Seeking protection

Industry lawyers are seeing a noticeable uptick in the amount of disputes taking place in the private funds space. One obvious reason why is that five years on from the credit bust, industry activity is returning to pre-crisis levels. That increases the odds of a deal or fundraising gone wrong.
“Disputes almost always follow a period of rapid growth and extraordinary success, for any industry,” says Tim Mungovan, co-head of the private investment funds disputes practice at law firm Proskauer.
A less obvious reason why though is that the game has changed since 2009. LPs have become more sophisticated players in the private funds arena, and are refusing, or at least pushing back on, terms they feel offer GPs too much protection. Couple that trend with nervous GPs watching more of their peers land in court, and some interesting battles are taking place around the negotiation table these days. Indeed, at a more firm-wide level, sources tell pfm that over the last two years more and more GPs are undergoing a massive review of their legal strategies.
One strategy many GPs are now pursuing is including some extra safeguards in the limited partnership agreement. Specifically more exculpation clauses are being agreed that relieve the firm or an individual dealmaker of blame if certain damages are done. For good reason though, investors are making it a hot topic during LPA negotiations.
The way these negotiations start is pretty basic, say sources. The LPA will say GPs and certain other people (including the management firm itself and dealmakers who take a portfolio company board role) are indemnified by the assets of the fund, including all undrawn commitments, when conducting fund business. But here investors are pushing back against terms that seem to reduce the GP’s fiduciary duties too far, and as a matter of best practice, demand any GP behavior that constitutes “gross negligence, fraud or willful misconduct” be excluded from the protections of the indemnification clause. The Institutional Limited Partners Association (ILPA) describes this particular element as best practice.
And the exact wording in the final LPA language makes a huge difference as these points are debated, says Jonathan de Lance-Holmes, a partner in law firm Linklaters’ private funds team. For instance lawyers say GPs are starting to have long arguments with LPs on whether a GP should lose its indemnity protections if it acts negligently, as opposed to the more standard grossly negligent test.
The rub is that GPs agreeing to the more narrow negligence test may be conceding more than they bargained for. Virtually every litigation suit against a private fund manager alleges negligence in some form or another, meaning a lost case would see a GP paying for any fines or damages out of its own pocket. In a similar way, larger LPs are debating whether GPs should lose their indemnification protections if a fund dispute takes place with a certain percentage of the fund’s investor base. 
At a less technical level, GPs say they feel uncomfortable not being covered for breach of agreements, meaning breaking some particular investment mandate or a side-letter provision could leave them liable for damages. The idea is that a LP shouldn’t have to cover the mistakes of a manager who breaks a promise. Yet in many fund documents these carve-outs are being written because GPs are able to successfully argue that a term may be broken inadvertently.
Sources point to a few common scenarios where this argument holds the most water. Take for instance a GP who guarantees it will abide by all securities laws and regulations, which is a fairly typical promise. As reported on pfm, many US-based managers have recently been receiving wrist slaps by the Securities and Exchange Commission for breaking its complicated and technical custody rule. An LP who wanted to take action against a GP that had broken this securities law – and had the aforementioned provision in a side-letter or the limited partnership agreement – may have a case should they choose to pursue it. Meanwhile GPs, feeling concerned about ramped-up regulatory scrutiny, are making it a point to negotiate more legal protections on the matter.
The same can be said for indemnity clauses that do not cover GPs committing criminal conduct. Again, the logic of why an LP would be against this carve-out applies, but criminal conduct is something else that can be committed unintentionally by an advisor, warn legal advisors. “A case I remember involved insolvency in Italy where it turned out that the indemnity didn’t cover criminal conduct. Directors’ liability for insolvency in Italy is criminal, so there was no indemnity to cover the legal costs and the penalties,” says de Lance-Holmes.
Money back guarantee 
Clawbacks are another area where managers are hungry for more legal protection – sometimes at the expense of the LP-GP relationship.
The issue stems from clawbacks that can arise when a fund doesn’t have enough available cash to satisfy an indemnity claim or some other legal expense; take for instance a lawsuit brought against a fund that’s already divested most of its assets. Here too it’s the fine print that’s being agonized over at the negotiation table, sources tell pfm.
Traditionally GPs didn’t face much restriction over when they could ask investors to send money back in light of unexpected fund legal costs. Today though LPs want an agreed time period restriction, or an agreed amount of total distributions, before this can happen, says de Lance-Holmes. A common time limit may be two years after a distribution is made, adds Nigel Hatfield, who leads the private funds group at law firm Clifford Chance. GPs meanwhile are fighting for two years after the fund is fully divested, creating more pressure points during fundraising. Antitrust fines charged to Goldman Sachs recently put the issue on GPs’ radars: the investment bank was forced by EU regulators to define its relationship with a portfolio company exited four years ago.
Fueling the fire 
Another way GPs are shielding themselves from legal fines is by limiting the amount of portfolio company information disclosed to LPs, sources tell pfm. Lawyers say the logic is to limit the amount of data that LPs can use to arm themselves with in the event they want to sue the GP. 
“If you are an investor who would like to find some reason to get some sort of remedy because investments are not doing well, you are going to want to get your hands on as much of the documentation as you can,” says Roger Leese, partner in Clifford Chance’s litigation and dispute practices team. “An investor is going to be unable to show negligence or misconduct without the paperwork for lawyers to crawl over to find any mistakes.” It’s rare that investors are suddenly asking for lots of information on an investment just because they are interested, he adds.
Hatfield says GPs should take time and care when agreeing information provisions in investor side-letters, as a too broadly worded clause could mean a GP is legally obliged to start handing over information it doesn’t want to.
Leese adds that recently there was a UK High Court case over this very issue – Inversiones Frieira SL and another v. Colyzeo Investors II LP and another.
“That was an interesting case which set out some principles for GP’s in considering the level of information LP’s should receive by virtue of their entitlement to see the partnership’s book and records, which is a statutory right. Essentially the case confirms that this right will not allow LP’s to conduct “fishing expeditions”.  It certainly doesn’t generally extend to the GP having to go and find out lots of information about the activities of investee companies.
One might add to this anecdote: welcome to today’s world of legal liability and defensive maneuvering.