Held to One Standard, Protected by Another: When GP Duty and Indemnity Don’t Align
>> An overlooked drafting gap that can render your hard-won fiduciary protections worthless.
Imagine a new investment opportunity crosses your desk. The strategy is well-conceived, complements your existing portfolio, and is managed by a team with a credible track record. But as you review the LPA, concerns begin to emerge. The General Partner’s operational discretion is strikingly broad, and many of the standard protections you’re accustomed to receiving are notably absent.
The LPA’s contractual risks are unacceptable, but you’re also not inclined to expend resources renegotiating the agreement wholesale. As a targeted remedy, you push for a provision holding the General Partner to a higher standard of care in the exercise of its powers and discharge of its duties. This is a significant concession—most LPAs provide only for gross negligence, but you’ve secured something with real teeth.
This likely describes the negotiation dynamic behind an LPA we recently reviewed. The agreement gives the General Partner a level of discretion that would be unacceptable without meaningful counterweights. Yet the otherwise sponsor-favorable document features a rare heightened fiduciary duty requiring the General Partner to act with the care of a prudent expert. Sounds like a potentially fair compromise, right? Not so fast.
The LPA contains a critical drafting flaw that undermines this hard-won protection. The standard of care in the indemnification provision is not conformed to the fiduciary duty standard and instead remains tied to typical gross negligence. This mismatch threatens to vitiate the fiduciary duty provision and risks situations where the General Partner breaches the negotiated standard of care but is still indemnified by the fund.
In this article, we unpack the relevant provisions in plain English so that you know what to look if you ever find yourself in a similar situation.
A Sponsor-Favorable Baseline
The LPA contains several provisions that, even taken individually, would raise concerns for most institutional allocators. We illustrate with a handful of examples below:
Uncapped and Undefined Follow-On Obligations. The LP is obligated to fund uncapped “then-existing commitments” and “follow-on investments” without time limitation. In practice, the GP will determine the scope of these undefined terms.
Blocker Payments Deemed Distributed. The LPA permits Blocker Payments to the Partnership to be “deemed distributed” to the Partner to which the tax liability is attributable. This allows the GP to shift the full tax burden on the LP.
Reserves Charged Generally Against NAV. When the General Partner creates reserves for liabilities and contingencies, it can charge them generally against NAV instead of specifically charging and allocating them.
No Negative Capital Account Prohibition. The LPA fails to prohibit negative Capital Account balances, omitting a common investor protection meant to protect against anyone taking out monies beyond what has been contributed by or distributed to the LP.
Discretion to Depart from LPA Allocations. The General Partner is granted unusual authority to “make allocations and adjustments to Capital Accounts” that “differ from specific provisions of the LPA.”
Each of these provisions warrants attention. In combination, they create a structure riddled with loopholes where the General Partner can gain advantage. Against that backdrop, a heightened fiduciary duty would appear to offer critical investor protection—if effective.
In the rest of our writeup, we look at:
A Rare Concession: Heightened Standard of Care
Undone in the Fine Print: Indemnification Misaligned
Key Takeaways:
Heightened Fiduciary Duties are Rare—and Valuable
Ambiguity Favors the GP
Best Practice to Align Standards across the LPA
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1 See ERISA Section 404(a)(1)(B).
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