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When Do Private Equity Funds Have Standing to Assert Indemnification Claims?

March 11, 2011

On March 3, 2011, the New York Supreme Court Appellate Division First Department affirmed the denial of a motion by defendant IAC/InterActiveCorp. ("IAC") seeking the dismissal of indemnification claims arising from the sale of a subsidiary, PRC LP ("PRC"), to affiliates of private equity firm Diamond Castle Partners ("Diamond Castle"). Diamond Castle Partners IV PRC, L.P. v. IAC/InterActiveCorp, 2011 WL 722402 (1st Dep't March 3, 2011).

Through a group of affiliates and related entities, Diamond Castle sought to acquire the outstanding membership interests of PRC, a provider of outsourced telephone based customer care for large and midsized companies and manager of customer call-center services. In order to effectuate the transaction, Diamond Castle formed an entity, Panther/DCP Acquisition, LLC ("Panther"), and on November 2, 2006, Panther, IAC and PRC entered into a Membership Interests Purchase Agreement, pursuant to which all of IAC's outstanding membership interests in PRC would be transferred to Panther. Diamond Castle was not a signatory to the Purchase Agreement. Diamond Castle merged Panther into PRC immediately following the closing of the transaction at the end of 2006.

In January 2008, PRC filed for bankruptcy and Diamond Castle's equity interest in PRC was extinguished by the plan of reorganization. Litigation between Diamond Castle and IAC ensued. Diamond alleged that IAC had breached various representations and warranties made in the Purchase Agreement. Diamond sought indemnification from IAC for losses caused by the alleged breaches, as provided for in the Purchase Agreement.

IAC moved to dismiss the complaint in its entirety, including on the ground that Diamond Castle lacked standing to assert the breach of contract claims. IAC argued that, because Diamond Castle was not a signatory to the Purchase Agreement, the breach of contract claims were barred by the "No Third Party Beneficiary" provision in the Purchase Agreement. Rejecting IAC's argument, the First Department held that the trial court "properly construed the agreement as granting [Diamond Castle] enforceable rights that were not extinguished by the 'boilerplate no third-party beneficiaries' language . . . " In making this finding, the court noted that the Purchase Agreement expressly provided that IAC agreed to indemnify and hold harmless Panther and its "Affiliates," and that such term included Diamond Castle as a "Buyer Indemnified Party." As a Buyer Indemnified Party, the Court concluded the Purchase Agreement "was plainly intended to give [Diamond Castle] enforceable rights."

The Court further reconciled the seeming conflict between its construction of the indemnification provision and the "No Third-Party Beneficiary" provision. It held that, "[i]n light of the numerous contract provisions granting [Diamond Castle] enforceable rights, it was reasonable to construe Section 11.7 [the "No-Third Party Beneficiary Provision"] to exclude only persons who are neither signatories nor buyer or seller indemnified parties." The Court stated, "[t]o construe the [Purchase Agreement] in the manner suggested by [IAC] would be to ignore, the clear, specific provisions of the [Purchase Agreement] recognizing [Diamond Castle's] rights under the agreement." The Court noted that its conclusion was compelled by the equitable consideration that Panther was "merely an acquisition vehicle" and to rule that Diamond lacked standing to seek indemnification from IAC would leave Diamond "without remedy." Id. at *2.

The takeaway of this decision is that New York courts will read an acquisition agreement in order to give meaning to all of its provisions, and that reliance on a "No Third-Party Beneficiaries" provision may not bar potential lawsuits by third parties if other provisions of the contract could plausibly be read to provide those third parties with enforceable rights.

Finally, this decision should be read in conjunction with the United States District Court for the Southern District of New York's decision in Control Data Systems, Inc. v. Computer Power Group, Ltd., 1998 WL 178775 (S.D.N.Y. April 15, 1998).

In that case, the court held that, with regard to a contract for the sale of assets, the seller's foreign subsidiary, as a non-signatory, was precluded by the contract's "No Third-Party Beneficiary" clause from seeking indemnification from the buyer, despite the contract's express statement that the buyer would indemnify the seller and "each of its subsidiaries." 1998 WL 178775 at *2. The Southern District, however, emphasized that its ruling was compelled by "practical considerations," namely that, under the New York common law of contracts, the seller-signatory could initiate a suit on its subsidiary's behalf and subsequently join the subsidiary as a plaintiff. Id. In Diamond Capital Partners, on the other hand, Panther ceased to exist upon the consummation of the PRC acquisition, and thus could not have enforced any rights granted to Diamond in the Purchase Agreement.

The Appellate Division's decision also offers a further takeaway for deal lawyers: notwithstanding that the court ultimately reached a commonsense interpretation of the Purchase Agreement, litigation over third-party standing issues would have been unnecessary had the "No Third-Party Beneficiaries" clause specifically carved-out application of the clause to provisions of the contract where third-party rights were in fact granted.