As litigation claims against portfolio companies have increased, so have accompanying claims asserted directly against funds (and their sponsors). Plaintiffs’ reasoning for including funds as defendants is no mystery: funds often have greater financial resources than the defendant portfolio company, particularly where the portfolio company is in distress, and thus represent the proverbial “deep pockets.” This is especially true where a liquidity event involving the portfolio company either recently occurred or is on the horizon. Liquidity events, which range from major portfolio company transactions to liquidation or reorganization, often lead to substantial returns for funds.

Liquidity events simultaneously provide increased opportunities for would-be plaintiffs to bring litigation, and may also motivate them to do so where such events create perceived “winners” and “losers” by, for example, treating different classes of stock unequally. This can create the perfect storm for funds, allowing a carefully crafted transaction to be blocked or effectively undone, cutting into the fund’s returns or, worse, preventing it from recouping years’ worth of investments. Fortunately, having an awareness of some of the most common legal hooks plaintiffs use to drag funds into litigation can help funds and sponsors manage and mitigate risk.

Aiding and Abetting

As we highlighted in Portfolio Company Playbook Chapter 2, a fund sponsor’s participation on a portfolio company board is an acute risk factor for the entire fund complex.  Risk arises from potential conflicts of interest relating to sponsor board designees’ competing fiduciary duties to 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, sponsor-appointed directors may be found to lack independence, triggering a harsher standard of review and increasing the risk surrounding the transaction. In addition to the fund’s typical indemnification obligation to designee directors (which will be discussed in depth in the next installment in the Portfolio Company Playbook series), litigation challenging a designee director’s actions can give rise to direct claims against the fund for aiding and abetting the director’s alleged breach of fiduciary duty.

Though defenses to aiding and abetting claims may be available and will vary by jurisdiction, the easiest way to defeat those claims is by preventing them in the first place. Fund sponsors can consider preventative measures by ensuring that designee directors are fully aware of their duties and always mindful of situations where those duties could be perceived to conflict. In the transactional context, the fund and designee directors should consider whether the fund’s interests align with those of other company stakeholders, and what board approval structures and legal safe-harbors might be available in the event that there is an arguable conflict.

Controller Fiduciary Duties

Funds (and sponsors) may also be vulnerable to direct breach of fiduciary duty claims where they are the majority shareholder or de facto controller of a portfolio company. Though the existence, extent, and triggering factors for controller fiduciary duties vary by jurisdiction, a fund should exercise caution when it assumes any significant degree of control over a company or transaction through majority stock ownership, majority board control, special voting rights, or by other means, as such control may give rise to direct fiduciary duties flowing from the fund to other shareholders. In some jurisdictions, the fund may be subject to claims even where it only exercises control as a member of a group of shareholders, sometimes referred to as a “control group.” Thus, funds should be particularly mindful of conflict-of-interest allegations where they work with long-time investment partners or affiliates to form a stockholder or board majority approving a given transaction.

In situations where the fund is arguably a controller or member of a control group with sufficient power over the company or a specific transaction, it should research the relevant jurisdiction’s law on controller and shareholder fiduciary duties, be mindful of the fund’s direct involvement in negotiating and approving the transaction, and consider when appropriate structures like a special committee or ratifying minority shareholder vote could help safeguard against litigation risk.

Unjust Enrichment

Following liquidation events that benefited a fund to the perceived detriment of some other set of stakeholders in the portfolio company, the fund may have exposure to unjust enrichment claims. Usually such claims are follow-ons to the claims described above, and often rise and fall with them.  However, in certain contexts such as company restructurings and liquidations, funds may be particularly vulnerable to unjust enrichment claims. In these contexts especially, sponsors should be watchful for potential conflicts of interest that could give steam to a plaintiff’s narrative that the fund unjustly drained the company’s coffers to benefit itself at the expense of the company, and particularly anyone to whom the fund or its designees potentially owe duties.

Stay tuned for our upcoming chapter on navigating fund indemnification risks.

For further information regarding sources of risks and liability for portfolio companies and fund sponsors, contact us regarding The Portfolio Company Playbook: A Fund Sponsor’s Guide to Risks and Liability.

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Photo of Timothy W. Mungovan Timothy W. Mungovan

Tim Mungovan is the Chair of Proskauer.  He is also the immediate past chair of the Firm’s Litigation Department and head of the Securities Litigation practice.

His practice is focused on securities, commercial litigation, governance, and bankruptcy-related matters. He has a national reputation…

Tim Mungovan is the Chair of Proskauer.  He is also the immediate past chair of the Firm’s Litigation Department and head of the Securities Litigation practice.

His practice is focused on securities, commercial litigation, governance, and bankruptcy-related matters. He has a national reputation for advising sponsors of private investment funds (hedge, private equity, private credit and venture capital) in a wide variety of matters, including litigation, governance, securities, fiduciary obligations, and regulatory enforcement.

Chambers USA describes Tim as “an extraordinary lawyer who is a fierce and very talented litigator. He is extremely knowledgeable, responsive and client-oriented.” Best Lawyers in America lauds Tim’s experience, integrity, work ethic, communications and courtroom skills. Tim has been listed in the “Top 100 Lawyers” in Massachusetts, and Benchmark Litigation has continually recognized Tim as a Litigation Star in Massachusetts.

Over the last six years, Tim has been the lead litigator representing the Financial Oversight and Management Board for Puerto Rico in the historic restructuring of Puerto Rico’s debts. The scale and complexity of this restructuring has resulted in one of the most active litigation dockets in the U.S. Almost every aspect of the litigation involved matters of first impression in part because the restructuring is governed by the Puerto Rico Oversight, Management, and Economic Stability Act, which was enacted for Puerto Rico in 2016.  The track record of success speaks for itself:  in the more than 150 lawsuits filed, Tim and the Proskauer team have prevailed in almost 95% of the cases.

Tim is recognized nationally for his experience in private fund litigation and disputes, having focused on the industry for more than 25 years.  As part of that focus, Tim created and is the lead editor of Proskauer’s blog on Private Equity litigation, The Capital Commitment.

Photo of Michael R. Hackett Michael R. Hackett

Mike Hackett is a partner in the Litigation Department and Co-Head of the Asset Management Litigation practice. An experienced litigator and trial lawyer, Mike’s practice focuses on complex commercial litigation, with a particular emphasis on asset management, financial services, M&A, shareholder, and life…

Mike Hackett is a partner in the Litigation Department and Co-Head of the Asset Management Litigation practice. An experienced litigator and trial lawyer, Mike’s practice focuses on complex commercial litigation, with a particular emphasis on asset management, financial services, M&A, shareholder, and life sciences disputes.

A significant portion of Mike’s practice concerns disputes and regulation involving private funds, including private equity, venture capital, hedge, real estate and private credit funds, as well as their sponsors, partners, investors, portfolio companies, and officers and directors. Mike’s experience representing private fund clients runs the gamut, from control contests within advisers, to disputes between limited partners and general partners, to representation of investment advisers in connection with regulatory examinations, investigations and enforcement matters. Mike routinely represents funds, fund sponsors, portfolio companies, and their officers and directors, including in significant post-closing M&A disputes.

Mike also litigates high-stakes commercial disputes in the life sciences and financial services areas, including for established pharmaceutical and biotechnology companies, emerging and innovative start-ups, asset managers, and other private capital investors, in areas such as M&A, breach of contract, indemnification, fraud, contested earnouts and royalties, securities and capital markets, and corporate governance.

Mike has been recognized by Chambers USA and was named a “Rising Star” by Massachusetts Super Lawyers.

Photo of Jonathan M. Weiss Jonathan M. Weiss

Jonathan Weiss is a partner in the Litigation Department. Jonathan represents both plaintiffs and defendants in a wide range of high-stakes litigation, including antitrust, class action, financial services, securities and other complex commercial litigation. Jonathan has won multiple noteworthy jury verdicts, including the…

Jonathan Weiss is a partner in the Litigation Department. Jonathan represents both plaintiffs and defendants in a wide range of high-stakes litigation, including antitrust, class action, financial services, securities and other complex commercial litigation. Jonathan has won multiple noteworthy jury verdicts, including the fourth largest jury award in the history of the State of Arizona (over $110 million), and has significant appellate experience briefing and arguing appeals in both state and federal courts across the nation.

Jonathan has been recognized as a “Rising Star” by Southern California Super Lawyers every year since 2011, and was recognized by Legal 500 U.S. in their 2015 leading lawyers in appellate litigation edition, noting his “incredibly dedicated” advocacy on behalf of his clients. Jonathan has also spent considerable time on pro bono matters, for which he has been honored by Public Counsel among other organizations.

In addition to his busy practice, Jonathan has taught courses on Ninth Circuit appellate advocacy throughout Southern California and has lectured at several universities nationally, including Harvard Law School, UCLA Law School, the University of Illinois and the University of Pittsburgh. Jonathan is also a member of the Pacific Council on International Policy.

Photo of Adam L. Deming Adam L. Deming

Adam Deming is an associate in the Litigation Department and a member of the firm’s Appellate and Product Liability groups, and Asset Management Litigation team. He focuses on complex commercial litigation in federal and state courts, covering a broad spectrum of business disputes…

Adam Deming is an associate in the Litigation Department and a member of the firm’s Appellate and Product Liability groups, and Asset Management Litigation team. He focuses on complex commercial litigation in federal and state courts, covering a broad spectrum of business disputes touching on corporate governance, fiduciary obligations, financial services, securities and insolvency. Adam has also represented clients in appeals spanning various areas, including consumer products, life sciences, bankruptcy, labor relations, patent and constitutional law.

Prior to joining Proskauer, Adam served as a law clerk to the Honorable Patty Shwartz on the United States Court of Appeals for the Third Circuit. Adam was also an associate in the New York office of an international law firm. Adam graduated cum laude from the University of Pennsylvania Law School, where he was the managing editor of the Journal of Constitutional Law and an Arthur C. Littleton Fellow instructor in legal writing.  Before law school, Adam was a Teach for America Corps Member in New Orleans, Louisiana, where he taught middle school English for three years.