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Dangerous Crossroads: the intersection between private equity and litigation

The rapid growth of the private equity industry and the increasingly litigious nature of the business world, have meant that private equity firms are more likely than ever to find a legal battle on their hands, according to Carl Metzger of Testa, Hurwitz & Thibeault.

You've seen the headlines and heard the stories. An established private equity firm is sued by an institutional investor for allegedly improper investments that lost the fund a lot of money. Another firm is accused of "controlling" a portfolio company and causing it to commit massive copyright infringement. Then, one private equity firm sues another and alleges improper dilution in a down-round. Still other private equity firms are seeing their representatives on public portfolio company boards dragged into securities class action suits. How did we get here? Wasn't private equity an industry that had been insulated from even the most common types of business litigation?

It seems the old maxim that "litigation abhors a vacuum" has once again proven true. Over the last several years, as the face of the private equity industry has changed, there has been a steady increase in both the number and types of lawsuits involving private equity firms and their managers. Many had hoped that this phenomenon was merely part of the fall-out from the bursting "technology bubble" and the "irrational exuberance" of the late 1990s. But the nature, severity and continued frequency of these lawsuits suggest that private equity-related litigation is here to stay. To manage and minimize this threat, firms need to become better aware of what the litigation risks are and what proactive steps they can take to protect against those risks.

Lawsuits that have been filed against private equity firms and their managers can be grouped into two principal categories — those arising out of dealings with portfolio companies and those arising out of the internal investment and management decisions of the private equity firms themselves.

Portfolio Company-Related Litigation. Lawsuits relating to portfolio companies have been more common and typically take three forms. First, private equity firms have faced liability for violations of federal and state securities laws relating to their public portfolio companies. The number of such lawsuits has increased as the country's heightened focus on corporate governance and corporate accountability has led to more frequent and severe securities litigation and governmental investigations overall. This situation mandates that private equity firms carefully re-think the value of any direct involvement (such as board representation) that they have with public portfolio companies. If strong business reasons justify the need to stay involved, then it is critical for the firm to have a solid understanding of the risks and the "rules of the road" for dealing with public companies. Second, lawsuits against private equity firms have arisen when a third party dealing with a portfolio company claims that the firm or its board representative is at least partly to blame for the company's alleged misdeeds. Not surprisingly, such suits are most common when the portfolio company is on the rocks financially — the private equity investors behind the portfolio company look like attractive, "deep pocket" defendants as compared to the company itself, its founders or the other directors and officers. These lawsuits often claim that the private equity investors somehow controlled the portfolio company and therefore are responsible for its misdeeds, such as alleged misrepresentations in a merger or intellectual property infringement. Those on the front lines interacting with the portfolio companies need to be trained to identify the potential traps for the unwary, including issues as diverse as fiduciary duty conflicts, bankruptcy-related obligations and employment-related statutory requirements.Third, private equity firms and their managers have faced lawsuits brought by one of their own portfolio companies or its principals, or even by a prospective portfolio company. These suits have involved a wide variety of claims, such as that the firm failed to provide promised financing, the firm improperly passed on confidential business information to another one of its portfolio companies, or the firm assisted with the unlawful firing of a portfolio company executive. To minimize the risk of such claims, private equity firms need to have established procedures in place for exactly how they do business with their portfolio companies.

Fund Management Litigation. Lawsuits arising out of a firm's own internal operations typically have taken two forms — claims brought by investors for fund management and investment decisions and claims brought by partners or employees of the firm arising out of the employment relationship.The first form has involved lawsuits alleging breach of fiduciary duties, misrepresentation and even fraud in connection with the management and investment of the fund's assets. Claims have been asserted against firm managers for breaching their fiduciary duties of loyalty and care by engaging in self-interested activities that allegedly injure or take advantage of the fund or its investors. Private equity firms and their managers have also been subject to claims regarding a lack of care in the investment process, the types of investments made (as compared to the investment limitations set forth in the offering memorandum, partnership agreement or side letters) and the level of risk associated with the fund's activities.

Claims of these sorts still are not common and will likely remain relatively rare. However, with the overall growth of the industry in the last decade and the heightened scrutiny of performance in the current economy, there is likely to be a continued uptick in such claims. Firms therefore need to ensure that they are complying with the terms of their investor agreements and establishing a clear record of how they are fulfilling their fiduciary duties by diligently managing the fund's assets on behalf of the investors.

The second form of management-related lawsuits — claims arising out of relationships with a firm's own partners and employees — has increased substantially in recent years. Private equity firms, like many employers, have been sued by their current and former employees for all kinds of alleged wrongdoing. Generational transitions at some private equity firms have brought certain of these types of claims to the forefront. Establishing sound employment-related policies and seeking early advice of labor counsel when issues arise can make a difference in avoiding claims of this nature.

Conclusion. The growth in the private equity industry and the more litigious nature of the business world have resulted in increased risks of litigation for private equity firms. Many of these risks can be significantly minimized, however, by using good business judgment, common sense and careful business practices.

This article is reproduced with permission of Testa, Hurwitz & Thibeault, LLP.  For more information about Testa, Hurwitz & Thibeault, LLP, please contact www.tht.com

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