Navigate the direct liability risks of portfolio funds
As legal claims against portfolio companies have increased, so have related claims against the funds (and their sponsors). The reasoning of the plaintiffs for including funds as defendants is no mystery: funds often have greater financial resources than the defendant holding company, especially when the holding company is in difficulty, and therefore represent the Proverbial “deep pockets”. This is especially true when a liquidity event involving the portfolio company has recently occurred or is on the horizon. Liquidity events, which range from large portfolio company transactions to liquidation or reorganization, often lead to substantial returns for funds.
Liquidity events simultaneously provide increased opportunities for potential claimants to bring legal action, and may also motivate them to do so when such events create perceived ‘winners’ and ‘losers’, for example by dealing with different categories of actions unevenly. This can create the perfect storm for funds, allowing a carefully crafted trade to be effectively blocked or canceled, reducing the fund’s returns or, worse, preventing it from recouping years of investment. Fortunately, knowing some of the more common legal traps that plaintiffs use to drag funds into litigation can help funds and sponsors manage and mitigate risk.
Help and complicity
As we pointed out in Chapter 2 of the Holding Company Handbook, the participation of a fund sponsor on the board of directors of a holding company is a significant risk factor for the entire portfolio complex. funds. The risk arises from the potential conflicts of interest linked to the competing fiduciary obligations of the representatives of the board of directors towards the fund on the one hand, and the portfolio company on the other. In actions challenging a transaction that arguably benefited the fund more than the portfolio company and its other stakeholders, the directors appointed by the sponsor may lack independence, triggering a higher standard of review. and increases the risk surrounding the transaction. In addition to the fund’s typical indemnification obligation to nominee directors (which will be discussed in detail in the next installment of the Portfolio Company Playbook series), litigation challenging the actions of a nominee administrator may give rise to claims. direct against the fund for aiding and abetting the administrator’s alleged breach of fiduciary duty.
While defenses against allegations of complicity may be available and vary by jurisdiction, the easiest way to defeat such allegations is to prevent them in the first place. Fund promoters can consider preventative measures by ensuring that appointed trustees are fully aware of their duties and always alert to situations where those duties might be perceived to conflict. In the transactional context, the fund and the appointed trustees need to consider whether the interests of the fund align with those of other stakeholders in the business, and what board approval structures and legal havens might be available. case of contestable conflict.
Fiduciary obligations of the supervisor
Funds (and sponsors) may also be exposed to direct breach of fiduciary duty when they are the majority shareholder or de facto controller of a portfolio company. Although the existence, extent and triggers of a supervisor’s fiduciary duties vary by jurisdiction, a fund should exercise caution in assuming a significant degree of control over a business or transaction through a fund. majority shareholding, majority control of the board of directors, special voting rights or other means, as such control may give rise to direct fiduciary obligations arising from the fund to other shareholders. In some jurisdictions, the fund may be subject to claims even though it exercises control only as a member of a group of shareholders, sometimes referred to as a “control group”. Thus, funds should be particularly attentive to allegations of conflict of interest when working with long-standing investment partners or affiliates to form a majority of shareholders or boards of directors approving a given transaction.
In situations where the fund is arguably a supervisor or a member of a supervisory group with sufficient power over the company or a specific transaction, it should seek the law of the relevant jurisdiction on the fiduciary duties of the supervisor and shareholders, be aware of the fund’s direct involvement in the negotiation and approve the transaction and consider whether appropriate structures such as a special committee or the ratification of the minority shareholder vote could help to hedge against the risk of dispute.
As a result of liquidation events that have benefited a fund to the perceived detriment of another stakeholder group in the portfolio company, the fund may be exposed to requests for unjustified enrichment. Usually, such complaints follow the complaints described above and often increase and decrease with them. However, in certain contexts such as corporate restructurings and liquidations, funds may be particularly vulnerable to unjust enrichment claims. In these contexts in particular, sponsors should be alert to potential conflicts of interest that might give force to a complainant’s story that the fund has unfairly drained the company’s coffers for the benefit of the company, and in particular of any person to whom the fund or its agents potentially owe duties.
Stay tuned for our next chapter on Navigating Fund Indemnity Risks.
© 2021 Proskauer Rose srl. Revue nationale de droit, volume XI, number 203