How limited is liability of limited-partner private equity funds?
The California Public Employees’ Retirement System, the largest public pension fund in the United States, rarely takes a stand as an amicus in trial court. But in an amicus brief filed earlier this month, Calpers warned that the future of private investment in California is at stake in a dispute over a few million dollars in unpaid bonuses to former employees of the now-defunct HRJ Capital. Unless a state-court judge overturns a colleague’s ruling that limited-partner investment funds are on the hook for liabilities of the general partner and fund manager, Calpers said, California risks losing its stature as an incubator of start-up business.
Lawyers for the former employees, meanwhile, contend that Calpers and the funds are drastically overstating the significance of a narrow, fact-based opinion with no precedential impact. On Thursday, both sides will make their cases to Judge Patricia Lucas of Santa Clara Superior Court.
Here’s the much-condensed backstory on the litigation that may – or may not – change the private equity industry. Darren Wong and Duran Curis once held coveted jobs with HRJ Capital and HRJ Capital Management, a fund-of-funds established by former San Francisco football stars Harris Barton and Ronnie Lott. But HRJ, which managed 22 limited-partner private equity funds, ran into trouble in the financial crisis. When management of the funds was eventually assumed by another company, Capital Dynamics, Wong and Curis lost their jobs. Their lawyers at Kirkland & Ellis eventually claimed Wong and Curis were owed about $4 million in unpaid bonuses and millions more in unpaid management fees.
Among the defendants Wong and Curis blamed for failing to pay up were several of the funds managed by HRJ. These funds were set up, like most private equity funds, as limited partnerships that contracted with a sponsoring general partner. The general partner was, in turn, responsible for managing the funds. with responsibility for managing the funds. I’m collapsing some of HRJ’s structural layers for the sake of simplicity, but Wong and Curis essentially said that through the various partnership and management agreements between HRJ entities, HRJ Capital and HRJ Capital Management were agents of the limited-partner funds, which had authorized the HRJ entities to act on their behalf. That agency relationship, as the plaintiffs explained in a summary judgment brief, made the funds liable for HRJ’s obligations to Wong and Curis.
The funds’ counsel at Orrick, Herrington & Sutcliffe said reality was quite to the contrary. There was nothing in the contracts that authorized the fund manager to bind the limited partner funds to HRJ’s obligations. Indeed, according to the funds, the agreements expressly stated that the managing entities were solely responsible for their employees. The funds paid their management fees to the general partner entities, they argued. What HRJ did with the fees was not their problem.
Nevertheless, in a summary judgment ruling last November, Judge James Kleinberg sided with Wong and Curis. “Under Delaware law,” he said, “obligations imposed on the general partners of the HRJ (general partner) entities likewise bind the funds.” The plaintiffs had adequately demonstrated that HRJ founders Barton and Lott had “generated a reasonable belief that HRJ was the funds’ agent,” Kleinberg ruled. “The evidence shows ostensible authority of HRJ to act on behalf of the HRJ funds.”
Kleinberg oversees complex litigation. After his summary judgment ruling, he said that the HRJ case was no longer complex and passed the litigation on to Judge Lucas. Earlier this year, she presided over a three-week trial of Wong and Curis’s claims against the HRJ funds and HRJ’s successor, Capital Dynamics. (HRJ and its chief lender, Silicon Valley Bank, reached settlements with the former HRJ employees.) In March, a Santa Clara jury awarded Wong and Curis $10 million.
Two months later, the funds brought in counsel from Simpson Thacher & Bartlett to ask Judge Lucas to set aside the jury’s verdict, arguing in their brief that, among other things, the trial was tainted by Kleinberg’s erroneous summary judgment ruling. “The underlying contracts and extrinsic evidence of the parties’ intent clearly demonstrate that the funds owe no obligations to plaintiffs,” the brief said. And for the first time, the funds asserted that Kleinberg’s holding to the contrary would have repercussions throughout the private equity industry. “It completely undermines the allocation of liability – here and industry wide – between funds, their general partners, and management companies retained by such general partners,” the brief said. Private equity funds like the HRJ limited partnerships enter agreements with general partners and management companies expressly to limit their liability, Simpson lawyers argued, so Kleinberg’s ruling undermined industry expectations.
The highly unusual Calpers amicus brief, filed by Ronald Wood of Proskauer Rose, bolstered the funds’ argument. “Judge Kleinberg’s conclusion and reasoning on the agency issue could have a harmful impact on large institutional investors, such as Calpers, and on the private investment fund industry in California,” said Calpers, which has $32 billion invested in private equity funds, $4.2 billion of which is in Californian funds. “Judge Kleinberg’s decision creates a new, unforeseen risk of Calpers and other investors in private investment funds: that their invested capital has exposure to claims by parties, like plaintiffs here, to whom the investors and the funds owe no contractual obligations. Given that this risk affects already invested capital, institutional investors will have to adjust their risk assumptions and projected returns. Institutional investors will also have to take this risk factor into account, prospectively, in evaluating whether to invest in funds whose managers are based in California, putting those California-based managers at a competitive disadvantage.”
“That brief was very significant,” said William Moliniski of Orrick, who will argue Thursday for Capital Dynamics. “It shows the interest of the investor community in this issue.”
But Michael Baumann of Kirkland, who represents Wong and Curis, said talk of industrywide impact from Kleinberg’s opinion is way overblown. “When he made that ruling, it was a determination of contractual rights between parties,” said Baumann. “This was not a class action ruling. It is not precedential.” Kirkland & Ellis, after all, has a big private equity clientele (which is how Baumann came to represent Wong and Curis). The firm, Baumann said, wouldn’t advocate a position adverse to those clients. “That’s the other reason the ‘sky is falling’ argument is absurd,” he told me. “This is a unique set of contracts and circumstances.”
Simpson partner Barry Ostrager, who will argue for the limited partner funds, was unavailable for comment. Calpers counsel Wood declined to say whether he will have a say at the hearing before Lucas.
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