Whose side are you on?

A pending lawsuit in Ireland is a case study in potential liabilities for GPs who sit on boards. By Philip Borel

As things currently stand, US-headquartered private equity house Warburg Pincus and the founders and certain investors in QoS Networks, a defunct Irish telecommunications company, are poised to meet in a New York courtroom later this year. The latter group are claiming that Warburg Pincus breached its fiduciary duty in refusing to allow the company to restructure its balance sheet so that additional capital could be raised in order to sustain the business.

The plaintiffs allege that it was Warburg's decision four years ago not to give the goahead to the proposed restructuring which effectively forced QoS into administration. Michael Keane, the company's former CFO, has been quoted as saying:?Warburg Pincus voted for the certainty of nothing instead of the possibility of something when they prevented a capital restructuring that would have allowed new funds into the company in 2001. Keane and his affiliates are looking for a hefty total of $650 million in damages.

Warburg Pincus says it doesn't comment on pending legal matters, although a spokesperson has described the case as ?frivolous and without merit? . The private equity house became QoS' controlling shareholder in 2000 following a $30 million equity investment in the company. Two of the firms' managing directors joined the company's board.

According to press reports, Warburg Pincus has filed a countersuit, alleging that it was misled by QoS over the financial predicament of the business.

If the QoS action goes ahead, it would representa rare escalation of a breakdown of relationships between an early-stage company and its venture capital backers.

So far, judging by calls made for this article to UK-based venture capital practitioners, the case has attracted relatively little attention within industry circles, despite the fact that it highlights one of the most important conflicts of interest potentially facing private equity professionals who sit on the boards of the businesses they invest in.

As noted in ?Director dos and don'ts elsewhere in this issue, in most circumstances a general partner taking a portfolio company board seat as a nominated director shouldn't have a great deal of trouble acting in the best interest of both the portfolio company and the investor they represent. This is so because in most circumstances, both entities are essentially interested in the same thing – the company's prosperity.

However, this may change when the portfolio company experiences financial distress. Imagine a scenario in which management argues that a recapitalization is required in order to ensure the company's survival and asks its private equity investor to either inject additional capital into the business or to step aside to allow the company to raise fresh funding from other sources, a move that would dilute the investor's stake. Imagine further that the investor has no interest in pursuing either option.

From the point of view of the private equity fund as an investor in the company, there is no ambiguity even in this situation. Simon Witney, a partner at London-headquartered pan-European law firm SJ Berwin, puts it: ?In English law, the private equity house as an investor in the business has absolutely no obligation to put more capital in place if they don't believe that there is still a realistic prospect of achieving the required return from the investment. This is the whole point of limited liability. Neither do they have to give any reasons for blocking a restructuring if that's what they believe to be in their best interest.?

(As an aside, it is worth noting that if the investor does agree that a capital injection from an outside investor is the best way forward, a conflict is likely to arise with regards to the company's valuation at which the recapitalization should take place. To avoid this conflict, according to a London-based venture capitalist, nominated directors representing an existing investor in the company often choose to give way to an independent board member to lead the relevant negotiation with third parties.)

An important complication arises if an employee of the private equity investor sits on the board of the company in need of extra funding. In his capacity as a nominated director, this employee has a duty to take ?every step to protect creditors from potential losses. If the nominated director agrees that additional funding is the best way to achieve that, that is what he is obliged to advocate in negotiations between the portfolio company and the private equity investor.

According to Witney, in order to avoid any wrongdoing and personal liability, the nominated director must in this case remove himself as far as possible from the investor's decision-making process. If the director communicates the board's intention to seek fresh funding back to the private equity investor who then decides to veto it, no obligations will have been breached – provided the investor's decision to veto was taken by individuals other than the nominated director himself.

If the nominated director has knowledge of the investor being likely to turn down the company's call for more cash prior to the decision being official, he must inform the company's board straight away. Failure to do so may lead the board to continue to make decisions based on the false assumption that the investor will provide additional funding to keep the business solvent. In court, this may be treated as socalled ?wrongful trading and lead to a personal liability for the nominated director in the event that the business has to be liquidated.

SJ Berwin's Witney says that most private equity houses have focused on these issues – some more carefully when private equity sponsored dotcom companies started going to the wall at the beginning of the decade. As a result, many groups now have sophisticated procedures in place to ensure potential conflicts will be handled adequately.