There’s so much sharp practice in private equity contracts that it’s hard to know where to begin describing their tricks and traps. But the train wreck of the Caesars bankruptcy, which was brought to investors by private equity kingpins Apollo and TPG, puts the spotlight on one of the most rancid “heads we win, tails you lose” features of these agreements: sweeping indemnification provisions which no fiduciary should accept.
We’ve attached the indemnification section from Apollo’s most recent “flagship” fund, Apollo VIII, at the end of this post, and have just added the full limited partnership agreement for Apollo VIII to our Document Trove. And to give you a quick preview: it provides for investors to reimburse Apollo for “all losses,” with narrow carveouts. Even losses from criminal conduct are subject to indemnification…if the party can dream up a credible-sounding way to claim that they they didn’t know their actions were criminal.
For those new to the concept, indemnification is a contractual obligation by one party to an agreement to pay another for certain losses, liabilities, or damages. The sweeping indemnification language in private equity agreements evolved, or rather devolved, from mergers and acquisitions advisory agreements. But the circumstances are utterly different. In M&A, you have an active principal, either a CEO or a business owner, who is advised by his own counsel and often hires consultants and other advisors. In most cases a board of directors will also have to approve a deal. The M&A advisor is concerned about legal liability, such as being sued by minority shareholders or by the buyer/seller for having second thoughts after the deal has closed. However, investment bankers being investment bankers, the indemnification is broad, generally with only a “bad faith or gross negligence” out.
By contrast, in private equity, the general partner is completely in charge. Why should passive investors give such broad protection against his bad actions when they have no ability to oversee, much the less constrain his behavior? And that’s before you get to the fact that other sections of limited partnership agreements waive the general partner’s fiduciary duty.* One common means of doing that is to provide that the general partner may consider interests other than that of the investors in his fund, including his own interest.
The Caesars bankruptcy puts the role of these indemnification agreements in sharp focus. As we wrote earlier this month :
Private equity firms Apollo and TPG did such an effective and over-zealous job of asset stripping after loading up their 2008 acquisition, Caesars Entertainment, with over $18 billion of debt that they’ve been hauled into court by creditors who are charing the two firms with fraudulent conveyance. And yes, sports fans, the operative word is fraud. The underlying idea is that if a company is insolvent, yet the people in charge divert cash or other assets to themselves, they’ve stolen from creditors and need to give the money back…..
FT Alphaville gives more detail:
Caesars went much further than standard capital market maneuvers, engaging in a series of complex sales of casinos and intellectual property as well as financings, allegedly to benefit its private equity owners Apollo Global and TPG to the detriment of creditors. These gambits included setting up an entirely new public company called Caesars Acquisition Corporation to buy several Caesars properties and the infamous release of a debt guarantee possibly enabled by a perhaps poorly-worded indenture.
Those transfers bothered creditors enough that they filed multiple lawsuits in 2014 and 2015 against various Caesars entities accusing the parent company, Caesars Entertainment Corporation (CEC) and its private equity owners of “looting” the subsidiary company where the assets and the debt were situated, Caesars Entertainment Operating Company (CEOC).
The big question underlying all the claims of fraudulent transfers and breaches of duty is whether CEOC, the subsidiary of CEC, was solvent, or not…
The Examiner concluded claims related to fraudulent transfers, breaches of fiduciary duty, and the aiding and abetting breaches of Caesars management and its sponsors were worth between $3.6bn and $5bn.
But if you read the indemnification language below, you’ll see that if the creditors prevail, Apollo may be able to impose some of these costs on investors like CalPERS, which is doubly exposed, having invested in both the Apollo and TPG funds that acquired Caesars. Mind you, this is the indemnification section from Apollo VIII, when the Apollo fund that looted, um, invested in Caesars was Apollo VI, but the provisions are likely to be very similar. We also have a TPG limited partnership agreement in our Document Trove, for a TPG credit fund. It also has an indemnification section in case you’d like to compare.
The key issue is the scope of the term Triggering Event, which is in the definitions section. Here is the set-up:
To the fullest extent permitted by applicable law, the Partnership shall indemnify each Indemnified Person against all losses, claims, damages or liabilities….unless such loss, claim, damage or liability results from any action or omission which constitutes, with respect to such Person, a Triggering Event;
And a Triggering Event is:
With respect to any Person, (a) the criminal conviction of, or admission by consent by or plea of no contest by, such Person to a material violation of United States federal securities laws, or any rule or regulation promulgated thereunder, or any other criminal statute involving a material breach of fiduciary duty, (b) the conviction of such Person of a felony under any United States federal or state statute, (c) the commission by such Person of an action, or the omission by such Person to take an action, if such commission or omission constitutes bad faith, gross negligence, willful misconduct, fraud or willful or reckless disregard for such Person’s duties to the Partnership or the Limited Partners, or (d) a finding by any court or governmental body of competent jurisdiction in a final judgment that such Person has received any material improper personal benefit as a result of its breach of any covenant, agreement, representation or warranty contained in this Agreement or the Subscription Agreements.
The open question is whether the various claims made by the creditors, namely “fraudulent transfers, breaches of fiduciary duty, and the aiding and abetting breaches of Caesars management and its sponsors,” constitute “the commission by such Person of an action, or the omission by such Person to take an action, if such commission or omission constitutes bad faith, gross negligence, willful misconduct, fraud or willful or reckless disregard for such Person’s duties to the Partnership or the Limited Partners.” From a common-sense standpoint, you’d think they would. But Apollo and TPG almost certainly had lawyers in the loop on every important step they took. Unless they disregarded the attorneys’ advice, that would seem to get them off the hook as far as “bad faith, gross negligence, willful misconduct” are concerned. I welcome lawyers weighing in, but as I read it, the Triggering Event waiver carves out violations of fiduciary duty (to the extent they exist, remember they’ve been gutted elsewhere) between the Indemnified Persons and the limited partners. But the creditors are asserting a separate set of fiduciary duties that kick in when a company becomes insolvent. So as I read it, the Apollo limited partners are on the hook for successful claims of breach of fiduciary duty by Caesars creditors.
And we have the open question of whether fraudulent conveyance constitutes fraud. Again, a layperson would assume it has to. But as this section is set up, Apollo interprets the terms; investors have to challenge it if they disagree. The Advisory Committee is simply notified of indemnification claims over $10 million. While the agreement does provide that a payment will not be made over the objections of the Advisory Board, this protection is pretty much meaningless for two reasons. First, the investors have to rouse themselves to object when notified, meaning a vote is not stipulated as part of the process. General partners make an art form of stacking their Advisory Committees so that they have a clear majority of complacent, friendly support. Second, as the Financial Times made clear it its story on Caesars, Apollo’s counsel Paul Weiss operated in a overly chummy manner. The only thing that is likely to be unusual about Paul Weiss’s behavior is that it came to light. Apollo spreads so much in legal fees across so many firms that it is has high odds of being able to gin up a favorable legal opinion in the unlikely event that it needed one.
So the “who is on the hook for fraudulent conveyance damages” hinges on how creative and cheeky Apollo is willing to be.
Here are some other oh-so-clever provisions from this section:
“If we didn’t think it wasn’t criminal, you are on the hook.” Here is the language:
In addition, indemnification shall be permitted with respect to a criminal Proceeding only if the Indemnified Person did not have reasonable cause to believe that its conduct was unlawful.
As we’ve seen from repeated performances of “I’m the CEO and I know nothing,” highly paid individuals can be remarkably adept at feigning ignorance when it’s important to them. In the absence of incriminating evidence, like e-mails, one can easily imagine how creative a general partner in the hot lights might get. As one lawyer riffed this out, “Oh, yes, my attorney did write that memo saying it was criminal to sell drugs to children. But I thought ‘children’ meant under 12, and we sold them only to teenagers.”
Indemnification payments can be clawed back out of distributions. And the indemnification provisions survive the termination of the partnership.
We also encourage readers to have a gander through the Apollo VIII limited partnership agreement. A couple of its noteworthy provisions:
Apollo has its own version of KKR Capstone, KKR’s captive consulting firm. As descried at length in the Wall Street Journal, investors assumed that KKR Capstone was an affiliate of KKR and hence its services were covered by their management fee, when in fact KKR was billing Capstone to portfolio companies as a third-party provider.
You can find the relevant section for Apollo’s consulting firm by searching for “Apollo Investment Consulting LLC” which appears under the defined term “Consulting”. It’s clearly an affiliate and Apollo, unlike KKR, doesn’t try to pretend otherwise. Instead, they simply carve it out completely from the management fee offset. In addition, a search on LinkedIn shows only two individuals listed as ever having worked for this organization. That suggests a lot of fees may be run through it for very little actual effort (for instance, they “supervise” consultants like McKinsey and Bain that do the real work).
Apollo also has “Special Fees,” which are the portfolio company fees generally. That section says that “Investment Banking” fees are subject to management fee offsets. Yet later, the very paragraph states that any fees paid to the Apollo “Affiliated Broker Dealer” are carved out. So what’s the difference between an “Investment Banking” fee and a “Broker Dealer” fee? Not a lot, it seems.
And remember, what is really scandalous about these provisions isn’t that Apollo asked for them. Anyone who does business with Leon Black should recognize that they are dealing with a fabulously aggressive character. The outrage is that investors went along.
This provision also makes a mockery of the pet claim that comes regularly from limited partners, that they spend a great deal of effort on making sure their interests are aligned with those of the general partners. In fact over 60% of the income for large general partners comes from fees that do not depend on performance, which means they get rich whether or not the fund does well. In the case of Apollo, on the Caesars’ deal, it got back its equity contribution via the transaction fees it charged to close the deal. And thy have indemnification against “losses” even when they have no skin in the game. Nice work if you can get it.
Update 7:00 PM. Hoisted from comments. By Ed Walker, former state securities regulator and staff member to the FCIC:
The idea of a fraudulent conveyance is one of those remarkable things in law that sound like one thing, but are in fact another. In bankruptcy cases, 11 USC Sec. 548 governs. Here’s a link: https://www.law.cornell.edu/uscode/text/11/548. The operative provisions define a fraudulent conveyance as one of two things. First, the transfer was intended to hinder, delay or defraud creditors. Second, the transfer was made for less than full consideration and either a) either before or after the transfer was complete the debtor was insolvent, or b) after the transfer the debtor had insufficient capital for the business it plans to undertake; or c) the debtor intended to incur debts that it could not repay.
The first head requires proof of intent, which is hard. Most cases are brought under the second heading, parts b and c, because there is no issue of intent. That means that there is no criminal case to be proved, despite the fact that the statute is written this way to cover the problem of proving fraudulent intent. There is no proof of fraud in these cases either, and whether the action meets one of the other levels is unlikely as Yves points out. So, most likely the fraudulent conveyance action is not a Triggering Event, and indemnification is permitted even if the transfer is set aside.
Note that the General Partner is in a position to settle the case, as Dino Rino says above, and that will mean no issue of intent will arise, and the damages become subject to indemnification, or at least a lawsuit will be required by a group of investors who have already proven themselves mostly incompetent and who will have already lost a bunch of money.
In a private equity fund, this kind of transfer is anticipated. The whole point is to screw the acquired company for the benefit of the managers and perhaps a few dollars to the investors. There are many cases where creditors have accused the managers of fraudulent conveyances, and many have been won by the creditors either in full or by settlement. This is a known risk, that the investor’s money is being used primarily to benefit the managers. Therefore the investors should not indemnify the managers, and in fact should not bear any of the costs or expenses of defense or investigation. with regard to any claim of a fraudulent conveyance.
* The SEC has taken the position that private equity fund managers nevertheless have a fiduciary duty under the Investment Company Act of 1940. However, that does limited partners less good than one might think, since only the SEC can bring an action under the Investment Company Act.