Thinking like a judge

Lawyers drafting the LPA often do so in circumstances where the spirit among the protagonists is collaborative owing to the inherent alignment of interests. But when things go wrong, there is often plenty of scope to argue about what the true intention of the parties was at the time of drafting.

Ultimately the courts can simply as a matter of interpretation read the word “black” as “white” if that is what the judges find to be the real commercial intent of the parties. And therein lies the risk; an examination of recent UK case law demonstrates that judges (for the most part former lawyers) are perhaps not best placed to work out the commercial intent of the GP and LP and have come to wildly opposing views on the same facts.

Therefore it is worth, where possible, seeking to spell out matters in greater detail at the drafting stage and not leave specific issues or concerns to be decided by the courts. It is through having experienced the many manifestations of the breakdown in the relationship between LPs and GPs that one can both seek to draft the LPA in a more certain way as well as maximizing the opportunities for resolution, favorable to one side or the other, when a conflict arises.

The nature of the negotiations surrounding the LPA, and the customary expectations as to how standard clauses ought to look, impacts on the ability to reach an agreement on detailed “judge proof” wording. It is important not only for litigators but for fund managers and their non-contentious advisers to understand how the courts approach the issue of construction of contracts so they can assess the risks and maximize their chances of winning in the event of a contested situation.

The law on interpretation

Thankfully we no longer live in a world where the UK courts apply a literal and rigid construction to a contract. At one time, the courts of chancery concluded on a particular case, that where a spinster had left all her money to a distant relative, the term “money” did not sufficiently cover bonds. As a result, her only assets went to the Crown.

Today, the search is for the true meaning of the contract, taking into account the whole factual matrix. The decision in ICS Ltd v. West Bromwich heralded this change, sweeping away the old rules of contractual interpretation. However, the court’s ability to take into account the whole factual matrix and the greater discretion given to the judiciary in working out the true commercial intent has created a new danger. The danger is not apparent from analyzing the fine words of Lord Hoffmann in this case but by noting that on its way to the House of Lords, four judges took the view that the words used were perfectly clear, while five judges thought the words were a “commercial nonsense.”

The key principles drawn from the case can be summarized as follows:

– Interpretation is the ascertainment of the meaning that the document will convey to a reasonable person, having all the background knowledge, which would reasonably have been available to the parties in the situation they were in at the time of the contract.

– Subject to the requirement that it should have been reasonably available to the parties, the background includes absolutely everything that would have affected the way in which the language of the document would have been understood by a reasonable person.

– The law excludes from the admissible background the previous negotiations of the parties and declarations of subjective intent.

– The meaning of words is a matter for dictionaries and grammar; the meaning of the document is what the party using those words would have understood it to mean against the relevant background.

Agreement to agree

In the private equity space (and more generally), there have been a number of cases that reiterate the reluctance of courts to hold a contract invalid for uncertainty. The gaps can be filled by allowing one party to choose the least favorable way of performing a contract or to give effect to obligations to use reasonable endeavors to take steps needed to enable the agreement to be concluded. The author acted for the defendant in a case that enabled a party to elect to choose the least favorable start date for a lease, which prevented it being void for uncertainty.

The safest line is to assume that the courts are reluctant to find contracts unenforceable. The line that they will not cross is to give effect to clauses requiring parties to negotiate in good faith or to agree matters. That is something that is often not understood by clients – many agreements involving significant sums of money have failed on the basis that the essential terms remain to be negotiated and are not enshrined in the contract.

In one example (where the author had an advisory role), an individual left their position on the basis of a heads of terms with a view to forming a fund, only to find the court determined that certain of the key terms had not been sufficiently covered. It amounted to an agreement to agree and was therefore not enforceable.

Conversely, in order to avoid arguments arising as to the status of heads of agreement, which are not intended to be legally binding, it is good practice to provide that: “No agreement will be reached on a legally binding basis until the solicitors acting for the parties expressly agree in writing that matters are no longer subject to contract.” Without these express words, the author has acted on cases where, even though parties initially start on a “subject to contract” basis, there has been litigation over whether a binding deal was subsequently agreed.

Too many cooks

Mistakes also often happen when input is received from different areas (whether within a firm or outside). One just needs to look at the number of claims arising out of arguments over the construction of completion accounts to appreciate how the involvement of forensic accountants and lawyers leaves room for mistakes.

Where a firm is coordinating a large document with input from different departments, judges expect a partner to take responsibility for ensuring that the different parts fit together, even if this is a cost clients may not wish to bear. The courts have indicated that it would be good practice to have input from someone who is not involved in the drafting of the agreement regarding what may be meant by the words used.

This practice may, in any event, lessen the chances of a mistake being made and if wrong advice is nevertheless given, reduce the prospects of it being found to have been negligent.

In putting together the LPA, there is a need to coordinate a number of different areas of expertise (for example, regulatory, tax and litigation). The fund manager should make sure that there is at least one partner with the requisite overview of how all the components fit together.

Late night compromises

In order to get a deal done, wording is often accepted that is less than clear. It may well be that had express wording making the issues crystal clear been put forward, the deal would have collapsed.

Using words that can mean different things to different parties may get a deal done, with each party implicitly accepting that there will be some argument as to what was actually agreed at the time of drafting, were a dispute to arise in the future. The danger for the law firm, in-house lawyer and the client is when there is no record of this process and they are later judged against the requirement to have drafted matters clearly in the LPA or to have warned the parties as to the ambiguity in meaning (if not apparent).

Fund managers and investors should encourage their lawyers to give them clear advice on what a clause may mean, while pointing out the risk that the law courts may take a different view. This should not be treated as uncommercial but a proper fulfilment of their obligations and what the courts have implicitly recommended. In-house lawyers are often at the sharp end of this process and have been subject to claims of contributory negligence in failing to spot mistakes arising from the interpretation of contracts and indeed the meaning to be attributed to their instructions. It is in this environment that it makes sense to find practical ways of avoiding mistakes.

Concluding thoughts

The drafting of clauses, which will be operative in the event of there being a falling out between GP and LP, requires an understanding not only of the law on interpretation and how different clauses might be argued, but also an understanding of commercial practice in this area.

Through understanding both of these areas well, it is possible to make small changes, which may be very important in the event that the parties fall out. If viewed purely through a legalistic angle, it would of course be safer to adopt a torrential style of drafting to provide specifically for all the possible consequences and circumstances that may arise in future, but this is not likely to be acceptable in practice.

Given the nature of private equity disputes (often resolved on a confidential basis before the issuing of proceedings or where proceedings are subject to arbitration proceedings), a whole bank of know-how and experience has been built up by practitioners in this area without it being shared with the wider profession.

Harnessing the understanding of accepted practice, the factual matrix and the uncertainty of how the courts may interpret provisions, can lead to matters being settled on favorable terms. Practitioners need to recognize the advantages of having joined up departments, which allow non-contentious and contentious lawyers to work together prior to actual disputes arising so as to benefit their clients.

Hilton Mervis is a London-based partner in the litigation and dispute resolution group at King & Wood Mallesons. This was an edited excerpt from a chapter in PEI’s recently launched title: Private Fund Dispute Resolution, available at: www.peimedia.com/books