Private Equity Funds and Fiduciary Duties

'Fiduciary duty' is a phrase being bandied around all the more frequently by aggrieved LPs and their counsel as they start to swing at those GPs they allege have betrayed that duty. But what is fiduciary duty? And how is it to be treated in fund agreements? Joe Bartlett takes a look inside this thorny, but topical, issue.

Both service providers and principals in the private equity fund space are aware that, relatively speaking, a fair amount of litigation is brewing between the capital providers and the asset managers, some of which has surfaced in the public press. The principal reason for these disputes arising is based on simple economics … the managers have lost a ton of money in the past couple of years and the investors are not only disappointed but often angry. I say the litigation is unusual because, up until quite recently, investor claims against private fund managers had been a rarity. The severity, however, of the nose dive in public and private valuations has spurred various investors and investor groups to declare the equivalent of war, meaning threats and actual claims of litigation.

In that regard, the banner the plaintiffs typically carry is that the managers have violated their 'fiduciary duties'. This phrase (which goes back to an opinion by then Judge Cardozo in the flagship case of Meinhard v.Salmon) revolves around the construction of an undefined and amorphous phrase I (somewhat cynically) translated in a 1978 book to mean 'recovery for the plaintiff.'

The fact is that the term 'fiduciary duty' still has no precise definition; it is commonly applied to a variety of patterns of behavior and wrongful acts by courts in Delaware and elsewhere. It is a serious concept with ramifications for the putative fiduciaries but troublesome for counsel and their clients in that it is often very difficult (if not impossible) to predict what will and will not be construed in a judicial proceeding, as 'fiduciary duty' and, more importantly, a violation of 'fiduciary duty.'

The good news is that the Revised Uniform Limited Partnership Act, as in effect in Delaware, provides in Section 17-110, subparagraph that:

'to the extent that a partner … has duties (including fiduciary duties) … to a limited partnership or to another partner … the partners duties and liabilities may be expanded or restricted by the restrictions in the partnership agreement.'

At first blush, this language appears to enable the drafters of the partnership agreement to exclude entirely investor actions against the general partner or partners of the partnership agreement 'fiduciary duty' concepts. With the potential for litigation becoming a pain in the neck, the question arises whether, as those sponsors go out to raise capital post the meltdown, the sponsors will try to take advantage of this language in the Delaware RULPA and, if so, whether the language means what it says.

The first question has to do with the issue of relative leverage. Is the opportunity to invest in a given private equity fund seeking capital so attractive that the investors will be willing to accept a document which excludes, or appears to exclude, application of fiduciary duty principles? A subset of that question is whether the sponsors of a private equity fund and their counsel will have the nerve to put plain language in the instrument which says, in effect, 'we are not bound by fiduciary duty concepts and, even if we violate what otherwise would be deemed to be our fiduciary duty our investors cannot sue us.'

That question will be resolved, of course, in the market place and the results will vary, as Mike Halloran mentioned long ago, inversely with the prestige of the managers. If the fund is a 'trophy fund', and the investors are required by their internal guidelines to favor the private equity asset class with a significant percent of their available capital, the LPs may accept just about anything including the restriction I have suggested. For first time funds, of course, the notion will typically be in the 'fuggedaboutit' category.

Assuming, however, that it becomes popular for lawyers practicing in this space to start off the process with a clause 'restricting' fiduciary duty actions, the next questions are (i) how such clauses should be drafted and (ii) if accepted by the investors, will the language in fact do the trick.

There is a very helpful article on this general subject in the most recent newsletter of the ABA Section on Business Law, The Committee on Partnerships and Unincorporated Business Associations.[1] As that piece suggests, the clause must be very specifically drafted, and express in its language, in order to displace effectively traditional notions of fiduciary duty. Approaching that concept by implication or indirection is likely not to do the trick, according to the case law cited in the footnoted materials. Fiduciary duty is the 'default standard' (as the authors phrase it), which means that, unless the duty is denied explicitly and unambiguously in the agreement, that standard may nonetheless be applied to allegedly wrongful conduct by the trier of fact.

The next question is whether the fiduciary duty standard can be completely eliminated.

The authors are dubious that a Delaware Court (or a court applying Delaware law) would hold in all instances. They cite a case in which the court referred to the Act as providing 'an apparently broad license to enhance, reform, or even eliminate fiduciary duty protections;' but they note that:

'even though the Court of Chancery has referred to the possibility of fiduciary duties being eliminated, no case has yet been presented to the Court of Chancery in which fiduciary duties have been replaced without some contractual protection being built into the limited partnership agreement to counteract the elimination of such traditional fiduciary duties.'

The argument is that the Act states that fiduciary duties can be 'expanded or restricted by the provisions in the partnership agreement' but does not say that the fiduciary standard can be entirely eliminated. The consensus seems to be that it is open for the sponsors and their counsel attempting to exclude the sometimes radioactive and inflammatory fiduciary duty standard to do so if some other standard, which comports with fundamental notions of fairness, is substituted. If, for example, the issue is whether the general partner is doing business with itself, an inside trade which is often the generator of fiduciary duty litigation, the agreement can substitute a procedure by which such a trade can be validated … a special committee of the limited partners or a vote of the limited partners themselves. The idea is that, if the standards are followed, then the fact that application of a fiduciary standard might have resulted inability to objecting limited partners is irrelevant. All the investors signed on to the document with their eyes wide open and are bound by the machinery established in the document. A companion idea is that there are certain types of conduct which are so egregiously unfair, a court will find a way to redress the situation. This goes back to Justice Frankfurter's notion of a general, common law exception to any rule if the conduct blessed by the rule 'shocks the conscience of the court.'

Leaving those extraordinary (and hopefully unusual) examples aside, then the point for counsel to consider carefully, I think, is apparent. With litigation becoming a possibility in an area where we in the past had not given it a lot of thought, Section 17-1101 of the Revised Uniform Limited Partnership Act should be studied carefully, along with the court decisions cited in the footnoted article and elsewhere on the subject. Careful drafting, substituting explicit rules for the vague and amorphous phrase, 'fiduciary duty,' can be built into the limited partnership agreement and, on occasion at least, sold to the investors. Thus, if the majority of the investors want to be able to sanitize a particular activity of the general partner, then it is not only in the best interests of the general partners but also of the majority of the limited partners to avoid and/or neutralize lawsuits a dissident limited partner might bring.

All this may seem like technical drafting tips but I am keenly interested in the ripple effects of the meltdown on the 'Market' or 'Industry Standard' Deal Terms in the new breed of private equity fund agreements. And, my guess is that the point discussed above will be one which we burn the midnight oil, in order to reach an optimal result.