New frontiers in liability

How can GPs get sued? Let us count the ways. The business of private equity is increasingly fraught with legal risks both known and unknown. By David Snow, Editor

As Deep Throat advised young Washington Post reporters hot on the trail of the White House Watergate scandal (in the movie All the President's Men),?Follow the money.?

This strategy is increasingly being adopted by aggrieved parties looking for someone to sue in the wake of a failed business, an employment termination, or an underwater pension scheme ? private equity GPs affiliated with these sad affairs have and control money, and therefore make good targets for lawsuits.

This is great news for providers of insurance and legal advice, but bad news for GPs, who naturally don'twant personal or partnership money sucked into legal battles or settlements. Perhaps even more importantly, a professional who's most valuable asset is time cannot afford to spend it on proliferating lawsuits.

And yet, a heightened threat of lawsuits may be a permanent fixture for private equity GPs globally. Private equity has grown exponentially as a participant in the economy over the past 10 years. Public awareness is beginning to catch up in good ways and bad. Lawsuits typically emanate from a failure of some sort, and the litigious-minded are now keenly aware that private equity sponsors play major roles in the operations and fates of businesses. In addition, private equity firms are often the only ones with money after the dust has settled.

Without a doubt, litigation involving private equity firms is on the rise. James O'Brien, a managing director in Aon's Private Equity & Transaction Solutions Practice , says his firm has seen a ?marked increase? in claims brought against private equity clients. ?The liabilities have always been there,? O'Brien notes.?But there appears to be a growing threat of litigation in today's environment.?

O'Brien, who is based in Aon's New York office, says his practice group keeps a database on its more than 400 private equity clients, and he has seen ?more claims in the last three years than in the previous 10 years combined.?

Much of the litigiousness stems from the bursting of the technology and telecom bubble, which saw hundreds of businesses go down in flames. Many of today's lawsuits still involve companies that failed in the early 2000 period. But legal action sets precedent for further legal action of the same type, and risk experts are watching the horizon for the next wave of business failures, which in turn will no doubt give rise to a large batch of GP-centric lawsuits and regulatory actions.

Lawsuits typically emanate from a failure of some sort, and the litigiousminded are now keenly aware that private equity sponsors play major roles in the operations and fates of businesses.

There are five broad stages of private equity activity which can give rise to lawsuits. These specific types of liabilities have always and will always be with us:

  • ? Fundraising ? a general partnership may be sued for presenting fraudulent information in the pursuit of LP commitments
  • ? Investment period ? LPs may allege an investment is against the interests of the partnership or involves self-dealing on the parts of the GPs
  • ? Portfolio company oversight ? Lawsuits may relate to sitting on boards, employment practices and perhaps allegedly favorable dealings with other portfolio companies
  • ? Distributions ? a GP group may be accused of improprieties surrounding inkind or cash distributions
  • ? Management of the fund ? clawbacks are a big issue.
  • ? Realizations ? IPOs, secondary offerings and trade sales are complicated affairs involving many competing interests, and often parties to these transactions blame GPs if they feel the game is rigged.
  • On a number of new frontiers within these five broad stages, general partners are being advised to watch out:

    The application of financial leverage is not new to buyout firms. But the ongoing wave of so-called dividend recaps is unprecedented as a method of extracting value from a portfolio company. Standard & Poor's Leveraged Commentary & Data counted 40 dividend recaps in 2003 and 91 in 2004. Many industry observers worry about the consequences of this trend if today's dividend recapitalizations become tomorrow's bankruptcies.

    Specifically, a private equity fund that has paid itself a dividend through a recapitalization that leaves the portfolio company in question too leveraged risks attracting the ire of others with vested interests, including employees, lenders, shareholders and, in particular now, unsecured creditors, says Aon's O'Brien.

    ?We expect to see more bankruptcy court disputes over the treatment of debt vs. equity,? says O'Brien.?Last year, we saw the unsecured creditors of a bankrupt portfolio company seeking permission to sue the private equity firm over loans that the private equity firm provided before the company sought bankruptcy protection, asserting that the loan should have been treated as equity.?

    Such a situation can result in claims where the GPs are accused of breaches of fiduciary duty, or possibly ?unjust enrichment.? Claims are usually made against both the private equity firm and its individual GPs but, adds O'Brien,?are usually settled out of court with insurance policies increasingly contributing to these settlements.?

    According to Danyalle Brinsmead, a European leader of the M&Amanagement liability group in Marsh's London office, her firm has looked into the liabilities thatmay arise from dividend recaps and concluded that for now commercial relationships between banks and private equity firms are ?so strong that you wouldn't see a court case.? But smaller bondholders have quietly communicated that they would be willing to litigate around this matter in certain situations, Brinsmead says.

    These days, the term ?passive investor? can be a dirty one for GPs trying to raise capital. Instead, private equity teams try to convey an image of hands-on builders working sideby-side with management, sometimes even stepping into management roles where needed. This operational profile attracts LP capital, but it also has been attracting employment practices-related lawsuits, which identify private equity funds and their GPs as employers, and therefore subject to claims brought by aggrieved employees.

    John Fox, a partner in the Palo Alto, California office of law firm Manatt, Phelps & Phillips, says he has on several occasions defended venture capital GPs against wrongful termination suits brought by former managers or employees of portfolio companies. Traditionally, private equity funds have been seen as investors protected by a ?corporate shield? with regard to employment issues. Now, according to Fox, while no one case in the US has definitively identified private equity sponsors as employers, a number of cases have proceeded under that assumption.

    For example, if a group of employees in the US are laid off without being given at least 60 days notice, they may file suit under the Worker Adjustment and Retraining Notification (WARN) Act, which requires such a notification. Unless a private equity firm is careful to draw a line between itself and portfolio company management, they could be fingered for violating the WARN Act in the wake of major layoffs.

    Fox says that while he always seeks to have his venture capital clients dismissed from such cases, the issue of whether they will be seen by a judge as an employer is evaluated on a case-by-case basis.?If [a venture capital sponsor] makes employment decisions wearing that hat of chairman of the company, it makes it more like they are the employer.?

    Fox adds:?In the real world, venture capitalists do not distinguish between their two lives? as both investor in a company and manager of the company. ?Many VCs are operating two or three tiers down the chain of command, directing the activities of more junior employees.?

    In the event of a company collapse ? not a rare occurrence in the venture capital world ? employees are now more likely to target a venture capitalist because, says Fox, ?there may be no one else with money.?

    In the end, private equity GPs will not likely step back from active oversight of portfolio companies just to avoid lawsuits. ?My experience is thatVCs, at least in Silicon Valley, are fully aware of this issue, however they don't care,? says Fox. ?The alternative for them is worse.?

    Related to the risk of GPs being seen as former employers of aggrieved parties is the combustible issue of underfunded pensions. In North America and across Europe, corporations face crushing burdens in the form of pension liabilities. Investors in and owners of these corporations may be on the hook if retirees stop getting their checks.

    Just this past April, the UK took a step toward GP liability in this regard with the creation of The Pensions Regulator, which the government has empowered to force employers to make contributions to underfunded pensions. The new regulator was part of the Pension Act 2004. In some cases, The Pension Regulator may require ?connected and associated persons? to bail out a pension scheme. It is not yet clear if this will be construed to refer to private equity funds.

    According to Dennis Gan, a due diligence specialist in Aon's London office, ?Private equity firms are concerned that if a portfolio company goes bust, can The Pension Regulator then come after the fund itself? To date it has not happened, but the regulator's power is very broad and it could include that.?

    Gan adds that he feels an imminent move by The Pension Regulator to require private equity sponsors to speak for underfunded pensions is unlikely.?Right now the risk to the GP and LP is quite limited.?

    According to Marsh's Brinsmead, the new Pension Act is expected to be applied such that private equity GPs will have to get approval from The Pension Regulator before taking a portfolio company through a dividend recap if the company in question has an underfunded pension.

    The [UK] Pension Regulator may require ?connected and associated persons? to bail out a pension scheme. It is not yet clear if this will be construed to refer to private equity funds.

    Private equity firms have been making great headway across Europe as owners and improvers of businesses. While the many successes of GPs will no doubt further the impression that they are not?locusts,?as one German politician put it recently, not all of these investments have happy endings. And in such cases, the insolvency laws of certain Continental European countries present huge liabilities for GPs who sit on the boards of failed companies.

    In Italy, for example, board members of an insolvent company may find themselves subject to a criminal case. Marsh's Brinsmead notes that very few board members actually end up in an Italian prison. ?The worst case scenario is that it takes 10 years to work its way through the [Italian] legal system,? says Brinsmead. ?Who's going to pay that cost??

    In France, Brinsmead says, the judicial system surrounding insolvency is ?full of black holes.?

    Directors and officers insurance usually pays the expense of fighting insolvency law suits. Brinsmead estimates that almost 100 percent of private equity firms in the UK use this insurance, but in Germany, for example, where a board member's risk of being held liable for an insolvency is greater, and where the public perception of private equity is not as positive, the use of D&O insurance ?may be as low as 25 percent?among GPs.

    Ugly things happen in the midst of a breakup. Manatt Phelps' Fox notes that partof the reason portfolio company managers seem more likely to sue their one-time venture capital partners now has to do with some of these executives not wanting to work in startups anymore.?In the old days the portfolio company CEOs would never sue because it was get along, go along,?says Fox. Now that venture capital investing is so much more difficult, some of these managers are ?less and less excited about the prospectof continuing in the role of temporary CEO?and therefore don't worry about burning their bridges to the venture capital community.

    Some limited partners, for whom the bloom is off the private equity rose, may take the same view. Thomas Beaudoin, a partner in the Boston office of law firm Wilmer Cutler Pickering Hale & Dorr, says he expects to see law suits in the future from LPs that are exiting the private equity asset class.?The late 1990s, early 2000s were a time of hasty decisions,?Beaudoin says. ?Some LPs that have allocations today are coming to the realization thaton a risk adjusted basis, the returns are not what they expected.?

    Beaudoin, who represents mainly venture capital firms and middle-market buyout, says that ?where the relationship no longer exists, people are more likely to sue.?

    Although high-net-worth individuals are prone to going after the personal assets of GPs, Beaudoin says these cases are ?like mosquito bites? compared to the damage that large pensions can inflict. In particular, Beaudoin says some of the more recent European entrants to the market may seek to sue GPs on their ways out of the asset class (see chart on p. 24).

    Where poor performance is a sore point, allegations of a breach of fiduciary duty may take center stage in these suits. But in an industry that presents so many perceived conflicts of interest, warns Beaudoin, ?You never know what people are going to come up with.?