Thursday, September 18, 2014

Indemnification: Particularly Powerful If You’re Negotiating With Yourself

Indemnification:  Particularly Powerful If You’re Negotiating With Yourself

My column this weekend in the News & Observer is about the initial public offering of PRA Health Sciences and its owner, KKR.  This post is a prequel.  In preparing the column, I looked through the appendices attached to PRA’s S-1 filing.  Normally, I’m looking for interesting bits of financial data.  However, in this case my attention was drawn to Exhibit 10.19, the indemnification agreement between PRA and KKR and its affiliates.  The exhibit was too technical to appear in my column.

In simple terms, indemnification means that one party agrees to pay the legal expenses and damages of another party if the second party becomes embroiled in a legal matter.  Directors and officers typically receive the protection of an indemnification agreement in exchange for their service to a corporation.  Since KKR owns virtually 100% of PRA, KKR insisted that PRA offer KKR and its wholly owned consulting firm, Capstone broad indemnification.  The operative phrase in the exhibit promises to indemnify KKR and its affiliates “to the fullest extent permitted by law in respect of any such claims and liabilities.”  It’s a fairly standard agreement in the world of private equity.  There’d be nothing wrong with this standard if two independent parties negotiated the indemnification provision.  However, there was nothing arms length about the negotiation between PRA and KKR.  PRA had to accept the broad indemnification.  For all intents and purposes, KKR was negotiating with itself. 

In the end, it’s KKR’s limited partners and, in due course, the new public shareholders who will bear the entire contingent liability memorialized in Exhibit 10.19.  KKR has as much protection as the law will allow.

If you want to see how an indemnification agreement can work to the advantage of insiders, read Susan Antilla’s fine piece in today’s New York Times.[1]  Ms. Antilla explains how a brokerage firm, Reef Securities, used an indemnification provision buried in an agreement to try to force its investors to pay Reef’s legal expenses when investors sued Reef for offering a an ill-conceived private placement.  The private placement represented interests in oil and gas companies.  Within a short time the private placement stopped paying out to investors, and they sued.  Reef countersued, claiming that the investors would have to pay Reef’s legal expenses for defending the suit.  Ouch.

According to Ms. Antilla this sort of practice remains relatively uncommon.  However, it demonstrates the power the general partner has, whether it’s a brokerage firm or a private
equity firm, to protect itself at the expense of its investors.


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