Private Equity Bulletin: Recent Legal Updates

Joseph W. Bartlett, Founder of VC

The GP's Fiduciary Duty Now Can be Eliminated in Delaware Limited Partnerships ... We Think?

The Delaware legislature has amended the Delaware Limited Liability Company Act, Section 18-1101; the Delaware Revised Uniform Limited Partnership Act, Section 17-1101; and the Delaware Revised Uniform Partnership Act, Section 15-03, to modify the holding in Gotham Partners v. Hallwood Realty, 1 the Delaware Supreme Court decision that expresses "Delaware's cautionary approach" against the unbridled enforcement of exculpation language in limited liability company and limited partnership agreements which would excuse the managers/insiders/general partners from any and all fiduciary duty obligations. We quote a description of the amendment from the piece by Louis Hering and Walter Tuthill of Morris Nichols, as reprinted in the Pubogram Vol. XII, No.1 of the ABA Section of Business Law ... the Newsletter alof the Committee on Partnerships and Unincorporated Business Organizations.

"Consistent with the principle of freedom of contract that is the hallmark of Delaware's alternative entity statutes, the DLLCA, DRULPA, and DRUPA have been amended to make clear that to the extent a member, manager, partner, or other person has duties (including fiduciary duties) to an LLC, limited partnership, or general partnership or to another member, manager, partner, or to another person that is party to, or bound by, the governing agreement, such member's, manager's, partner's, or other person's duties may be eliminated (as well as expanded or restricted) in the governing agreement, except that the governing agreement may not eliminate the implied contractual covenants of good faith and fair dealing."

As Yogi Berra, however, has been reputed to say, "it's never over until it's over." Put another way, the Delawarelegislation gives rise to a series of additional questions, which have been quite imaginatively and cogently stated by Howard Lefkowitz of Proskauer Rose; his article, which we reproduce in its entirety with his permission, appears in the same ABApublication.2 Finally, although the entire article is too long to reprint in this flash report, we are pleased to refer all hands to a third treatment of this issue by Paul Altman and Srinivas Raju of Richards Layton, again in the same Pubogram. We urge that general partners/LLC managers and their counsel, consult the entire article for a first class review of the laws that now exist, and as interpreted in cases leading up to the current legislation.

In most private equity funds with which we are familiar, the amendment is arguably superfluous, because the fund ordinarily defines the duties of the general partner to the limited partners ... although not superfluous to the extent (as is often the case) the instrument fails to refer specifically to the term "fiduciary duty" but, instead, talks only about liability imposed on the GP for "willful misconduct" and "gross negligence." "Fiduciary duty" carries within it a lot of potential meanings ... duty of loyalty, duty of care and, arguably, the duties of candor and/or good faith. The point of the story is that, in light of the amendments to the Delaware statute, any expression of the standard in the limited partnership agreement of a private equity fund should be elaborately stated ... and negotiated ... and more comprehensively drafted than had previously been the case. Thus, we recommend that all the materials in the Pubogram be consulted when counsel is drafting the provisions in question.

In that regard, in my experience the amendment will be of particular use when a special purpose vehicle is being organized, typically an LLC, and the manager of the same (a commercial bank, for example) is using the vehicle to hold assets as an agent, often as an escrow agent or as an accommodation to customers for some other purpose. Often the bank, as sole LLC manager, will be uncomfortable with common law responsibilities; it will agree to act if importuned by the parties to a given transaction, but only if exculpated to the outer limits imposed by law. The amendments open the possibility to make the deep pocketed institution comfortable that it is not simply a target if anything goes wrong with the collateral or its administration, even though the institution itself is not (as a matter of common sense) responsible.

Portfolio Valuation: International Associations Endorse Standard Approach (SJ Berwin)

Last week saw a huge leap forward for private equity and venture capital as an asset class. For a long time, one of the big complaints of investors has been that the approach to valuation - critical for the regular reports produced by fund managers - has been inconsistent and, in some cases, unscientific. Although the industry has been working for some time to improve the quality and consistency of valuations, and national associations have produced guidelines that many funds have adopted, until last week there was no single accepted European rulebook.

New "international" valuation guidelines were published in March this year, following a collaborative exercise involving the European Private Equity and Venture Capital Association (EVCA) and the French and British national associations. But the rather grand title was not really justified until 16 June, when the originators of the guidelines announced that a further 21 regional and national associations had endorsed their valuation rules. These include 15 national associations, comprising most of the European ones (including Germany, Spain and Italy) and some beyond (including, for example, Australia and Africa).

One significant endorser is the International Limited Partners Association (ILPA), a Toronto-based body that represents the interests of around 140 investors across 10 countries. In September last year, ILPA also endorsed the most important remaining alternative - the US Valuation Guidelines issued by the Private Equity Industry Guidelines Group. In comparing the two sets of rules, ILPA concluded that the approaches were similar. Both rely on the concept of "fair value" (which will be a significant departure for many in Europe), and are consistent with US and international accounting principles. ILPA said that "minor differences in technical detail are expected to allow ... consistent results in practice". They also say that they are working with all parties towards one universal rulebook.

It is of course up to individual private equity fund managers - and their investors - whether to adopt the new guidelines, but pressure to do so will now be almost irresistible.

For those who have issues with the rules, there is now a way to make representations, and a promise that the rules will be kept up to date and respond to market needs. Last week's announcement included news of an independent board reporting to a general assembly of all endorsing associations, whose job will be to monitor developments and propose amendments. The role of that board is likely to be crucial in ensuring that the rules become widely accepted in practice across Europe and the world.

24 June 2005

Alert To Lawyers And Their Clients - Conflict Issues Ahead.

Some time ago, in the 1995 edition of Equity Finance, I included some materials on counsel's potential conflicts of interest when an early stage company was being organized and/or when the lead investor (venture or buyout) winds up picking counsel for the company or buyout. That material is now in Section 5.1.4 of The Encyclopedia of Private Equity and Venture Capital.3.

5.1.4: Note on Counsel's Conflicting Roles in Drafting Term Sheets

Counsel may want to insert a disclaimer in the term sheet that they are representing, if time permits, the founder and the Company itself, and ask for a conflict waiver.

Thus, when an early-stage company is organized, there is usually not a lot of money around to pay counsel fees. As a consequence, counsel to the organizers are accustomed to multiple-party representation; indeed, it is typical for founder's counsel to act for the corporation and the majority shareholder and (since he is usually the same individual) the CEO. The minority shareholders may not be represented by anyone.

For some time, however, practitioners have been troubled by the potential for conflicts of interest in such situations without, however, a clear idea of exactly what to do about it.[1] In a perfect world, independent counsel would represent all parties to a venture financing. However, there simply is not enough money around to finance that luxury in the early stages of most companies. The currently recommended method for handling the issue is procurement of written waivers of the conflicts from the constituents to the financing. The Massachusetts Supreme Judicial Court, however, has suggested in a curious opinion that there may be inherent conflicts that cannot be waived.[2] The court stated in dictum:

"Indeed, there is logic in the proposition that, even though counsel for a closely held corporation does not by virtue of that relationship alone have an attorney-client relationship with the individual shareholders, counsel nevertheless owes each shareholder a fiduciary duty."

See Fasschi v. Sommers, Schwartz, Silver & Tyler, P.C., 107 Mich. App. 509(198 1), for a well-reasoned opinion supporting that view.[3]

This doctrine, if pursued to extremes, has widespread implications for the venture capital bar and its clients-both the start-ups and their founders. The lesson is clear: Counsel must inform the parties to a financing which it represents of the potential for conflicts, counsel should obtain written waivers of the conflicts at the outset, and counsel must be ready to cease representation of one or more parties should the need arise.[4]

[1] Perhaps the leading savant on this issue is Bruce Alan Mann of Morrison & Foerster. See Mann & Wilkinson, The Role of Counsel in Venture Capital Transactions if Disputes Arise, 46 Bus. Law. 759 (1991). In the article, the authors also remark on conflicts that often arise when the lawyer is called upon to (1) invest in an early stage start up, and/or (2) serve as a director of the same.

[2] Schaeffer v. Cohen, Rosenthal, Price, Mirken, Jennings & Berg, P.C., 405 Mass. 506, 541 N.E.2d 997 (1989).

[3] 405 Mass. at 513.

[4] See also Granewich v. Harding, (Ore. S. Ct. 7/9/99).

Recent events have accelerated my concerns on the issue of counsel's conflicts. Let me refer to only a few (not an exhaustive list) of the reported materials which bear on the subject. Thus, in a 1997 case Barkhordarian v. Cooley Godward, (Cal. Ct. of Appeal, 4/10/97), the Court held that the issue whether certain shareholders in a private company enjoyed an "implied-in-fact attorney client relationship" and/or were owed a duty of care even absent the attorney/client relationship were questions of fact ... i.e., for the jury. The court's opinion in Cooley contains the following language:

"Determination of whether in a specific case an attorney will be held liable to a third person not in privity 'is a matter of policy and involves the balancing of various factors, among which are the extent to which the transaction was intended to affect the plaintiff, the foreseeability of harm to him, the degree of certainty that the plaintiff suffered injury, the closeness of the connection between the [attorney's] conduct and the injury, and the policy of preventing future harm ... Limited exceptions to the privity rule have evolved in situations where the third party is the intended beneficiary of the attorney's services or the foreseeabiity of harm to the third party resulting from professional negligence is not outweighed by other policy considerations." (Skarbrevik v. Cohen, England & Whitfield, supra, 231 Cal.App.3d at p. 701, citations omitted.).

Secondly, I note an opinion in Massachusetts which (in an egregious case, of course) wound up with the offending firms suspended from practice for six months. Finally, a 2002 Massachusetts decision, Applebaum v. The Verndale Corporation, 15 Mass L. Rep. (Mass. Supr. Ct., Aug. 2002) has reaffirmed adherence to the holdings cited above, in Schaeffer v. Cohen, Rosenthal, Price, Mirkin, Jennings & Berg, P.C., 405 Mass.506 513, 541 N.E.2d 997 (1989) and Fassihi v. Sommers, Schwartz, Silver & Tyler, P.C., 107 Mich App. 509, 309 N.W.2d 645 (1980).

The classic issue has to do with hypothetical situations, as the above materials indicate, in which company counsel is (i) hired by the founder, based on a previous professional association, to organize an emerging growth company (abbreviated universally as Newco) or (ii) of relevance for purposes of this Bulletin, brought into the picture as company counsel post closing, as in the Cooley case, by the lead private equity fund investor. The question then has to do with the ambit of counsel's responsibility. Perhaps there is a long relationship with the founder or the fund, but none at all with the other investors. Based on the above, it is becoming increasingly clear that, when a private equity fund picks company counsel, the conflicts issues have to be addressed up front and in a writing, subscribed (ideally) by all the shareholders, and which includes effective waivers of conflicts arising out of pre-existing relationships with one or more of the parties to the transaction. Even then, assuming that there arises an intramural dispute amongst proprietors, company counsel has to be quite careful in appearing on behalf of the company, under the direction of the controlling shareholders and, say, a majority of the board, if a minority shareholder is alleging what F. Hodge O'Neal has styled in his two volume work as "oppression" ... a dispute of such importance that it entails a plausible allegation that the controlling shareholders are breaching their "fiduciary duties."

A Recommended "Out" Clause in The LP Agreement.

Given the complexity of private equity funds, I am beginning to insert in the LP Agreement a provision conceding material interpretive powers to the general partner, assuming an opinion of counsel that the interpretation is not inconsistent with the substance of the partnership agreement. The point is that, as we unravel partnerships in these parlous time, we are facing unusual and unexpected contingencies which may involve nice questions of construction vis-…-vis the partnership provisions ... without much guidance in the express language of the Agreement itself. I believe the better course is to give the general partner power to interpret and amend, by virtue of its interpretation, the provisions of the partnership agreement to take into account as many unanticipated contingencies as may be included within the penumbra of the GP's common sense interpretative power, without doing violence to the rights of the parties. Attached is some language, which I am running up the flagpole for the review of any and all subscribers to the Private Equity Bulletin;.

"The General Partner is hereby authorized to take, in its sole discretion, any action (including making structural, operating or other changes in the Partnership, making structural or other changes in any Investment, amending this Agreement in any manner that would otherwise require the Consent of Limited Partners pursuant to Article XI, canceling in whole or in part the Unused Capital Commitment of any Limited Partner, requiring the sale in whole or in part of any Limited Partner's Interest or dissolving (pursuant to Section 9.1) the Partnership) if it has determined in good faith, upon the written advice of counsel to the Partnership, such action is necessary or advisable in order for (i) the Partnership not to be in violation of the Investment Company Act, (ii) the General Partner or the Management Company not to be in violation of the Advisers Act, (iii) the Partnership, the General Partner, any of their respective Affiliates or any of the Limited Partners not to be in violation of any other material law, regulation or guideline applicable to the Partnership, the General Partner, any of their respective Affiliates or any Limited Partner, as the case may be, (iv) the Partnership not to be treated for federal income tax purposes as an association taxable as a corporation, (v) the Partnership to reduce any federal taxation on its net income generally, and (vi) to cure an ambiguity, omission, failure to deal with an unanticipated contingency or like example of incomplete or less than exact drafting entailing a question (a) on which, from the surrounding context, the parties did not adequately focus or negotiate; (b) which is not of sufficient substance as to warrant resort to the formal amendment provisions; (c) can be resolved by the General Partner with reasonable, albeit in some cases less than perfect fairness, to all "parties; and (d) does not entail a conflict, [in the opinion of the Advisory Committee] [in the opinion of fund counsel] involving the personal interests of the General Partner.

Privacy Provisions

It is no news that the question of transparency is becoming increasingly of concern to private equity funds in general. We are, accordingly, adapting our model LP forms to the new realities ... as a number of state and municipal pension funds duke it out on the issue of transparency and the disclosure of confidential information. Again, in the interests of soliciting informed commentary and educating practitioners in this space, I include language from a recent partnership agreement in which I have been involved, which states:


Each Limited Partner agrees to keep confidential, and not to disclose to any Person, any matter relating to the Partnership and its affairs (other than any general disclosure with respect to such Limited Partner's participation and investment in the Partnership as a limited partner thereof), including any matter related to any Investment (other than disclosure in good faith to (i) such Limited Partner's directors, officers, employees, agents, advisors or representatives responsible for matters relating to the Partnership and who need to know such information in order to perform such responsibilities (each such Person being hereinafter referred to as an "Authorized Representative") or (ii) a potential transferee of such Limited Partner's interest in the Partnership in accordance with Article VIII hereof, where the General Partner has consented in writing to such disclosure and the potential transferee has entered into a non-disclosure agreement with the General Partner to the satisfaction of the General Partner); provided, however, that such Limited Partner or any of its Authorized Representatives may make such disclosure to the extent that (x) the information being disclosed is otherwise generally available to the public, (y) such disclosure is requested by any governmental body, agency, official or authority having jurisdiction over such Limited Partner or (z) such disclosure is otherwise required by law. Prior to making any disclosure described in clause (z) of this Section 7.4(a), each Limited Partner shall notify the General Partner of such disclosure. Each Limited Partner will use reasonable efforts to cause each of its Authorized Representatives to comply with the obligations of such Limited Partner under this Section 7.4(a). Notwithstanding anything to the contrary set forth herein or in any other agreement to which the parties hereto are parties or by which they are bound, any obligations of confidentiality contained herein and therein, as they relate to the transaction contemplated by this and any other such agreements (the "Transaction"), shall not apply to the federal tax treatment or federal tax structure of the Transaction, and each party hereto (and any employee, representative, or agent of any party hereto) may disclose to any and all persons, without limitation of any kind, the federal tax treatment and federal tax structure of the Transaction and all materials of any kind (including opinions or other tax analysis) that are provided to any party hereto relating to such tax treatment and tax structure. The preceding sentence is intended to cause the Transaction not to be treated as having been offered under conditions of confidentiality for purposes of Treasury Regulations Sections 1.6011-4(b)(3) and 301.6111-2(a)(2)(ii) (or any successor provisions) and shall be construed in a manner consistent with such purpose.

The General Partner may, to the maximum extent permitted by applicable law, keep confidential from any Limited Partner any information (including information requested by such Limited Partner pursuant to Section 7.1) the disclosure of which (i) the Partnership, the General Partner or the Management Company is required to keep confidential by law or by the terms of any agreement entered into in good faith in connection with any proposed or actual Investment or (ii) the General Partner reasonably believes may have an adverse effect on (A) the ability to consummate any proposed Investment or any transaction directly or indirectly related to, or giving rise to, such Investment, (B) the Partnership or (C) any Person in which an Investment has been, or is proposed to be, made; provided, however, that the General Partner may not withhold any information from any Limited Partner pursuant to this Section 7.4(b) for the purpose of defeating or impairing any right of disclosure that such Limited Partner may have in connection with any action, suit or proceeding brought by such Limited Partner against the General Partner. If information is withheld from any Limited Partner pursuant to this Section 7.4(b), the General Partner shall provide such information to such Limited Partner after the circumstances described in the preceding sentence are no longer continuing.

1 817 A.2d 160 (Del. 2002)

2 See Appendix A.

3 The contributing editor for this section is Ronald C. Minkoff of Frankfurt Garbus Kurnit Klein & Selz, P.C. To review The Encyclopedia go to;



Howard N. Lefkowitz
Proskauer Rose LLP
New York, New York

The August 1, 2004 Amendments to the Delaware Laws (the "Delaware Amendments") regarding alternative entities (See, e.g., Amendments to Delaware Revised Uniform Limited Partnership Act, õ17-1101) have been stated by several members of the Delaware Bar to be "clarifications."

The following are questions or issues that might be asked, and possibly answered, relating to the Delaware Amendments:

  • Why do the Delaware Amendments prevent elimination of liability for bad faith violation of implied contractual covenant of good faith and fair dealing, but not prevent elimination of liability for breach of an express covenant? In other words, liability for breach of an express covenant can be eliminated; a breach of an implied covenant cannot?
  • It has been stated in answer to question 1 that there is an implied covenant to perform express covenants, and therefore, that a breach of the express covenant would violate the implied contractual obligation of good faith! Apart from the clear language of the amendment, if the agreement expressly eliminates liability for breach of contract, and expressly permits a general partner to rely on the provisions of the agreement, how could an aggrieved limited partner claim that it could reasonably expect that the express covenants would be performed?
  • Delaware courts have stated that the implied covenant of good faith and fair dealing in contract law may not be waived or contracted away by the parties to an agreement. In fact, revised Section 17-1101(d) states that the agreement may not eliminate the implied contractual covenant of good faith and fair dealing. However, under revised Section 17?1101(f), liabilities for breach of contract and breach of fiduciary duty may be eliminated except for a "bad faith violation of the implied contractual obligation of good faith and fair dealing." Why must the violation be in "bad faith"? Do the Delaware Amendments establish a new policy less rigorous than that established by the Delawarecourts?
  • Some Delawaredecisions have suggested that a violation of the implied covenant of good faith and fair dealing is itself bad faith. Does the express reference to bad faith in the Delaware Amendments mean that a plaintiff must allege and prove scienter or a conscious and deliberate improper purpose? If not, what does "bad faith" mean?
  • If the limited partnership agreement:
    • expressly, clearly and unambiguously permits a General Partner to consider its own interests, and not to consider the interests of the Limited Partners or the Partnership,
    • expressly eliminates all duties including fiduciary duties,
    • eliminates liability for breach of contract and breach of fiduciary duty,
    • permits reliance on counsel but does not require counsel to be competent, disinterested, to give advice in writing, or to have knowledge of or access to all material facts, and does not state that reliance must be in good faith,
    • permits reliance on the language of the agreement, and
    • provides that the agreement is not to be construed against the draftsperson, how could an aggrieved Limited Partner successfully allege, let alone prove, a bad faith violation of the implied covenant of good faith and fair dealing?
  • If the answer to question 5 is that it is impossible or almost impossible to prove "bad faith", is the supposed "floor" or minimum duty or obligation of the General Partner illusory? Is the contract illusory? If so, what will be the reaction by the Delaware Courts? Could the Delaware Courts undercut or invalidate the legislation as a matter of public policy, or would the legislatively expressed policy favoring freedom of contract prevail?
  • Will the Delaware courts create new public policy, now that they cannot rely, for example, on good faith (as a separate fiduciary duty)?
  • If the advice given by counsel in question 5 and relied upon by the General Partner is in fact in error (whether or not manifestly in error), would the courts find a way to impose liability on counsel? What if the exculpation clause refers not only to the General Partner, but also to its professional advisors, thus an "other person" mentioned in the Delaware Amendments?
  • Some practitioners believed that as a matter of public policy, liability for gross negligence could not be waived, nor could gross negligence be indemnified. Do the Delaware Amendments eliminate that public policy and permit exculpation for gross negligence because of the new, lower "floor"?
  • Numerous agreements have been negotiated against the background of the Delaware Supreme Court decision in Gotham Partners v. Hallwood Realty and other decisions that repeatedly express "Delaware's cautionary approach" against escaping from fiduciary duty. The Delaware Amendments do not state that they are to operate only prospectively. Does that mean that under Section 17-1108, which apparently gives retroactive effect to Delaware Amendments, exculpation, indemnification, and other clauses that use phrases such as "to the fullest extent permitted by law" will be given a new meaning? Or is there an implied contractual covenant of good faith and fair dealing to interpret and enforce the agreements under the law then in existence?
  • The Delaware Bar and the Delawarejudiciary have been very sensitive to possible incursions by the federal government in areas of governance. The approach taken by Delaware laws toward corporations reflects that sensitivity. The Securities and Exchange Commission is now considering requiring advisors or managers of hedge funds (or even private equity funds) to register under the Investment Advisors Act. Concern has been expressed that such registration of advisors could be a precursor to requiring registration and regulation of the funds themselves. If new Delawarepartnership agreements take full advantage of the new freedom of contract to eliminate liability for breach of contract and breach of fiduciary duty in agreements which are in reality contracts of "quasi-adhesion", is it possible that the Delaware Amendments would have the unintended consequence of inviting federal attention and regulation of alternative entities?

Given the nature of limited partnerships, with no power to remove or re-elect a general partner, no transaction approval rights, usually no power to transfer or withdraw, and very little power to make significant changes in agreements prepared by counsel for the general partner, is it possible that the Delaware Amendments have gone too far? "Elimination" of fiduciary duties was, we are told, considered and deliberately rejected when "freedom of contract" was first adopted. Chief Justice Veasey's "dicta" in Gotham Partners was perhaps written against that background.