The down draft in valuations in the portfolio in most of the venture capital and buyout funds in the United States over the last couple of years has produced the typical U.S. reaction: litigation. When investors lose money in the United States, particularly when the decline is sharp, the natural reaction (perhaps built into our DNA) is that some villain must be at fault and, accordingly, there is a wrong that cries out for a remedy. In view of that phenomenon, we have recently seen widely disseminated reports of proceedings initiated by aggrieved parties against private equity funds, the most prominent being (i) the Atlantec matter; (ii) an action by the State of Connecticut against Forstmann Little; and (iii) an investor in MeVC, Millenco L.P., suing the general partner of that public venture fund.
A couple of points need to be made at the outset of any discussion. First, these actions are not typical examples of litigation involving the purchase and sale of U.S. securities. Securities are involved, of course; but the investors are generally highly sophisticated and the purchase, being private equity (except, technically, in the VC case), is accompanied by detailed agreements setting forth the rights, obligations, powers, privileges, etc., of the parties. Given that the limited partners of a private equity fund are typically sophisticated investors with sophisticated advisers, the plaintiffs in these cases generally face a heavy burden of proof. That is, unless the breach by the sponsors and managers of the fund is apparent from the face of the governing instruments. If the fund documents give wide discretion to the general partner, the plaintiff ordinarily shoulders a heavy burden to show that discretion has been abused.
The plaintiff's burden is not insuperable though; under U.S. law, there is a certain residual, common law (and sometimes statutory) obligation of controlling parties in partnerships and corporations to treat minority investors fairly and equitably – or at least (and better stated) at some level of fairness and equity which is more than zero. Violations of that amorphous (and very fact-specific and fact-driven) obligation are usually based on egregious breaches of standards of fairness which common sense and good judgment would suggest are across the line.
Given these high thresholds, it is not surprising that the insatiable appetite of U.S. investors to litigate has produced relatively few reported cases in this context. What is somewhat remarkable is (to paraphrase Dr. Johnson's notation concerning a woman preaching and/or a dog walking on its hind legs) that there are any cases at all.
A second point to consider is that, in the cases cited, there is no one single theme to the disputes. In many segments of the U.S. litigation universe, the cause of action repeats itself time after time after time. Numerically a very high majority of the cases brought against public companies by or on behalf of investors (both buyers and sellers) have to do with the failure of the company and its managers to disclose accurately and sufficiently all items of material information in a timely fashion. The complaints may read differently on a case-by-case basis; but the central theme is very familiar. The cases mentioned earlier, in view of the complexity of the arrangements involved in the private equity universe, are not variations on a central theme though, other than there is a claim that some sort of non-contractual fiduciary duty principle is involved.
The MeVC complaint (sparse as it is) alleges that, as the value of MeVC's position deteriorated, the general partner continued to charge and collect a management fee, which was egregiously out of proportion to the portfolio valuations. The answer has not yet been filed but it is assumed that the fund documents were followed to the letter; otherwise the complaint would have alleged (as it does not) a specific contractual provision. The idea is that it is somehow egregiously unfair to charge an inflated fee when the performance has cratered and valuation has sunk to subterranean levels.
In the Connecticut v. Forstmann Little case, there is a different theme, based on an issue sometimes referred to in the business as the ?cross over? problem where the fund in which the State of Connecticut's pension fund invested is suffering at the hands of a subsequent Forstmann fund. The facts, very roughly stated, involve an investment by Forstmann Fund VI (in which Connecticut was a limited partner) in a telco named XO Communications. The investors in the earlier fund have experienced significant losses in the XO position, both relatively and absolutely, since XO is in bankruptcy. Lo and behold, in the most recent fund, Forstmann Fund VII, Forstmann Little is ?doubling down,? as they say in blackjack, or dollar averaging, meaning it is putting money into an initiative to buy XO out of bankruptcy at a bargain. If that strategy works, the investors in Fund VII will benefit disproportionately.
The Atlantec case is yet another variation. This time the plaintiffs, who were successful to the tune of $15 million as a result of a settlement, were also claiming conflict of interest, but in the context of a ?burn out? (also known as ?cram down? or ?wash out?) financing. Here is a transaction in which the same parties control both the sell (in this case the issuer's board) and buy (in this case the VC investor syndicate) side. The price in Atlantec was negotiated intramurally (the VCs negotiating with themselves) and was highly dilutive to the minority, who could not participate. After the dilutive financing, the Company recovered and a liquidity event produced significant returns to the VCs. The minority sued for their portion of the proceeds that would have accrued to them had they not been burnt out, and the resultant settlement was in the $15 million range.
Although I am not involved in any of these cases professionally and therefore do not claim to have studied the facts intensively, I am citing them as illustrative in order to make the following points and, of course, without predicting how they will turn out eventually, other than the Atlantec case, which has been concluded. If the allegation does not involve an express breach of a contractual provision (which would be surprising in any well regulated environment) and simply cites general common law principles labeled ?fiduciary duty,? the plaintiff's burden is high. However, as suggested in the Forstmann Little case and as in fact a feature of the Atlantec litigation, once one finds and can prove the conflict of interest (with controlling parties standing on both sides of a given trade) then under long standing principles of Delaware law the balance between the plaintiff and the defendant changes. There are various articulations of the Delaware rule; perhaps the best is that the Delaware judges will subject transactions where the conflict is compelling (or at least plausible) to what is called ?enhanced scrutiny.? Once a court starts using the term ?fiduciary duty? (other than in a pejorative way) and/or ?enhanced scrutiny,? the case is well on its way to recovery for the plaintiff.
What is the likely upshot of these litigations? First, it is to be expected that the cases reaching public attention will continue to be relatively few and far between. This does though leave aside instances in which the limited partners have simply refused to honor ongoing commitments to contribute capital based on pitiful performance in the portfolio and where the LP in effect dares the general partner to sue: this is a contest with mainly extra-legal overtones. Secondly, however, if Forstmann or MeVC wind up (as cases often do) resulting in a judicial opinion which appears to enlarge the rights of the plaintiff investors (the limited partners), one can expect the frequency of complaints against VCs and buyout sponsors to increase. There are major amounts of money involved; a number of the limited partners are, in fact, public officials, the stewards of retirement funds for the benefit of public employees around the country. If there is an opportunity to stand up as a ?tribune of the people' and sue a private equity fund, one can count on the instincts of politicians for survival in predicting that additional actions will be brought.
At the moment, it is still early days. Given the pace of litigation (and the propensity of litigants to settle on a confidential basis), it will continue to be early days for some time too. Ultimately, however, the consequences of the meltdown will be imprinted on private equity law and practice. We will know either that the law remains as it was, with its emphasis on the contractual obligations between the parties, or the underlying ?fiduciary? principles imbedded in the common law will find their way to the surface. Stay tuned.
Joe Bartlett is a senior partner at Morrison & Foerster LLP in New York. He is also the Founder Chairman of the Board of VCExperts.com, the premier US website destination for entrepreneurs and professionals in the venture capital industry.