ABA Section of Business Law Spring Meeting Investments

ABA Section of Business Law Spring Meeting Investments -- Institutional Investors and Delaware Limited Partnerships and Limited Liability Companies April 23, 2010 www. rlf. com

Presented by: James G. Leyden, Jr. , Esq. Elisa Erlenbach Maas, Esq. Richards, Layton & Finger, P. A. www. rlf. com

Overview § The primary investment fund vehicles used in Delaware limited partnerships (“LPs”) and Delaware limited liability companies (“LLCs”). § Delaware LLCs and LPs have become very popular. § While there approximately 272, 000 Delaware corporations, there are over 520, 000 Delaware LLCs and approximately 70, 000 Delaware LPs. Copyright © 2010 Richards, Layton & Finger, P. A. All rights reserved. 2

Reasons for Popularity § Limited Liability – Like corporations, LLCs and LPs are separate legal entities. § As a general rule, limited partners of an LP and members and managers of an LLC are not liable for the debts, obligations or liabilities of the LP or LLC, whether arising in contract, tort or otherwise. § Thus, upon bankruptcy, limited partners of an LP and members or managers of an LLC are not required to satisfy liabilities. – Delaware has a strong policy of protecting the liability of limited partners and members and managers. § Delaware courts rarely “pierce the veil” of a legal entity. § Under existing case law, courts only do so in extreme cases of fraud or a disregard of “corporate” formalities. – Limited liability opinions are routinely requested by limited partners of LPs and members of LLCs. Copyright © 2010 Richards, Layton & Finger, P. A. All rights reserved. 3

Reasons for Popularity § Freedom of Contract – Both the LP and LLC Act provide that their policy is to give maximum effect to the principle of freedom of contract and to the enforceability of LP and LLC Agreements. – Freedom of contract with respect to: § Economic rights: You can have separate classes or groups of limited partners or members and separate series of LP interests and LLC interests. § Voting rights: Voting rights can be assigned in any manner provided in the agreement (e. g. , on a per capita, number, financial interest, class group or any other basis). § Fiduciary Duties § Indemnification § Exculpation § Informational rights Copyright © 2010 Richards, Layton & Finger, P. A. All rights reserved. 4

Reasons for Popularity § Up-to-Date Statutes – The LP Act and LLC Act are updated on an annual basis. – The drafting committee meets on a weekly basis throughout much of the year to work on amendments and deal with other issues under the LP and LLC Act. § Responsive Delaware Secretary of State – Easy to form (e. g. , electronic and fax signatures are accepted) – Only general partners are listed in filed certificates; limited partners and members of an LLC are not listed – Expedited filings: § 24 hour, same day, 2 hour, 1 hour, and as short as ½ hour service are available. § Certified copies of documents and good standing certificates can be promptly obtained. Copyright © 2010 Richards, Layton & Finger, P. A. All rights reserved. 5

Reasons for Popularity § The Delaware Court System – Delaware Court of Chancery § The Delaware Court of Chancery often has jurisdiction when disputes arise involving an LP or LLC. § The Delaware Court of Chancery is a court of equity that does not have jurisdiction over criminal or tort matters. – Excellent Judges – Appeal Rights § There is a direct appeal right to the Delaware Supreme Court. § Often, judges from the Delaware Court of Chancery later serve on the Delaware Supreme Court. – The Delaware Court of Chancery is consistently recognized by many as the best business court in the United States. Copyright © 2010 Richards, Layton & Finger, P. A. All rights reserved. 6

Fiduciary Duties, Indemnification & Exculpation § Fiduciary Duties – LP and LLC Act: § May expand, restrict, and eliminate fiduciary duties, subject to the implied contractual covenant of good faith and fair dealing (§ 17 -1101(d) of the LP Act and § 18 -1101(c) of the LLC Act). § Have no liability for breach of the fiduciary duty for good faith reliance on an LP or LLC Agreement. § Maximum effect to principles of freedom of contract. Copyright © 2010 Richards, Layton & Finger, P. A. All rights reserved. 7

Fiduciary Duties, Indemnification & Exculpation § Fiduciary Duties – Restrictions or eliminations must be clear and unambiguous. – How are fiduciary duties modified in the fund context? § § Sole discretion language. Competition Provisions. Resolution of Conflicts. Transactions with Affiliates. – Ambiguities construed against the General Partner (drafter). Copyright © 2010 Richards, Layton & Finger, P. A. All rights reserved. 8

Fiduciary Duties, Indemnification & Exculpation § Fiduciary Duties – Default duties – Analogous to fiduciary duties of Directors to a Delaware corporation and its stockholders. § Duty of loyalty. § Duty of care. § Duty of disclosure. – Business judgment rule. § Entire fairness standard (fair price and fair process). – Cleansing mechanics used in investment fund transactions. § Vote of majority of the minority. § LPAC. Copyright © 2010 Richards, Layton & Finger, P. A. All rights reserved. 9

Fiduciary Duties, Indemnification & Exculpation § Fiduciary Duties – Implied Contractual Covenant of Good Faith and Fair Dealing. § § § Delaware case law development. “Gap-filler”. Application is fact-intensive. Courts are reluctant to infer implied obligations. Examples. – Transfer of interests in General Partner. – Amendments. – Successor funds. – Mergers. § Fisk Ventures, LLC v. Segal, 2008 WL 1961156 (Del. Ch. May 7, 2008). § Bay Center Apartments Owner, LLC v. Emery Bay PKI, LLC, 2009 WL 1124451 (Del. Ch. Apr. 20, 2009). § Joseph Nemec v. Ralph W. Shrader, et al. , 2010 WL 1320918 (Del. Supr. April 06, 2010). Copyright © 2010 Richards, Layton & Finger, P. A. All rights reserved. 10

Fiduciary Duties, Indemnification & Exculpation § Exculpation – LP and LLC Act: § May include exculpation provisions in an LP or LLC Agreement that eliminates liability for breach of contract and breach of duty (including fiduciary duty) subject to the bad faith violation of the implied contractual covenant of good faith and fair dealing. Copyright © 2010 Richards, Layton & Finger, P. A. All rights reserved. 11

Fiduciary Duties, Indemnification & Exculpation § Indemnification: – Indemnification is expressly permitted by § 17 -108 of the LP Act and § 18 -108 of the LLC Act. – Scope of Indemnification § Case law: The Delaware Court of Chancery applied the principle of contra proferentum in analyzing the parties’ interpretations of the indemnification and advancement provisions and found such provisions can be construed against the drafter (Stockman v. Heartland Industrial Partners, L. P. , 2009 WL 2096213 (Del. Ch. July 14, 2009)). – Advancement § May expressly provide for advancement in an LP or LLC Agreement § Is the indemnification mandatory or discretionary? – Apportionment § Does the portfolio company, fund, or sponsor pay for the case? Copyright © 2010 Richards, Layton & Finger, P. A. All rights reserved. 12

Side Letter Agreements in Investment Funds § Increased focus. § Side letters. – – Investors subject to particular policies and laws. Lead investors. Early practice. Solution. § Enabling provision. – Disclosure to investors. – Authorization in partnership agreement. – Not a panacea. Copyright © 2010 Richards, Layton & Finger, P. A. All rights reserved. 13

Side Letter Agreements in Investment Funds § Many variations. – RLF form: Notwithstanding the provisions of this Partnership Agreement, including Section __ [Amendment Section], or of any Subscription Agreement, it is hereby acknowledged and agreed that the General Partner on its own behalf or on behalf of the Partnership without the approval of any Limited Partner or any other Person may enter into a side letter or similar agreement to or with one or more Limited Partner(s) which has the effect of establishing rights under, or altering or supplementing the terms of, this Partnership Agreement or of any Subscription Agreement. The parties hereto agree that any terms contained in a side letter or similar agreement to or with one or more Limited Partner(s) shall govern with respect to such Limited Partner(s) notwithstanding the provisions of this Partnership Agreement or of any Subscription Agreement. Copyright © 2010 Richards, Layton & Finger, P. A. All rights reserved. 14

Side Letter Agreements in Investment Funds § Three areas for analysis. – Disclosure. – Contents of side letters. – Concerns for lawyers. § Disclosure issues. – PPM disclosure. – Partnership agreement. § Contents of a side letter. – Fiduciary duties. – Partnership agreement authorization. – Specific side letter provisions. Copyright © 2010 Richards, Layton & Finger, P. A. All rights reserved. 15

Side Letter Agreements in Investment Funds § Types of side letter provisions. – General partner exercise of discretion. – Provisions that supplement (but do not amend) the partnership agreement. – Provisions that alter partnership agreement terms for only one investor. – Provisions that alter the partnership agreement terms for one investor, with incidental effect on other investors. Copyright © 2010 Richards, Layton & Finger, P. A. All rights reserved. 16

Side Letter Agreements in Investment Funds § Types of side letter provisions. – Incidental effect: Potentially problematic provisions. § § § § Indemnification. Jurisdiction and forum provisions. Reduction of investor’s capital commitment. Investor as observer on LPAC. Alter liability of investor to other investors. Investor pays lower fees. Withdrawal rights. – Provisions that alter the terms of the partnership agreement for all investors. Copyright © 2010 Richards, Layton & Finger, P. A. All rights reserved. 17

Side Letter Agreements in Investment Funds § Concerns for lawyers. – Facilitating fund or general partner wrongdoing. – Opinion problems: Do investors understand the partnership agreement enforceability opinion? § Side letter opinions. – Increasing numbers of requests for such opinions. – Additional issues. Copyright © 2010 Richards, Layton & Finger, P. A. All rights reserved. 18

Issues in Light of Economic Downturn in Private Equity Transactions § Capital Calls and Insolvency – Fiduciary duties: § In zone of insolvency, if corporate analysis is applicable, there is no fiduciary duty to creditors. § Fiduciary duties to creditors are triggered when an LLC or LP becomes insolvent unless otherwise provided in an LP or LLC Agreement. – May general partners make calls to satisfy partnership expenses if a partnership is in the zone of insolvency or insolvent? § We believe that if limited partners have agreed to make contributions for such expenses in an LP Agreement, then such obligations should be enforceable. § Fiduciary duties that the general partner may owe should not eliminate obligations of limited partners under an agreement to make capital contributions. § A general partner should not have to self-sacrifice and absorb liabilities. Copyright © 2010 Richards, Layton & Finger, P. A. All rights reserved. 19

Issues in Light of Economic Downturn in Private Equity Transactions § Enforcing Contribution Obligations – How may a general partner or managing member enforce contribution obligations against defaulting limited partners or members? § Unlike normal Delaware contract law, the LP Act and LLC Act expressly permit specified penalties and consequences in addition to normal contract remedies (§ 17 -502 of the LP Act and § 18 -502 of the LLC Act). § Example: An LLC Agreement may provide that a penalty for failure to make a contribution is the forfeiture or forced sale of an LLC interest in addition to other specified penalties and consequences. – Limited partners and members of LLCs are asking for enforceability opinions on LP and LLC Agreements not only against general partners and managing members, but against the other limited partners and members to make certain other parties are bound to make agreed to contributions. Copyright © 2010 Richards, Layton & Finger, P. A. All rights reserved. 20

Issues in Light of Economic Downturn in Private Equity Transactions § Reducing or Eliminating Capital Commitments – LJM 2 case § Do Fiduciaries have to Self-Sacrifice? § Role of Advisory Committees § Release of Liability for Contributions and Wrongful Distributions (§ 17704 of the LP Act) § In-Kind Distributions § Removal of General Partners or Managing Members § Key Man Provisions § Side Letter Agreements Copyright © 2010 Richards, Layton & Finger, P. A. All rights reserved. 21

Issues in Light of Economic Downturn in Hedge Fund Transactions § In-Kind Distributions – Can assets be distributed in-kind in lieu of cash? – Yes, if an LP or LLC Agreement provides for such distribution complies with § 17 -605 of the LP Act or § 18 -605 of the LLC Act. § Creditor Status – Would a limited partner or member have creditor status to enforce a creditor remedy? § We believe the analysis may be different than the corporate analysis. § See § 17 -606 of the LP Act and § 18 -606 of the LLC Act. § Redemption Requests Prior to Dissolution – If a limited partner or member gives a redemption request prior to a dissolution of an LP or LLC, should that limited partner or member have priority with respect to distributions? Copyright © 2010 Richards, Layton & Finger, P. A. All rights reserved. 22

Issues in Light of Economic Downturn in Hedge Fund Transactions § Distributions and Fiduciary Duties – Absent an authorizing provision in an LP or LLC Agreement, can a general partner or managing member, basing its authority on fiduciary duties, suspend distributions to partners or members if the remaining assets will be illiquid after those first-in-line are paid? § Obligations to Return Distributions – Do limited partners or members who received distributions based upon a Ponzi scheme or fraud have an obligation to return the monies under § 17 -607 of the LP Act or § 18 -607 of the LLC Act [actual knowledge standard] or fraudulent transfer statutes? § Dissolution and Winding Up – What is the liquidation time period for winding up? – Can assets be distributed in-kind during the winding up? Copyright © 2010 Richards, Layton & Finger, P. A. All rights reserved. 23

Legal Opinions § Common Legal Opinions for Investment Funds – Due formation and valid existence – Enforceability of LP or LLC Agreement § This means that: – each specified remedy will be enforced subject to bankruptcy and equitable principles; – if there is no specific remedy, then there will be a remedy subject to bankruptcy and equitable principles; and – that the other terms, such as governance provisions, will be enforced by the highest court of the state. – Due admission of limited partners or members – Validly issued LP or LLC interests (i. e. , the terms of the interests do not violate the applicable Act) – Limited liability opinion – Side letter enforceability opinion – Subscription Agreement enforceability opinion Copyright © 2010 Richards, Layton & Finger, P. A. All rights reserved. 24

§ For questions or more information, please contact: James G. Leyden, Jr. , Esq. Richards, Layton & Finger, P. A. One Rodney Square, 920 King Street Wilmington, DE 19801 Email: Leyden@rlf. com Telephone: 302 -651 -7620 - Or Elisa Erlenbach Maas, Esq. Richards, Layton & Finger, P. A. One Rodney Square, 920 King Street Wilmington, DE 19801 Email: Maas@rlf. com Telephone: 302 -651 -7776 Copyright © 2010 Richards, Layton & Finger, P. A. All rights reserved. 25

This presentation and the material contained herein are provided as general information and should not be construed as legal advice on any specific matter or as creating an attorney-client relationship. Before relying on general legal information or deciding on legal action, request a consultation or information from a Richards, Layton & Finger, P. A. attorney on specific legal needs. www. rlf. com