of the conduct reflected in the dismissed indictments before allowing indemnification.59 The Court explained that Delaware corporate law should be read with an eye towards the public policy incentives it was written to promote. The DGCL “prevent[s] corporations from indemnifying corporate officials in only the most incentive-disorienting circumstances: when the officials have been convicted or otherwise incurred liability as a result of culpable conduct and that liability was the result of conduct that involved a certain level of scienter.”60 In encouraging Heartland to proceed with indemnification, Strine pointedly noted that “turning an indemnification case into a hypothetical trial on the merits of a dismissed case is a bizarre notion to propose . . . .”61 Strine declared such a scenario would be counterproductive to Delaware’s policy goal of assuring indemnities “that their reasonable expenses would be borne by the corporation they have served if they are vindicated.”62
The court’s decision provides protection and comfort to indemnitees of partnerships that intend to provide coverage consistent with § 145 of the DGCL. The decision also is extremely valuable to indemnitees who are mired in multiple proceedings. The case makes clear that the favorable resolution of one proceeding will help to safeguard indemnification and advancement rights in the remaining proceedings, whether in a corporate or partnership context.
For partnerships, given the Court’s extensive focus on the plain language analysis, if there is an interest in limiting indemnification or advancement rights for its indemnitees, the ruling establishes that the burden is on the organization to make any such limitation patently clear in its partnership agreement. Throughout the opinion, the Court repeatedly chastised Heartland’s partnership agreement’s drafters for inelegant drafting and a lack of focus. Indeed, in justifying its interpretation of the agreement, Heartland had appealed to the concept of freedom of contract embedded in Delaware’s partnership code, arguing the principle should be given maximum effect.63 The Court summarily rejected this argument, noting that the “drafters of the Partnership Agreement could have exercised their freedom of contract to eschew the Delaware statutory approach to corporate indemnification and create an indemnification scheme that does not grant mandatory indemnification to successful Indemnitees. But, they did not do so clearly in this case.”64 In short, if Heartland did not want mandatory indemnification, Heartland should have drafted around it.
Thus, while Heartland’s principals received broad indemnification and advancement rights in this case, that was due to the specific language in the Heartland agreement which explicitly adopted relevant Delaware statutory indemnification concepts. Partnerships can easily avoid such an outcome by modifying their agreements to clarify the scope of indemnification and advancement rights. Of course, having seen what can happen to someone like Stockman – being indicted on sweeping criminal charges that could lead to life imprisonment, only to have those charges dismissed because of his lawyer’s ability to mount a strong defense – partnerships may well prefer a system that enables its indemnitees to defend themselves fully.
4 Stockman’s career was abruptly set back in 1981 after a profile appeared in the Atlantic Monthly, entitled “The Education of David Stockman.” The article led with his evocative quote (particularly prescient in today’s financial context) that “[n]one of us really understands what's going on with all these numbers.” William Greider, The Education of David Stockman, The Atlantic Monthly, December 1981, available at http://www.theatlantic.com/politics/budget/stockman.htm.
10 Press Release, United States Department of Justice, U.S. Charges David Stockman -- Former CEO of Auto Parts Maker -- and Other Former Executives with Securities Fraud; Company not Charged (March 26, 2007) (available at http://www.usdoj.gov/usao/nys/pressreleases/March07/stockmanetalindictmentpr.pdf).
16 News reports indicated that, in a relatively rare move, Stockman’s defense team submitted a “white paper” to the acting U.S. Attorney and prosecutors explaining why the prosecution was unfounded. This white paper apparently provided an extensive analysis of the more than 15 million corporate documents relevant in the complex accounting case. The white paper appeared to cause the government to backtrack and dismiss the charges. See Carrie Johnson, Federal Charges Dropped Against Stockman, Wash. Post, Jan. 10, 2007 at A07.