Generally it’s believed any talks with your lawyer about a deal in the works is protected by attorney-client privilege. Private equity executives need to be able to speak candidly with legal counsel during M&A negotiations without having to worry about outside observers misconstruing their language.
But in a case that’s changing how lawyers draft M&A contracts, that assumption is being proven wrong. And now it looks like the case may prompt GPs to think about how they conduct their M&A due diligence too.
The case, Great Hill Equity Partners IV, LP v. SIG Growth Equity Fund I, is still moving through the Delaware court system, the US jurisdiction of choice for private fund managers. To put the facts of the case simply: one private equity firm is accusing another of turning a blind eye to fraudulent statements made by a portfolio company prior to its sale. When gathering evidence to prove its case, the plaintiff (the buyer) discovered records of pre-merger discussions between private equity board directors and target company management that they feel show the selling GP had knowledge of or even assisted in the alleged fraud.
The defendants initially wanted the court to rule that a sold portfolio company doesn’t bring with it privileged conversations made pre-merger. Last year, based on specific facts and circumstances, a Delaware court rejected that argument. In the time since, private equity lawyers tell us the case has produced a noticeable influence on M&A negotiations, with sellers more mindful that privileged conversations can become accessible to the surviving corporation post-merger.
After losing that battle, the selling GP presented a new argument: the case should be dropped because as outside directors, they can’t be held liable for portfolio company execs' behavior. The day before Thanksgiving, the court rejected that argument too.
This may give pause to some. One of the core principles of the private equity model is that GPs are (legally speaking) one step removed from the actions of portfolio companies. Board directors parachuted in by the management firm are afforded a similar liability shield, within reason. The case at hand however isn’t questioning this fundamental tenet of private equity: instead, plaintiffs provided the court with lengthy communications between the GP and portfolio company management that they claim serve to show a willingness by the private equity board directors to facilitate fraud.
The takeaway is that GPs need to be mindful that attorney-client privilege isn’t a “say whatever you want with immunity” rule. When discussing a merger, talks with your lawyer can be exposed to buyers who may suspect something fishy about the deal post-transaction. The 76-page opinion released over the holiday break is itself a notable outcome of the case: in atypical fashion for a memorandum opinion, the court took great lengths to show where and how the private equity directors could be tied to the case. The super-diligent within the industry may use it as a roadmap for how their portfolio company management teams present facts, provide answers to written due diligence questionnaires, and upload data room disclosures during the sale process, because any representations or language that could be tied back to the firm is a potential legal liability as a result of the opinion.
Following the Thanksgiving opinion, defendants have roughly a month from today to answer plaintiff’s original complaint. Private equity dealmakers should consider tracking the case right through to the end.
For more on M&A negotiations and where key deal terms are moving, see the December issue of pfm.