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Avoiding Litigation Risks Arising Out of Private Investment Firms’ Controlling Interest in Portfolio Companies

Posted in Litigation Trends, Massachusetts Courts

Avoiding Litigation RiskRecently, my firm Cooley Manion Jones LLP, successfully obtained summary judgment (download pdf) on behalf of its clients, Boca Raton-based private equity firm Sun Capital Partners, Inc. and six of its affiliated entities.  The claims were brought by two entities that had entered into contractual relationships to serve as independent sales representatives on behalf of Sun Capital portfolio company ACT Electronics, Inc.  Plaintiffs asserted numerous contractual related claims under veil piercing theories, together with claims for tortious interference, violations of the Massachusetts unfair trade practices statute, and state law statutory claims for commissions.  The gravamen of Plaintiffs’ claims was that Sun Capital and its affiliated entities pervasively controlled ACT Electronics and siphoned off corporate assets to the detriment of Plaintiffs.  While much of the Plaintiffs’ allegations were baseless and rejected by the Court, this case is a perfect example of the increased risk of liability associated with majority ownership and control of portfolio companies for the private investment industry, and illustrates steps companies can take to limit exposure in such cases.

Shareholder or control person liability arises in an increasing number of situations faced by private equity firms, including common law veil piercing claims, as well as WARN Act and Wage and Hour claims, and claims brought under provisions of the Securities Act and Securities Exchange Act.  While the factors considered by courts to determine whether a controlling shareholder should be held liable for the acts of a portfolio company vary from state to state and vary based on the context in which the claims are brought, all generally boil down to the following:

  • Disregard of corporate formalities
  • Disregard of corporate governance structure
  • Disregard of the corporation’s economic separateness
  • Undercapitalization
  • Siphoning of funds
  • Common ownership
  • Common directors and officers
  • Exercise of impermissible control

As these factors are used in guiding courts’ consideration of whether to extend liability to private investment firms and other controlling shareholders, these controlling shareholders must keep these factors in mind when structuring relationship with each of their portfolio companies.  Moreover, they should be mindful of the measures detailed below in order to reduce or eliminate the risk of such claims.

Recognize corporate formalities.  Private equity firms and their affiliated entities, by their very nature, must have inter-corporate relationships with their portfolio companies due to their interests as shareholders in those companies, and due to various other economic interests associated with their investment in those companies.  As a result, it is imperative that private investment firms and their affiliated entities observe proper corporate formalities.

In addition, private equity firms must encourage their portfolio companies to do the same.  All of the companies involved must take steps to create “corporate separateness.”  For instance, they should “separately: (a) conduct regularly scheduled meetings of their board of directors; (b) conduct and record shareholder votes; (c) prepare and record timely corporate minutes; (d) issue and record stock certificates; (e) make routine filings with the appropriate offices of the appropriate secretaries of states; and (f) maintain individual and separate corporate records and financial accounts.

Recognize separate business activities and governance.  While the success of private equity firms is largely based on the business success of their portfolio companies, private equity firms and their affiliated entities, must not micromanage the day-to-day business of their portfolio companies.  The more autonomy given to the portfolio companies, the less likely a court will extend liability to the shareholders.  For example, portfolio companies should be responsible for their own personnel matters, including the hiring and firing of their own employees.  In addition, portfolio companies should maintain their own financial accounts and finances.  Further, to the extent a portfolio company has a relationship with a private equity firm controlled management services company, it should be abundantly clear that the management company’s role is merely to consult and advise the portfolio’s management team, and that all decisions are explicitly reserved for portfolio management.  Moreover, ensure that any management services agreement is the culmination of an arms-length transaction, and that the fees charged are within norms for the private investment industry.

Adequate capitalization.  Portfolio companies should be adequately financed for their anticipated business purpose.  To the extent feasible, portfolio companies’ operating credit should be secured by independent lenders.  To the extent that private investment firms or their affiliated entities loan portfolio companies money, it should be an arms-length transaction, based upon commercially reasonable market terms and must be fully documented.

Directors and officers.  Ideally, officers and directors of private equity firms should not serve as officers of their portfolio companies.  The officers of the portfolio company should be independent and operate with the business of the portfolio company in mind.  Often, private equity firms, by virtue of their majority shareholder status, will have the right and obligation to appoint their own employees to the boards of directors of their portfolio companies.  While it is typical and justifiable to appoint members aligned with the interests of the private investment firm, it is wise to have one or more independent directors – often a senior member of the portfolio company’s corporate management team.  In any event, it is critical that each officer and director be cognizant of the capacity in which they are acting at all times.

It is unlikely that any company can completely eliminate the litigation risks associated with being a majority shareholder or control person, and the steps detailed above are by no means an exhaustive list of measures that a private equity firm can, and should take.  Nevertheless, it is clear from the case law that the more consideration private equity firms give to recognizing the separate corporate existence of portfolio companies, and the more effort expended on acting in conformance with that recognition, the better chance of success those firms have when confronted with litigation which seeks to extend to them the liability for a portfolio company’s conduct.