Not covered: insurance, fraud and private equity liability

In recent years, there has been explosive growth in private equity firms taking out M&A insurance when buying and selling assets, with more than three quarters of all deals globally involving some form of policy.

At the Mergermarket Nordic M&A and Private Equity Forum in Stockholm, Marsh's transactional risk specialist David Lillo said European law firms were reporting as many as 50% of global private equity deals being worked on included some sort of M&A insurance.

"The starting point is that private equity sellers want speed of execution, certainty and a clean break. They do not want to be exposed to liability for assets they have sold," says Linklaters private equity partner Ben Rodham.

In most European deals, private equity sellers will give incredibly limited protections to the buyer" – Ben Rodham, Linklaters

Furthermore, M&A insurance is increasing in popularity for private transactions, such as SBOs and trade sales, which are based on a private contract between the buyer and seller: according to research by law firm Marsh, 79% of M&A insurance policies taken out in EMEA transactions in 2015 were for private deals.

"In most European deals, private equity sellers will give incredibly limited protections to the buyer," Rodham says. "The private sale agreement between them comprises all the deal terms; so whether it is a claim for misrepresentation or another tortious claim, the contract will stipulate that the seller has no liability to the buyer unless something is explicitly provided for in the contract."

When sponsors exit through an IPO, the buying public can find some protection and recourse through a range of investor protection laws including the EU's Prospectus Directive. Potential liabilities are assumed by companies being listed under such laws and are increasingly insured against.

However, the lay of the land changes substantially in cases where there is evidence to suggest a seller has somehow acted maliciously, because any clause that stipulates the exclusion of liability for fraud is unenforceable. "Fraud would be one of the few avenues to pursue if anyone were seeking redress against a GP in the context of an IPO," says Rodham. "However, it is worth immediately pointing out that it's an unlikely fact pattern to arise and in any event there is an incredibly high burden of proof to bring a successful claim for fraud, because you're ultimately having to prove what someone knows and what their intentions were."

The fraud factor
Outright fraud is a rare occurrence in private equity deals and no major cases of fraud have been successfully mounted against a European GP in recent years, but one such case may be building in Denmark.

In November 2014, just seven months after being floated on the Copenhagen Stock Exchange by Nordic GP Altor, Danish shipping fuel business OW Bunker went bankrupt, in what is considered to be one of the biggest scandals in the country's recent financial history.

In December last year, the ad hoc curator of OW Bunker's estate, Søren Halling-Overgaard, turned over findings from his ongoing investigation of the collapse. In early March 2016, the Danish public prosecutor for financial crime, SØIK, submitted charges against several members of management in OW and its Singapore subsidiary at the heart of the case.

While Halling-Overgaard's report does not allege any fraud on the part of Altor, it does level substantial criticism of the GP and the bookrunners' involvement in the IPO. Meanwhile, a group of 27 institutional investors – including Danish pension funds that are former LPs in Altor's Fund IV and invested in OW Bunker's IPO – have sued the GP and the company's management for DKK 800m in damages relating to the collapse.

Double trouble
The group is pursuing two lawsuits: one of prospectus liability and one of neglect in adhering to public market disclosure regulations. Altor is only named in the former. While no wrongdoing has been alleged on the part of Altor, its absence from the latter is in part evidence of the difficulty of bringing a successful claim for fraud against a GP.

The general principle governing IPOs in Europe is a legal duty to not mislead or conceal material facts, for anyone looking to induce someone to try and undertake investment activity. In an IPO, the main sales material is the prospectus, governed by the EU's Prospectus Directive, and it is produced and authorised by the company and its directors and not the private equity sponsor.

"There is no requirement for the sponsor to [authorise the contents of the prospectus]," says Rodham. "A private equity house should not be involved in authorising the contents of the prospectus – and for this reason there will not usually be a cause of action against a sponsor.

"Equally, when a private equity house wants to undertake an IPO of one of its portfolio companies, we [Linklaters] are typically engaged by the portfolio company because it is the portfolio company that is undertaking the process and the private equity sponsor will be concerned to ensure the potential liability assumed by the company and its directors is limited and the right protections are in place."

GP protections
There is an avenue of recourse set out in US legislation through the concept of secondary liability, against anyone who effectively controls the party making the statements, such as the sponsor controlling the company.

However, that concept does not exist in markets governed by EU legislation, meaning financial sponsors cannot be held liable for financial crime perpetrated by their portfolio companies unless clear involvement is proven.

Without secondary liability, GPs enjoy broad indemnity from being sued for fraud as a result of wrongdoing at a portfolio level. While most funds will have a partner or investment director sitting on their portfolio company boards, it does not guarantee a link to the fund or its partnership.

"A director is sat in the capacity as a director of the company. It would be very challenging to look beyond their role as a director of the issuer and say that because their day job is with the fund, that somehow the fund is vicariously liable for that individual," Rodham says.

While a public sale has a buffer between the seller and the GP built in, there are fewer steps to pinning a claim of fraud on a GP in private transactions, such as a trade sale or SBO.

The blame game
If a suit is able to be successfully brought against the private equity firm, it raises the question of whether the suit is against the GP, a separate manager or if it can be pinned to the partnership itself.

"That will be very fact-specific," says Linklaters partner and global head of investment management group Matt Keogh. "It would be difficult to [bring the suit against the partnership] in some cases, if the knowledge that lies behind the fraud is knowledge that sits entirely within the GP or a separate manager. In those cases, in order to access partnership assets, a successful suitor would be relying on the GP or manager's right of indemnity, and that kind of right would almost never cover losses arising as a result of fraud."

For that reason, it would most likely end up being the private equity firm footing the bill, as opposed to the partnership itself: "GPs don't generally have within them a large number of employees who benefit from knowledge; they rely on advice or management services that are provided to them," says Keogh.

While a case of fraud could hypothetically be linked as far as the partnership, taking a suit one step further – to the LPs – is near-impossible. "There's a chain that would be necessary in order to get the suit to the manager or the GP in the first place," says Keogh. "To get it from there to the fund is an additional step that in many cases will be difficult to make."

In cases of fraud, LPs hold the greatest protection of any party. While LP agreements stipulate that investors finance the liabilities of the GP, most LPAs will have a cut out for fraud, ensuring that LPs will not end up footing the bill for the wrongdoings of their manager.

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