Private Equity Litigation Risks
VerifyInvestor.com
As part of our highly litigious society, lawsuits are always a looming possibility for any individual, investor, or business. But the risky, complex, and ever-changing landscape of private equity (PE) lends itself to litigation perhaps a bit more than other endeavors. That’s why investors, PE funds, and firms all need to take a proactive approach when it comes to litigation risks.
Thus, it is no surprise that effectively managing litigation risk is crucial for all PE fund participants. In this post, we’ll take a look at some of the more common litigation risks that arise in the context of private equity deals and investments and discuss what steps investors and PE firms can take to avoid or mitigate those risks.
Private Equity Deals and Litigation Risks
According to Forbes, private equity continues to grow at a rapid pace. Between 2016 and 2021, PE firms grew by 58%. Which is exciting from a profits and investment standpoint.
On the other hand, there are downsides to PE investments. One major risk of PE participation is the risk of litigation. Both the lifecycle of a PE offering and the ever-changing ways of structuring deals may play a part in increased litigation exposure for PE firms.
The lifecycle of a PE fund refers to the stages of activity involved in private equity transactions. The four primary stages of a PE transaction are:
The fundraising stage
Investment
Portfolio management, and
Exit.
Litigation can arise at any stage in the lifecycle of a PE transaction.
Fundraising —the fundraising stage is the initial stage of a PE transaction where the PE firm seeks out accredited investors to raise the capital needed to invest in private companies.
PE firms know that it can be difficult to figure out how to find accredited investors. Plus, coming up against the Securities and Exchange Commission (SEC) for securities trust violations — for example, by failing to have only accredited investors participate in a Rule 506(c) offering, or by not verifying the accredited status of every single investor in a Rule 506(c) offering — can lead to lengthy, expensive, and stressful litigation.
Investment — at the investment stage, the firm identifies and acquires private companies that are expected to have growth and profitability potential. The aim is to purchase portfolio companies that will eventually (and hopefully) generate profits for the investors and the firm.
Portfolio management — the next stage, portfolio management, comes into play after a PE firm has acquired a portfolio company. During this stage, the PE firm operates the portfolio company to help it grow and become more valuable — with the ultimate purpose of selling the company for a profit.
Exit - the final stage, the exit stage, is where the PE firm either sells the company or takes it to an IPO. It can take many years (often more than 10) to get a PE fund to the exit stage.
The problem is that litigation can arise at any — and every — stage in a PE fund’s lifecycle. Plus, each stage in the process brings with it different litigation risks. For example, if a PE firm uses Rule 506(c) at the fundraising stage and fails to take reasonable steps to verify that every single investor is an accredited investor, the firm may be subject to an enforcement action by the SEC.
Likewise, the portfolio management stage exposes General Partners in the PE firm to potential litigation related to fees, or employment issues, as well as shareholder actions. Legal disputes can involve everything (and anything) and everyone from portfolio companies to employees, managers, business partners, investment fund General Partners, to the investors (limited partners), and more.
Making the potential for litigation an even bigger risk is the fact that a PE firm cycles through these stages multiple times as they seek out new investment opportunities and manage the investments in the fund’s portfolio.
Some Common PE Litigation Claims
Diverse legal disputes could arise at each stage in the life of a PE investment lifecycle. While a complete recitation of all the possible lawsuits and legal claims is beyond the scope of this post, here are a few of some of the more common claims we tend to see alleged against PE firms.
SEC regulatory violations - First and foremost are the threat of regulatory violations brought by the Securities and Exchange Commission (SEC), U.S. Department of Justice (DOJ), and other state and federal regulators.
The securities laws are complex, comprehensive, and varied. Plus, they are constantly changing. The SEC regularly amends old laws and adds new laws to rigorously regulate issuers and financial advisors in response to the ever-changing landscape of investing and evolutions in technology. These laws are strict, and the SEC is vehement in pursuing enforcement actions. Many of these laws are altering the way in which private equity has historically been conducted.
Some areas that the SEC has been bearing down on for private equity lately include cybersecurity, disclosures, the calculation of management fees, and conflicts of interest.
Violations can carry large penalties with them. In addition, a regulatory enforcement action by the SEC can ruin a PE firm’s reputation, its relationships with investors, and its potential offerings.
Breach of contract - breach of contract claims can arise at any stage in a PE fund’s lifecycle. For example, PE firms can be sued for breach of contract caused by the PE firm’s portfolio company — even if the PE firm had nothing at all to do with the contract itself or its alleged breach. Litigation can also arise as a result of the debt incurred by a portfolio company. At least one case has held a PE firm liable for the debt of a portfolio company that grew out of the PE firm’s efforts to stave off bankruptcy of the portfolio company. Another example: is breach of contract claims asserted against a PE firm emanating from confidentiality agreements and failed mergers. (Whether those claims will stick is another matter entirely.)
Fraud and breach of fiduciary duty — PE firms have a fiduciary duty to act in the best interests of their clients — in other words, their investors. Breach of fiduciary duty and fraud claims are commonplace in PE litigations. These types of claims are often asserted together and can show up in any number of contexts. For example, breach of fiduciary duty claims have been asserted against PE firms for failing to adequately disclose a conflict of interest; because of fund transfers performed without investor consent; and even for failure to conduct a proper investigation related to a buy-out.
Portfolio company issues — the purchase, management, and sale of portfolio companies can lead to countless litigation claims. Some of the more common include employment claims. For example, whistleblower employment disputes can occur when a PE firm shuts down a portfolio company. Whistleblower claims also may be alleged against a PE firm not due to its actions, but based on the conduct of its portfolio company. In other instances, litigation can arise because of the PE firm’s management of a portfolio company. For example, in one case, antitrust class action claims were asserted against a PE firm due to its operation of a portfolio company.
Shareholder claims - Shareholder claims in the PE industry can cause crippling litigation. Such assertions can emerge after or as a result of the sale or IPO of a portfolio company. Many shareholder claims allege that managers misled investors or mismanaged funds. Litigation of this type frequently includes allegations of breach of fiduciary duty or fraud. When limited partners (i.e., the investors) are unhappy with how the portfolio company is being managed, this can lead to shareholder claims.
Whatever the cause, and no matter the stage in the lifecycle of a PE investment that it occurs in, one thing is certain: PE investments very often give rise to litigation claims. The cost of private equity litigation — not including the time, stress, and defense costs involved — can be in the millions of dollars.
Given the prevalence of litigation and its costs, the next question is, how to avoid it?
Let’s look at some ways in which PE firms can mitigate their risks of litigation.
How to Mitigate the Risks of PE Litigation
While there is no way to completely avoid litigation, there are some basic principles you can follow to mitigate or reduce your risks of attracting regulatory enforcement actions or a civil lawsuit.
Here are a few ideas propounded by various law firms and legal experts:
Be proactive. One of the best things a PE firm can do is to take action to avoid litigation. This can be achieved by proactively implementing policies and procedures that can help to ensure the firm is compliant with all regulations and laws.
Robust compliance procedures. Having robust compliance procedures in place can help to avoid problems down the road. Staying abreast of all regulatory requirements and changes to the law can be a daunting, but essential task. To give yourself the best possible advantage, work with experienced securities counsel and other professionals who can guide you through the complexities of the securities laws.
Be honest and transparent. Likewise, it is essential to operate honestly and transparently.
Strong internal controls. Putting strong internal controls in place to identify potential weak areas is also a good idea, as is having and maintaining comprehensive records. Take the time to periodically review and update your policies and procedures so they stay current with all regulatory and other legal changes.
Don’t neglect due diligence. Be particularly diligent when conducting your due diligence. Investigate potential portfolio companies carefully and thoroughly. Meticulously review the prospective portfolio company’s compliance programs, audit practices, and litigation potential, and history. Again, engage legal and other professionals to assist you with this.
Maintain corporate separateness from portfolio companies. Follow best practices related to corporate separateness and corporate governance of portfolio companies.
Regularly monitor litigation risks. Another proactive tip is to regularly monitor your business for potential legal risks. This may look like conducting regular audits and risk assessments, or compliance reviews. Catching potential problems early can help you to mitigate legal disputes or avoid them altogether.
Get legal advice when you need it. Finally, part of being proactive means seeking out and getting legal advice when you need it in order to avoid a dispute. Counsel can assist with all necessary documents (like contracts) and help to avoid regulatory and other compliance issues (for example, related to employment law).
How to Manage Legal Disputes When They Arise
But what if all your proactive management cannot avoid a lawsuit? What should you do then?
There is no “one size fits all” answer here, but there are a few things you can consider.
First, evaluate your options carefully. To do this, you may need to consult with counsel as suggested above, but keep in mind that negotiation and settlement may be a better solution than taking a case all the way to trial.
Next, communicate clearly and transparently with all parties involved. It is essential at all stages of litigation that you be honest – with your lawyer, at your deposition, etc. The facts are what they are. Not being honest can only complicate matters and make everything worse. So operate from a place of honesty and integrity.
Litigation in private equity is a business risk that comes with the territory. It may be impossible to avoid all risks of litigation, but there are actions you can take to mitigate or reduce those risks.
At VerifyInvestor.com we understand the regulatory challenges facing issuers and investors alike. That’s why we offer world-class accredited investor verification services. Our services are fast, efficient, cost-effective, confidential, and reliable. We help companies fully and easily comply with their legal obligations to verify investors as accredited investors.