It is rare that private equity firms end up in court, but law firms say they are gearing up for an increase in disputes on both sides of the Atlantic should there be an economic downturn.
In instances where managers or assets come under pressure, the likelihood of disputes arising between sponsors on deals, between investors and their managers, and between lenders and GPs, looks set to increase.
Stephen Surgeoner is a London partner in the disputes practice at law firm Dechert, who often works with funds. He says: “Most falling out between funders or between GPs and LPs happens below the radar and is resolved behind closed doors. That remains true unless and until we find ourselves dealing with more distressed situations, where there are private equity funds struggling to make the promised returns or getting into distressed situations. With situations like Abraaj Group, which did fall into a distressed situation, there is plainly the potential for LPs to be looking for some sort of recompense if it’s available in relation to investments that may have gone wrong.”
Abraaj, the $14 billion buyout firm based in Dubai, collapsed in 2018. In April 2019, the US Securities and Exchange Commission filed a civil lawsuit in federal court against the firm and its founder for fraud and alleged misappropriation of more than $230 million.
Many of the situations where PE firms do end up in court involve them undertaking some form of restructuring transaction in a portfolio company, resulting in disgruntled lenders or investors. Although those deals do not always involve distressed situations, we are likely to see more of them if the market turns.
Aaron Marks, a partner in the commercial litigation practice at Kirkland & Ellis in New York, says debt restructurings are a contentious area. “After a sponsor has purchased a company and the company has various levels of debt from the leveraged buyout, the company is often interested in doing some form of restructuring. There have been a number of lawsuits recently where company lenders, noteholders in particular, allege that the restructuring transaction has moved assets away from their reach,” he explains. “The noteholders sue not only the portfolio company, but also the private equity sponsor, on aiding and abetting and similar theories.”
US retailer Neiman Marcus and its private equity owner Ares Management were both sued last year by bond trustee UMB Bank in an ongoing case that alleged they illegally transferred Neiman’s Mytheresa subsidiary out of the reach of creditors.
Meanwhile, pets product retailer PetSmart and its private equity owner BC Partners were subject to a lawsuit in 2018 after they transferred a 20 percent stake in Chewy.com to parent Argos Holdings. PetSmart insisted it was in full compliance with the financial requirements under its debt agreements when it transferred the shares out of reach of lenders and secured bondholders.
Marks says: “We see cases where noteholders allege that they have either lost their ability as the result of a company transaction to be able to access the security for their notes or that they otherwise have had their rights impinged, and they bring lawsuits to either try to block those transactions or accelerate on their notes. The private equity sponsor is often named as a defendant in the case by the noteholders, so sponsors therefore have to be conscious of that risk.”
The US plaintiffs’ bar
In the US, a move by the Delaware courts to stem the number of cases against directors of public companies has led the plaintiffs’ bar to seek out new targets.
Shannon Rose Selden, head of the asset management litigation practice at Debevoise & Plimpton in New York, says: “The plaintiffs’ bar has been quite frank about the fact that it is now more interested in testing claims against financial advisors, minority blockholders, officers and even counsel. They are interested in the roles of those parties and the impact their actions can have in corporate transactions, and they are looking to test the law in a number of areas.”
“Most falling out between funders or between GPs and LPs happens below the radar and is resolved behind closed doors. That remains true unless and until we find ourselves dealing with more distressed situations”
With private equity sponsors increasingly interested in taking less than controlling stakes in portfolio companies, that can create a significant new area of risk, as can efforts by plaintiffs to ‘impute control’ to owners who hold less than 50 percent of a company.
Selden says: “We have seen that in federal securities cases, in Delaware M&A litigation and generally across a wide spectrum of cases asserting breach of fiduciary duty and control claims. The plaintiffs’ bar is now much more sophisticated about the role of a minority stakeholder that is a sophisticated investor, and they are arguing that despite the stake being less than 50 percent, the sophistication of the investor and the fact that it has a seat on the board means it is exercising control disproportionate to its technical ownership stake.”
She adds: “You can see why the plaintiffs are interested in testing that, but it’s troubling because the law is in flux. To the extent that the courts are willing to entertain these arguments, they may be shifting the ground rules on what investors would typically consider to be their role as a minority investor.”
The implication is that PE funds face new exposures. Selden adds: “At the macro level, as the profile, number of players and amount invested by the private equity industry has increased, the plaintiffs’ bar is more inclined to pursue claims against sponsors and funds. The assumption that litigation attaches to public deals not private deals, and to strategics not private equity, is no longer so clear.”
In the UK, an April 2019 Supreme Court decision has also shone a spotlight on expanding liabilities for private equity firms, with a judgment involving Vedanta Resources suggesting private equity funds could be liable for human rights breaches by their portfolio companies. The Vedanta case involved claims brought by Zambian farmers against a Zambian subsidiary of Vedanta, and the parent company. Where previously it had been thought that liability only attached to a parent company for acts of its subsidiaries in very limited circumstances, the judgment suggested the parent should be liable.
“Because private equity funds are now investing at different levels of the capital structure, or because the capital structures are becoming more complicated, we are seeing a lot more multi-party litigation focused on that, including value breaks and who gets out first”
That suggests private equity firms could be liable for portfolio companies. Marcus Thompson, a partner with Kirkland & Ellis in London, says: “That has real consequences for private equity, where the debate continues as to how to strike the right balance between, on the one hand, leaving the operations of the portfolio company to the portfolio company’s management team and, on the other hand, taking a more active role in risk management and protecting the value of the investment. The latter is what many investors increasingly expect to see, and there is growing pressure from LPs and NGOs for private equity to take more responsibility for their investments.”
One final area that has been identified as a growing area of risk relates to confidentiality exposure, particularly in relation to due diligence.
Marks of Kirkland and Ellis in New York says: “We see substantial litigation activity relating to different stages of a private equity transaction, beginning with the initial bidding stages. There have been several lawsuits where a potential acquirer and a target company come together, execute a non-disclosure agreement, and the potential acquirer is then given access to the target company’s proprietary data in order to assess the company. The transaction ultimately does not go forward and, sometime later, the target company sues for trade secret or some other IP misappropriation. There are a number of suits currently pending against PE firms that have similar fact patterns.”
“There have been a number of lawsuits recently where company lenders, noteholders in particular, allege that the restructuring transaction has moved assets away from their reach”
Kirkland & Ellis
“The advice from the get-go for a sponsor that is a potential acquirer is to be mindful of the terms of the executed NDA and to be thoughtful about who is involved with diligence and how the potential target’s confidential information is handled,” says Marks. “Even though a case of alleged misappropriation may ultimately prove to be meritless, discovery of the potential acquirer alone can be very invasive and expensive. But that can be mitigated by keeping a diligence team to a small, tight group, and being disciplined in routing and storing confidential diligence material relating to the target in a designated drive or folder, rather than permitting the target’s data to go throughout your data storage and email systems.”
These disputes arise most frequently where the sponsor already owns an asset in the industry and was looking to buy a competitor, or where a sponsor passes on the opportunity to buy a company and then subsequently buys that company’s competitor.
The litigation risks that private equity firms are exposed to on both sides of the Atlantic continue to evolve and will only increase should the economy take a turn for the worse.
Andrew Fox, a litigation partner with Sidley Austin in London, says: “Private equity litigation has changed a great deal in the last 10 to 15 years, largely driven by the diversification of PE assets and interests. We used to be looking only at the standard LBO model, but what we see now is a much wider array of subject matters and types of disputes. Often, because private equity funds are now investing at different levels of the capital structure, or because the capital structures are becoming more complicated, we are seeing a lot more multi-party litigation focused on that, including value breaks and who gets out first.
“That’s quite an exciting area and we are at a point in the economic cycle now where not everyone is going to get paid out at all levels, because maybe an asset was over-leveraged or because of the economic climate, and that creates more potential for disputes.”
Private equity clients are notoriously keen on certainty and predictability of outcomes, but a changing disputes environment could create new risks for funds going forward.
As well as increasingly supporting private equity firms before the courts, law firm litigation departments are seeing a growing number of mandates to advise funds on investigations.
Angela Zambrano, the Dallas-based co-head of Sidley’s global commercial litigation practice, says: “One of the things in the last two years that has really picked up is internal investigations for PE firms, based on a concern about regulatory risk or publicity exposure. The biggest example relates to the #MeToo movement, where an investigation can be prompted by a whistleblower letter, somebody raising a concern or a desire to make sure things are thoroughly reviewed in a company before it is taken public.”
Marcus Thompson, a partner with Kirkland & Ellis, says: “We are advising clients on wider risk management issues for sponsors and portfolio companies, where there is a continuing focus on anti-money laundering, anti-bribery and corruption and economic sanctions, and a growing emphasis on cyber-risk and the management of data, particularly if it’s personal data, and workplace compliance and #MeToo.
“If I were to give one piece of advice, it would be to make sure that the sponsor representatives who have seats on the boards of portfolio companies are challenging those boards to identify and understand key business risks and then to come up with the internal controls to mitigate those risks.”
Stephen Surgeoner, a partner with Dechert, adds: “In the modern world, and not just in private equity, if you are a director of a company you need to be much more certain of your duties and responsibilities and performing those to the best of your abilities. In the background, you will also need to have a sensible mitigation piece, which is usually a well-drafted D&O [directors and officers’ liability] insurance policy.”