PEI: What impact did the global financial crisis have on disputes and litigation in the world of funds?
Hilton: The financial crash triggered conflict within both well run and badly run funds. A clear distinction emerged between hedge fund and private equity fund structures. PE funds were structured with long term commitments from investors and the inability of those investors to seek the return of their capital prior to the full life cycle of the fund being completed. By contrast hedge funds had a much greater exposure to investors seeking the return of their capital at short notice and as such had to rely on gating and other means to retain liquidity. However, the assumptions on which both types of funds had previously done business changed with pressure on liquidity as a common theme. The private equity funds tended to face internal conflicts arising from pressure on profits, conflict with management teams and difficulties associated with removing poorly performing managers and preventing the extension of the life of PE funds. The failure of investors to meet their commitments in PE funds led to some interesting disputes arising but other than in funds which were in the process of being launched on the back of a major sponsor investor, they did not unduly disrupt the life cycle of the fund or ability of the funds to invest.
There have been some high profile fraud cases involving hedge funds (ranging from deception of investors in hedge funds to insider dealing). While PE houses tended to have investors whose interests were closely aligned and experienced advisory boards, hedge funds often relied on a more conventional board structure and the diligence or otherwise of executive and non- executive directors. Recent cases have highlighted the standards to which those directors ought to be judged in monitoring or spotting breaches
or wrongdoing by others.
What are the most common disputes you are seeing in the alternatives space?
Disputes amongst partners occur during good and bad times – they tend to be more pronounced when profits reduce suddenly but equally we were busy dealing with disputes triggered by excess profitability. A lot of these disputes are settled confidentially through the mediation or arbitration process. Very few of these disputes find their way into the courts. Amongst hedge funds the financial crisis and fraud triggered high profile cases often fought out in off shore jurisdictions. The downturn led PE funds to face and bring claims arising from the sale and disposal of their portfolio companies as well as becoming involved in the disputes faced by their underlying portfolio companies.
What measures can fund managers take to protect themselves against potential action?
1. Review key partnership and other documents to ensure they are fit for purpose and cover the basis on which the parties are operating, as well as the positon of leavers and succession points.
2. Ensure that the GP checks the investment policy to make sure that it is operating within the confines of the deed – there is the risk of being liable to account on a strict basis for steps taken outside the scope of the deed even if taken in the best interests of the fund.
3. Ensure there is adequate insurance to cover for claims both against the GP but also against deal teams sitting on the boards of portfolio companies.
4. Beware of the extent to which side letters entered into with investors are in fact permitted and do not end up being an unlawful variation of the partnership deed and ensure that terms agreed in side letters are properly built into the manager’s internal process manuals.
5. Put in place a system of governance and interaction to ensure that there is a culture of risk reduction in the portfolio companies – some of the competition and other risks can result in strict liability for the GP without the ability to reclaim under the indemnity.
6. Seek advice early: there is scope for avoiding liability or optimising one’s position by getting input both on the letter of the law but also on the likely settlement scenarios.
7. Ensure that the various advisory boards/investment committees and checks and balances are fully engaged to reduce the likelihood of mistakes in the first place and the extent to which they are made they do not lead to litigation.
8. Reduce the chance of removal for gross negligence/loss of indemnity by ensuring proper process for sale and disposal and risk reduction in portfolio companies.
Litigation isn’t just defensive. When should a fund use litigation for its own protection or to take action?
Both PE and hedge funds have made litigation a part of their business model – after all it is the ultimate calculation of a risk/reward assessment. A number of loan to own funds will work out the extent to which rights can be litigated in the context of conflicting interests amongst different levels of security holder. There are of course activist funds seeking to buy into conflict situations by acquiring minority interests in companies for the purpose of effecting change. Likewise some funds purchasing instruments are inherently subject to litigation risk such as certain sovereign debt.
As to which forum to conduct disputes, this depends on why the litigation is being pursued. If a swift and correct outcome on the law is required (with a priority on ensuring the true facts come out) one could seldom better the English commercial court. If a more drawn out process is preferred there can be grounds which allow cases to be started in other jurisdictions (e.g. Italy) which are considerably slower. If publicity is a key sensitivity then parties are better off agreeing for disputes to be resolved through arbitration, which is a confidential process. The counter to this is that the risk of the glare of publicity in a dispute against, for example, a defaulting investor might more readily lead to settlement. The modern litigator in this space is as much involved in the art of getting cases to resolve on good terms prior to proceedings as in winning those proceedings because of the inherent risk, disruption and publicity associated with the process.
If you find yourself in a dispute, what should you expect from your external legal advisor?
Ultimately one requires from one’s lead advisor judgment as to how to steer the path which is most likely to optimise one’s commercial objectives. It is helpful to have an advisor that not only consciously understands the importance of this but is also able to provide suggestions as to what may be a realistic and sensible outcome. It is also advantageous to have an adviser who understands the sector so they can look out for pressure points and pitfalls that may have been missed. They need to have had experience of undertaking the type of litigation in question – so understanding how the personality types who often get to the top of PE and hedge funds operate is useful. Ultimately, the conduct of the client, as opposed to the legal advisor, is often ignored as it is an important ingredient in optimising the chances of a successful outcome; demonstrating confidence in the legal advisor and creating an environment which encourages the existence of creative solutions and the taking of appropriate risk (without a culture of blame) is extremely important.
Since the global financial crisis, what is the biggest change in the conduct of PE funds?
The crisis has given rise to a realisation amongst the owners of PE houses and investors that risk reduction and good governance actually assist in delivering value to the bottom line as well as being consistent with the expectations of many regulators. There is recognition of the need for this to extend to the investee companies – with the most significant risks arising out of competition law. There is strict liability for the house where there is “decisive influence” over a portfolio company – which is almost inevitable in the PE structure – meaning fines move up the chain regardless of fault and the risk of sharing information with competitors during a bidding process. Many portfolio companies and investors have lost significant sums as a result of these risks. The PE houses have recognised that one is generally in a worse position by ignoring these issues in portfolio companies than seeking to address them, albeit with no guarantee of avoiding such risks. This is a fundamental shift in the mind-set of many funds. ?
Hilton Mervis is a partner in the litigation and dispute resolution group at King & Wood Mallesons LLP. He is also editor of PEI book Private Fund Dispute Resolution.