It is a truism in the U.S. economy that as a particular industry grows in size and influence, it becomes a magnet for litigation. Litigation risk for an industry follows a typical arc, trailing the industry upward as it grows, and then rapidly closing the gap with a proliferation of suits over scandals and misdeeds, both real and imagined. Recent examples abound, including the mutual fund market timing and late trading scandals earlier this decade, the underwriting of initial public offerings of technology companies during the late 1990s, and the accounting scandals at one-time stock market darlings such as WorldCom, Enron, and Adelphia.

by Timothy W. Mungovan, Partner, and Jonathan Sablone, Partner

The private equity industry is not immune from similar litigation risk. In fact, the risk of litigation has substantially increased, based on the number and types of cases that have been filed nationwide in 2006 and 2007. For example, there have been a number of cases recently over proposed buyouts, by both shareholders and competing bidders. These disputes tend to relate directly to the mechanics of the transaction at issue (e.g. managing the auction process) or whether the disinterested directors obtained the highest price and made full disclosures to shareholders.[1 ] Such disputes have been part of the private equity landscape for 25 years and amount to an occupational hazardalbeit one that appears to be growing after a period of relative dormancy.

More troubling are cases that involve industry practices and allegations of fraud. Recent cases include antitrust investigations, disputes between private equity firms, disputes between bankruptcy trustees and private equity firms, and a dispute between a private equity firm and a law firm.[2 ] These cases are emblematic of a maturing industry where competition is fierce, business risks are higher, and returns are pressured.

These types of cases could be a prologue to another type of lawsuit on the horizon: disputes among general partners and limited partners. Previously rare, the number of these partnership disputes is likely to rise based on disputes recently observed in currently pending cases in the venture capital and hedge fund industries.

Connecticut v. Forstmann Little. A watershed

The case of Treasurer of the State of Connecticut v. Forstmann Little is the highest profile case thus far of a limited partner in a private equity fund suing its general partner over a failed investment. The Connecticut state employees pension fund had been a limited partner in funds managed by Forstmann Little, and, in 2002, the treasurer for the State of Connecticut sued Forstmann Little and several of its general partners to recover in excess of $120 million in failed investments in two telecommunications companies, which Connecticut claimed had been made in breach of the funds partnership agreement and of the general partners fiduciary duties.

After a month-long trial, a six-person jury found that Forstmann Little had acted with gross negligence, bad faith, or willful misconduct, but declined to award monetary damages based on the fact that Forstmann Little had relied on the advice of its legal counsel in managing the investments and that the State of Connecticut had agreed to the investments. To resolve the case and avoid any appeal, Forstmann Little settled the case by reportedly paying $15 million to Connecticut.

While the trial offers many lessons, it also foreshadows litigation risk between limited partners and investment firms.

Theodore Forstmann told the New York Times in October 2004, shortly after the settlement was announced, that this will be the first of many suits between investors and private equity firms due, in part, to increasing competition, high fees, and the participation of public entities in private equity funds.[3 ]

Amaranth: A cautionary tale

While its facts and circumstances are quite different from the Forstmann Little case, the lawsuit against Amaranth Partners, LLC, following its failure, is a cautionary tale for private equity firms. As most industry insiders may recall with a shiver, likelyAmaranth was a $9 billion hedge fund that lost $6 billion in a matter of days in September 2006. The San Diego County Employees Retirement Association (SDCERA) was a large investor in the fund and lost approximately $100 million of its investment. In March 2007, SDCERA filed suit against the funds management company and several individuals, alleging, among other things, fraud and breach of fiduciary duty. This case marks the first time in memory that a pension plan filed suit against a hedge fund as a result of pure market losseswithout disputing that the fund was a legitimate commercial enterpriseas opposed to the more typical allegation of criminal misconduct by the funds managers, as in the Bayou and International Management Associates, LLC cases.

Amaranth and the funds individual managers have filed motions to dismiss the complaint based primarily on the express terms of the limited partnership agreement. These motions to dismiss are currently pending. If the court declines to dismiss the complaint, it will signal that hedge funds and private equity funds, and their managers, have litigation risk even in the absence of criminal misconduct.

Lessons from venture capital

Following the bursting of the technology bubble, many venture capital firms restructured and shed general partners, on both a voluntary and an involuntary basis. Most of these departures were handled quietly as an internal partnership matter. Some departures, however, resulted in significant, high-stakes litigations between the departing partners and

the partnerships. An example of such litigation involved Prism Venture Partners in Boston in 2005. Prism had attempted to terminate David Baum, a longtime general partner in the firm. Baum, in turn, sued his partners and obtained an injunction against them on the grounds that the attempted termination constituted a breach of their fiduciary duties to him. As this matter demonstrated, when returns diminish, pressure on GPs increases, which results in restructurings. Private equity firms must be cognizant of the risk that internal disputes can turn into litigation where dirty laundry is aired in the public arena.

Private equity litigation heats up

In the past few weeks, several significant lawsuits have been filed in the private equity world, including cases involving Thomas H. Lee Partners, L.P. (TH Lee) and its failed investment in Refco, Inc. First, TH Lee sued the law firm of Mayer, Brown, Rowe & Maw alleging that Mayer Brown had misled it concerning the financial condition of Refco. Then, the trustee of the Refco bankruptcy estate sued TH Lee and several of its members, alleging that they, among other things, breached their fiduciary duties by taking Refco public, despite allegedly knowing about material financial problems at the company. Finally, TH Lee sued Grant Thornton, Refcos former auditor, alleging, among other things, that Grant Thornton aided and abetted Refcos fraud, made misrepresentations, and engaged in professional malpractice.

Because these cases are still in their earliest stages, it is difficult to draw any meaningful conclusions from them, other than the fact that private equity firms are not immune from the vagaries of high-stakes litigation when a financial disaster occurs. In the event that TH Lee is found liable, or otherwise reaches a monetary settlement with the trustee, a dispute could arise between TH Lee and its limited partners over who bears the burden for losses. TH Lee may attempt to push some of the obligation onto the investment partnership that made the original investment, while the limited partners undoubtedly will expect TH Lee to bear this burden. Complicating matters further, TH Lees founder, Thomas H. Lee, who is named personally as a defendant, is no longer with the firm, and not all partners at TH Lee are named as defendants in the suit. Thus, in the event that liability is imposed, disputes could arise between the general partners on sharing responsibility.

Whats next

As a general matter, litigation risks will likely continue to increase in the private equity space. Pension plans continue to be significant investors in private equity funds. These pension plans owe fiduciary duties to their own plan participants, and many such pension plans have already shown a penchant for litigation in the securities class action context. Public pension plans have also brought the most significant suits to date against a hedge fund (Amaranth) and a private equity fund (Forstmann Little).

While private equity firms probably would prefer to slip back below the radar, we have seen that litigation is a real but manageable risk of doing business. All indicators suggest that the risk of litigation is ever present as the business cycle turns.

1. See In re Lear Corp. Sholder Litig.. 926 A.2d 94 (Del. Ch. 2007); In Re Topps Co. Sholder Litig.. 926 A.2d 58 (Del. Ch. 2007); In Re Netsmart Techs. Inc. Sholder Litig.. 924 A.2d 171 (Del. Ch. 2007).

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