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Managing general partner litigation risk

The rapid growth of the private equity industry, the recent economic downturn 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 Rebecca Silberstein of Debevoise & Plimpton.

One effect of the recent economic downturn: many private equity funds have suffered significant losses, including funds that were top performers just a few years ago. Some investors have looked to litigation to recoup some of their capital losses, particularly where they believe the losses are attributable to a breach of duty by the general partner. For example, in February 2002, a lawsuit was filed by the attorney general of the State of Connecticut against Forstmann Little & Company following a write-down of investments in XO Communications Inc., although that case has not yet resulted in a decision on the merits of Connecticut's claims. Although lawsuits by limited partners against general partners of private equity funds are still not commonplace, even funds that are well-managed and have honest general partners can lose money; thus, general partners have become increasingly focused on ways to avoid the reputational and financial damage of litigation by investors.

Litigation exposure will depend to some extent on the type of entities involved and the terms of the organizational documents. General partners of private equity funds and their principals may act both on behalf of the fund itself, ordinarily a Delaware limited partnership, and also as directors of public or private portfolio companies. The first part of this article examines some of the risks and relevant standards of conduct that apply to general partners and their designees. In the second part of the article, we suggest some guidelines to help reduce these risks.

The Relevant Duties: A Reminder
Private equity funds customarily organize as limited partnerships (although this discussion generally applies to limited liability companies as well). The Delaware Revised Uniform Limited Partnership Act provides that a partnership agreement may expand or restrict the general partner's fiduciary duties. If the partnership agreement does not establish an explicit standard, the fiduciary duties relevant to directors of corporations apply to general partners by default - namely, the duty of loyalty (the director's actions are solely motivated by the best interests of the corporation and its stockholders) and the duty of care (the director exercises the degree of care and prudence that would be expected if the director managed his or her own affairs). Generally, if directors of a Delaware corporation observe their duties of loyalty and care to the entity and its stockholders, they will be entitled to rely on the business judgment presumption, which is intended to prevent liability for losses caused by business decisions that turn out to be wrong, so long as they were made on an informed basis and in the honest belief that they were in the best interests of the corporation and its stockholders. However, if a director (or its affiliate) is on both sides of a transaction, the entire fairness standard may apply, requiring both a fair price and a fair process, which may include a determination made by "independent" directors.

Under the default duties applicable to general partners (absent modification in the partnership agreement), the general partner's decisions should be shielded by the business judgment presumption if it complies with the duties of loyalty and care. However, in a transaction where the general partner has a personal financial interest in the result, the enhanced duty of entire fairness may apply. The distinction between directors and general partners is that general partners cannot be truly "independent." Although the economic interests of a general partner that invests its own capital in its private equity fund are in part aligned with the interests of the fund's limited partners, there are inherent conflicts of interest between a general partner and its limited partners that cannot be entirely eliminated given the economic and business deal common to private equity funds - among other things, the general partner's carried interest and the other activities of the general partner or its affiliates. Fortunately, unlike a corporation, as stated above, a partnership can modify the default fiduciary duties by clearly providing for it in the partnership agreement - this freedom of contract principle is critical to allow a fund to provide a reasonable approach to dealing with conflicts that may arise. For example, partnership agreements for private equity funds often have provisions allowing for allocation of investment opportunities that might be appropriate for the fund or other entities or affiliates, or setting out specific guidelines to be followed during transactions with affiliates. While it is not clear that fiduciary duties can be entirely eliminated, they clearly may be restricted, and some claims can be barred by a well-drafted partnership agreement.

Several important principals govern any restriction of a general partner's fiduciary duties. First, the provisions must be clearly drafted and explicitly override the default fiduciary duties of care and loyalty. One recent case, Miller v. American Real Estate Partners, L.P., held that a real estate partnership controlled by Carl Icahn was subject to fiduciary duties because the sole discretion provision in the partnership agreement did not expressly supplant the default fiduciary duty standards.

A related point is that courts tend to interpret ambiguities in the partnership agreement against the general partner. This is particularly true where the limited partners took no part in drafting the limited partnership agreement.

Guidelines for Minimizing Risk
The second step in minimizing the legal risks is to implement safeguards. Of course, business practices such as maintaining good relations with your limited partners and enabling assignments of limited partners interests can also help avoid lawsuits. Following is a list of suggested safeguards:

Draft organizational documents clearly. The key provisions dealing with general partner duties in the partnership agreements need to be clearly drafted. Traditional fiduciary principles will be supplanted only by express provisions that cannot be reconciled with the application of the default fiduciary principles. These include the standard for duties owed to the partnership and limited partners set forth in the limited partnership agreement; exculpation and indemnification provisions, where default duties of loyalty and care may be modified; and conflict provisions, where certain actions can be permitted and procedures established. The general partner will be protected from liability if it acts in good-faith reliance on the provisions of the partnership agreement.

Comply with relevant standards. The general partner must carefully consider which provisions of the limited partnership agreement govern a particular action and comply with the relevant standards of conduct. The general partner should consult with counsel to ensure it is following the standards set forth in the agreement and should interpret any ambiguities in the language in good faith (and not to its own benefit).

Process counts. The general partner must establish the proper level of care in making its determinations. This involves being fully informed of all material information reasonably available (and fully informing other decision-makers as well) and deliberating over a reasonable period of time. As a practical matter, courts will be far more inclined to support the judgments of decision makers who act with appropriate care.

Use more care with conflicts. Conflict of interest transactions attract scrutiny and litigation. If the entire fairness standard under Delaware corporate law applies, directors bear the initial burden of proving that both the process and the price were fair to minority stockholders. Likewise, if the limited partnership agreement does not restrict the standard of care, a general partner and its directors may be required to show that a conflict transaction was fair to the partnership and the limited partners. A market check, third-party fairness opinion or consultation with the fund's advisory committee may help to establish that the process and/or price were fair.

Maintain a record. A corollary to good process is the ability to prove it. Minutes should indicate when and for how long decision-makers met and generally what was discussed. However, minutes should not editorialize or enumerate the details of discussions.

D&O insurance. Premiums have increased significantly over the past few years in the wake of numerous corporate scandals, but most funds consider it advisable to insure against the risk of investors' claims. Insurance is not a replacement for good corporate governance, however, for several reasons. In addition to the negotiated deductibles and policy limits, D&O policies typically have important exclusions for bad acts such as willful violations and gaining an improper profit or advantage.

Full disclosure. Remember that certain standards of behavior cannot be negotiated away. For example, a claim of misleading statements or omissions under the anti-fraud provisions (Rule 10b-5) of the Securities Exchange Act of 1934 can apply to disclosure provided in the private placement memorandum, notwithstanding any modification of duties in the partnership agreement.

Rebecca F. Silberstein is a partner with Debevoise & Plimpton LLP and a member of the firm's Investment Management Practice Group and the Private Funds Practice Group. Timothy S. T. Bass is an associate at Debevoise in the Finance Group, the Mergers and Acquisitions Group and the Securities Group. Both are based in New York.

Debevoise & Plimpton LLP, an international law firm, was founded in 1931. The firm, which now has nearly 600 lawyers, provides international services in corporate, litigation, tax, and trusts and estates law. Debevoise & Plimpton offices are located in New York, Washington, D.C., London, Paris, Frankfurt, Moscow, Hong Kong and Shanghai.

Reprinted with permission from The Debevoise & Plimpton Private Equity Report. © 2004 Debevoise & Plimpton LLP. All rights reserved. No portion of this article may be reproduced without the express consent of the authors.