“Shareholders are unlikely to bat an eye over festering conflicts when economic times are good. Success has a thousand fathers, after all.”
Los Angeles Lawyer Magazine has published a practice tips article by Miller Barondess counsel Robby Naoufal, examining the key risks and potential liabilities investors face in portfolio companies, particularly as economic conditions change and pressures mount. As markets shift, those overlooked conflicts can quickly surface—bringing real risk for venture capital and private equity firms.
Navigating Risk Areas in Private Equity and Venture Capital Investments
Fifty years ago, Steven Spielberg’s Jaws terrified audiences nationwide with the tale of a great white shark that had a taste for Martha’s Vineyard tourists. Spielberg opted against revealing the waterborne villain until well into the second act, but the Oscar-winning John Williams score famously offered clues of a looming threat. Private equity (PE) and venture capital (VC) managers should similarly recognize the signs of potential challenges that lie ahead. For example, civil litigants are increasingly testing the legal waters through which they might hold PE and VC firms liable for acts of their portfolio companies. However, if managers think ahead and remain disciplined, the risks can be mitigated.
Private equity and venture capital firms generate returns for their investors by investing in companies. Although PE and VC firms invest at different stages, each extracts value by supporting the growth of those investments. In a survey of over 2,000 PE transactions conducted by the Harvard Business Review, the authors found that the most successful PE firms took an increasingly hands-on approach in their interactions with their portfolio companies.[1] Partners engaging in PE have historically limited their role to buying and selling companies, but firms have more recently provided support and advice. They now even get involved directly in hiring and firing managers. This trend leaves PE and VC firms more exposed to direct liability, particularly where managers exercise control over operations and speak on behalf of their portfolios. Firms that represent PE and VC interests can avoid heightened liability risk by taking a disciplined approach to investment management and respecting the tested legal formalities. Key risk areas that managers must be aware of include control person liability, conflicts of interest, corporate form, and solicitation—with tips on how to limit liability in a litigious environment.
Moderate Control Liability
When the issuance or sale of a security is concerned, control-person liability remains a prevailing claim that investors and shareholders can use to hold managers liable for securities violations. Section 15 of the Securities Act of 1933 and Section 20(a) of the Securities and Exchange Act of 1934 impose the same liability on those who control the relevant activity as those who are controlled. To prevail on such claims, a plaintiff must assert 1) a primary violation of the securities law, often under U.S. Securities and Exchange Commission (SEC) Rule 10b-5, and 2) direct or indirect control of the primary violator.[2] This relatively brief standard is resoundingly complex, particularly under the Ninth Circuit Court of Appeals’ standard, which only requires a plaintiff to allege the power to control the overarching corporate policy that resulted in the violation.[3] Courts in this circuit are instructed to rely on “traditional indicia of control” such as having a prior lending relationship, owning stock in the target company, or having a seat on the board.[4] This interpretation more closely aligns with the SEC’s definition, which does not require exercising actual control over the alleged violation.[5]
As a result, funds with significant equity interests are particularly attractive targets for plaintiffs once their portfolio company’s conduct gives rise to a plausible claim. Managers of PE and VC firms should anticipate control-person liability where they hold a majority interest, have the power to appoint the majority of the board, and actively participate in the hiring or firing of management.
A fund still may mitigate control liability by limiting its governance control or control over the specific acts that can give rise to a claim. Managers of PE and VC firms should balance the upside of operational control against the increased risk of control-person liability. Before seizing the opportunity to appoint additional board members—a seemingly attractive spoil following an increased ownership stake—managers should consider whether the firm can shepherd its investment to success without the added exposure. Allowing independent directors to occupy more seats than required by statute could help fend off actions designed to rope in deep-pocketed financial backers. Firms might even consider resigning from the board entirely if the portfolio moves toward a public offering where heightened securities compliance poses additional risks.
Anticipating Conflicts of Interest
Investments by PE and VC firms require care for the interests of both limited partners and portfolio companies. This arrangement is not inherently conflicted because a fund-principal’s compensation is directly tied to the fund’s performance, and value creation moves in step with the success of the portfolio companies. Nevertheless, conflicts might arise when a manager’s duties as a board member of the portfolio—including to employees, customers, or creditors—conflict with the duties owed to limited partners in their fund.
Two common conflict scenarios are insolvency and multiple board memberships. Managers should be especially careful in these two scenarios. Fiduciary duties mandate that directors prioritize the corporation’s and shareholders’ interests over any personal or extraneous considerations.[6] Portfolios floating in a “zone of insolvency”—generally defined as a period of financial uncertainty in which a company’s future as a going concern is in question—may require directors to delicately balance duties to creditors and equity holders.[7] Duties owed to limited partners invested in the same portfolio company—but through different funds—is one such scenario. For example, if a portfolio company requires a capital infusion to meet creditor demands or to stave off insolvency, limited partners in a more recent fund still subject to capital calls might benefit from a course of action that is different from limited partners without such obligations.
Fund managers serving on the boards of multiple portfolio companies should also be aware of their duties with respect to corporate opportunities. The duty of loyalty requires that directors present business opportunities to their companies that are within the company’s line of business.[8] Fund managers serving on the boards of multiple companies operating in the same sector—as is often the case where a PE or VC firm specializes in a certain industry—could face a conflict regarding which company should be brought the opportunity. Best practice dictates that directors 1) always disclose all material facts concerning the transaction, 2) obtain approval from independent directors or shareholders, and/or 3) consider presenting the opportunity to all their companies, then recuse themselves from further decision-making.
Shareholders are unlikely to bat an eye over festering conflicts when economic times are good. Success has a thousand fathers, after all. However, when losses mount and liquidity events with upside are hard to come by—even if losses are merely a symptom of macroeconomic conditions—these types of conflicts will be ripe for challenge. Understanding these scenarios ahead of time and drafting provisions in relevant operating and limited partner agreements can help minimize exposure and set the stage for a favorable outcome for managers in the event of litigation.
Corporate Formalities and Liability Protection
Fund managers often appoint directors to serve on a portfolio company’s board because it gives the fund valuable insight into management affairs and provides influence over those decisions. Notwithstanding the risks discussed above, it is often well worth the added liability exposure to fill one or more board seats. In those cases, PE and VC firms should maintain corporate forms and practices that are proven liability shields.
A basic tenet of American corporate law is that the corporation and its shareholders are distinct entities.[9] As such, maintaining corporate separateness remains an effective measure in fending off shareholder liability. Alter-ego theories of liability are still highly fact-intensive; experienced plaintiffs’ counsel can allege their way through the pleading stage to seek invasive and expensive discovery. So long as firms maintain corporate formalities, separation of ownership interests, and deal with their portfolio companies at arm’s length, defendants can position themselves to ultimately defeat these claims. Factors demonstrating unity of interest are numerous, but several are particularly noteworthy: 1) Firm funds and those of its portfolios, funds, and other assets should not be commingled; 2) funds for separate entities should be segregated; 3) assets of the corporation should not be treated as those of any one individual (or family); 4) principals, directors, and officers of the fund and those of its portfolios should be treated as separate chains of governance; 5) portfolio companies should not be left undercapitalized and the assets of the fund should not be treated as a source of capital to which the portfolios are entitled (see (1)); and 6) assets from one portfolio should not be diverted to another and the assets and liabilities should not be manipulated between entities so as to concentrate the assets in one and the liabilities in another, particularly to the detriment of creditors.[10] Managers are wise to operate within these formalities even if they are a less convenient option. With these measures in place, litigation strategies can leverage the positive facts to dispense with the claims—either through a negotiated voluntary dismissal, motion to dismiss, or, if necessary, at summary judgment.
Private equity and venture capital firms should also ensure that the indemnification and exculpation provisions shield their directors from liability to the fullest extent permitted by law. Section 317 of the California Corporations Code permits companies to indemnify their directors against expenses, judgments, fines, settlements, and other amounts actually and reasonably incurred if that person acted in good faith.[11] The indemnification provisions should be expressly and unambiguously defined in the portfolio companies’ articles of incorporation and bylaws. The fund’s operating agreements may contain provision limits or fully release its managers and the fund itself from liability. To be enforceable, releases must be clear and unambiguous and cannot contravene public policy.[12] The agreements should be periodically reviewed to verify that they afford managers, partners, and the fund itself the most robust liability protection consistent with applicable law. In California, Section 1668 of the California Civil Code prohibits contracts from shielding their principals from willful misconduct and conflicted dealings.[13] In Delaware, Section 102(b)(7) of the Delaware General Corporation Act now allows releases from gross negligence for both directors and officers, but willful misconduct, including waiver of self-dealing, remains invalid.[14]
Lastly, directors serving on the boards of publicly traded corporations must contend with a wide suite of securities regulations and disclosure requirements. As any portfolio company approaches an initial public offering, fund managers with board seats should seek sophisticated legal counsel to prepare for heightened scrutiny or consider stepping down from the position altogether.
Solicitation Statements
Private Equity and venture capital firms often seek to advance their investments by promoting the business to the broader market. Partners are uniquely exposed to solicitation liability in the Ninth Circuit. A recent Northern District of California case illustrates the risk of liability PE partners face when making public statements about the securities of their portfolio companies or paying for promotional materials. In Houghton v. Leshner, the plaintiffs sued Compound Labs and its PE backers for statements made in soliciting investment in the firm’s tradable currency—“COMP” tokens.[15] Formed as a general California partnership, Compound Labs was a cryptocurrency fintech company allowing users to borrow and lend crypto assets through its own savings-and-loan business. Compound Labs opened to significant interest and secured several notable PE backers, including Bain Capital, Andreessen Horowitz, Paradigm, and Gauntlet (PE defendants). Compound Labs issued its COMP token. After an initial surge in popularity, however, COMP lost half its value in a three-month period.
The Houghton complaint alleged that the PE defendants were liable under sections 5 and 12(a) of the Securities Act of 1933 for soliciting investment in Compound Labs through their public statements, even though they were not themselves sellers. This solicitation included paying exchanges to carry promotional videos for Compound Labs. The PE defendants moved to dismiss on the basis that they were merely “collateral” participants in the transaction, which Pinter v. Dahl, 486 U.S. 622, and its progeny conclusively exclude from Section 12 liability.[16] Applying broad standards for solicitation under the recent Ninth Circuit decision in Pino v. Cardone Capital, LLC,[17] the court denied the PE defendants’ motion to dismiss, finding the plaintiffs plausibly alleged solicitation under the Ninth Circuit’s broad construction of the term. The court relied on the PE defendants’ design and governance decisions, their efforts to successfully monetize COMP and bring it to secondary markets, and their public comments. By alleging that the PE defendants had control over the solicitation and over others making solicitations on their behalf and at their direction, the plaintiffs cleared their pleading threshold in the Ninth Circuit, where direct contact is not required and liability may flow from mass communications. The court cited Pino as a statement of the Ninth Circuit’s decidedly broader standard for solicitation when compared with other circuits.[18]
An ounce of prevention is worth a pound of cure, but the fictional mayor in Jaws still had to balance the economics of keeping the beaches open with trouble from a lurking risk. While a genuine fear of great white sharks that spread as far as Midland, Texas is hard to rationalize, firms can account for liability pitfalls and address lurking risks head-on. Although Jaws ends in spectacular fashion when the shark is blown to bits, firms can be a bit less reactive in their approach to developing an investment thesis by relying on proper legal assessment to ensure every risk is handled accordingly.
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- https://hbr.org/2002/06/lessons-from-private-equity-masters.
- Howard v. Everex Sys., Inc., 228 F.3d 1057, 1065 (9th Cir. 2000).
- In other jurisdictions, including the Second and Third Circuits, plaintiffs must show that the control person was in some meaningful sense a culpable participant in the fraud perpetrated by the controlled person. See, e.g., SEC v. First Jersey Sec., Inc., 101 F.3d 1450, 1472 (2d Cir. 1996); Belmont v. MB Inv. Partners, Inc., 708 F.3d 470, 484-85 (3d Cir. 2013
- No. 84 Emp.-Teamster Joint Council Pension Tr. Fund v. Am. W. Holding Corp., 320 F.3d 920, 945 (9th Cir. 2003).
- See Rule 405 of the Securities Act (17 C.F.R §230.405) defining “control” as “the possession, direct or indirect, of the power to direct or cause the direction of the management and policies of a person, whether through the ownership of voting securities, by contract, or otherwise.”
- Central Laborers’ Pension Fund v. McAfee, Inc., 17 Cal. App. 5th 292, 317 (2017); Corp. Code §309.
- See Berg & Berg Enters., LLC v. Boyle, 178 Cal. App. 4th 1020, 1037 (2009).
- Broz v. Cellular Info. Sys., Inc., 673 A.2d 148, 155 (Del. 1996).
- Dole Food Co. v. Patrickson, 538 U.S. 468, 474 (2003).
- Estate of Ricardez v. Ventura County, No. CV 20-79-JFW(ASx), 2020 WL 3891460, at *4 (C.D. Cal. June 24, 2020) (citing Associated Vendors, Inc. v. Oakland Meat Co., 210 Cal. App. 2d 825, 838-40 (1962)).
- Corp. Code §317.
- See Madison v. Superior Court., 203 Cal. App. 3d 589, 598 (1988).
- Cal. Civ. Code §1668.
- Del. Code Ann. tit. 8, §102(b)(7).
- Houghton v. Leshner, No. 22-cv-07781-WHO, 2023 WL 6826814, at *1 (N.D. Sept. 20, 2023).
- Pinter v. Dahl, 486 U.S. 622, 648–54 (1988).
- Pino v. Cardone Capital, LLC, 55 F.4th 1253, 1259 (9th Cir. 2022).
- See, e.g., Holsworth v. BProtocol Found., No. 20 Civ. 2810 (AKH), 2021 WL 706549, at *3 (S.D.N.Y. Feb. 22, 2021) (rejecting solicitation claim where plaintiff had not “shown that he was directly contacted by [d]efendants or that he purchased securities as a result of any active solicitations by [d]efendants”).