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Private Equity - avoiding liability for wrongdoing of a portfolio company

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By Julian Bubb Humfryes

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Published 12 June 2018

Overview

A successful private equity investment depends on containing liabilities in the portfolio company. Firms need to prevent clams against portfolio companies creeping up to the fund level. Conversely, claimants against portfolio companies have every interest in accessing the deep pockets of the fund - especially where the claim is large or open-ended.

Restricting contractual claims to the portfolio company is simple enough. The courts will not 'pierce the corporate veil' and find the parent liable where it was not a party to the contract in question. Matters are not so simple where the claim is for a tort such as negligence or civil fraud. Two recent decisions show how the Court might interpret a claim against a parent company for the alleged wrongdoing of its subsidiary.

 

Recent cases

In Vedanta Resources1 the Court found that a London-based parent company could be liable for negligence, even when the torts were committed by a subsidiary in Zambia and even - crucially - where the subsidiary was not wholly-owned. (The Zambian state owned a significant stake in the subsidiary.)

Okpabi v Royal Dutch Shell2 confirmed that a parent company could be held liable in such circumstances. The Court of Appeal found (in a split decision) that Shell was not liable on these particular facts, but confirmed some useful guidance for when a parent will be liable.

In order for liability to be established the following basic requirements must be met:

  • The loss must be foreseeable;
  • There must be a sufficiently close relationship between the parent of the subsidiary which committed the wrong and the victim of that wrong; and
  • It must be reasonable to impose liability (this is often viewed through the lens of public policy).

In most cases, the key issue is likely to be establishing a close relationship between the parent and the party making the claim. In deciding whether there is a sufficiently close relationship, the Court will consider:

  • The degree of control the parent has over the subsidiary, including by implementing policies for the subsidiary to follow (although merely setting out best-practice guidelines is unlikely to be enough to establish liability);
  • Any knowledge and expertise of the parent which makes it well-placed to protect the party claiming to have suffered loss (e.g. where the parent and the subsidiary are in the same industry); and
  • Whether the parent company knew, or ought to have known, that the subsidiary was at risk of causing the loss.

 

Private Equity - the dilemma

The court is unlikely to find that private equity firms have greater industry knowledge and expertise than their portfolio companies. The real risk arises where the fund is exercising control over its subsidiaries' operations. The court's approach has sometimes been to look for the deepest pockets to meet any claim, even if it means imposing liability on an entity which is not directly at fault. In some circumstances, the court would rather do this than let a victim go without compensation.

Fund employees may be made directors of portfolio companies, giving them both the right and the duty to exercise a degree of control over the subsidiary. Some funds may also view it as best practice to impose policies on portfolio companies relating to topics as diverse as anti-corruption, data protection and health and safety. Merely laying down policies as 'best practice' guidance is unlikely to create liability, but is a factor that the Court will consider if the policies are coupled with some other means of exerting control, or of enforcing compliance with those policies.

There are perfectly good reasons for funds to exercise some control or enact sensible policies at the subsidiary level (and in some circumstances they will need to do so in order to meet their own legal and regulatory obligations), but the need to contain liability and risk within the portfolio company itself should also be borne in mind. Every situation is unique, but we would always suggest that a fund's interests are best served by preventing liability arising in the first place, rather than simply confining it to the subsidiary. Even if contained within the portfolio company, the subsidiary's liability reduces that subsidiary's value as an asset to the fund.

However, funds should be on the look-out for situations where the subsidiary's assets may not be enough to meet a claim. It is in these circumstances that claimants may seek to sue the parent as well. This covers major instances of damage caused by negligence or fraud, as well as cases where there are numerous potential claimants or seemingly open-ended losses. Examples include environmental damage, significant data security issues, defective products, and unsafe systems of work.

Finally, we note in passing that claims may also be brought against parent firms for portfolio company wrongdoing where claimants allege an unlawful means conspiracy between the fund and the subsidiary - i.e. that the parent and subsidiary colluded to cause damage to the claimant. Whilst it is far from clear that such a claim would succeed at trial in most fund / subsidiary situations, we observe an increasing use of this claim because of the tactical advantages it brings. The claimant can access to a bigger pool of disclosure documents, and may be able to extend limitation periods for bringing a claim. This tactic also increases the complexity and costs of defending the litigation. Moreover, such claims invariably contain an allegation of fraud, with its associated reputational harm and the risk of directors' disqualification. In these ways a claimant may seek to leverage a lucrative settlement from the fund.

1[2017] EWCA Civ 1528

2[2018] EWCA Civ 191

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