[Rupam Dubey is a 2nd year B.A.LLB student and Hrithik Merchant a 4th year B.A.LLB student, both at the National Law School of India University Bangalore]
The traditional essence of private equity was rooted in the strategy of acquiring companies for the purpose of selling them, while remaining detached from the day-to-day operations of the portfolio company. However, the landscape of modern private equity is constantly evolving and dynamic. Funds have acquired companies to benefit from synergies between their investee companies. The relationship between funds and their portfolio companies has become vital to address issues related to agency costs between the fund and the company, as well as between the fund and its investors. As a result, funds are increasingly becoming more involved in the companies they invest in. This increased involvement can be observed through various aspects, inter alia, including majority board representations, mandatory approval on affirmative voting matters, anti-dilution rights, and liquidation preferences.
In March 2023, in Doris Anderson v County of Fresno, the US District Court of California extensively addressed the issue of private equity funds’ liability in portfolio investments. The Court ultimately ruled in favour of the funds and decided not to disregard the separation between the fund and its portfolio companies. While the decision relied heavily on the plaintiffs’ inability to sufficiently back up their claims, an important question arises: what is the responsibility of private equity funds given their increasing influence over various entities? Moreover, is there a definitive test or threshold to determine when liability can be attributed to the private equity fund? These questions would attain some relevance for India as well. This post delves into these questions by examining recent legal precedents and contemporary jurisprudence.
Peeking Behind the Corporate Curtain: Unmasking the Corporate Veil in India’s Business Realm
The current framework to impose liability on a parent company for tortious act of the subsidiary through lifting the corporate veil to understand the interconnectedness of the transactions in companies has been a subject matter of judicial decisions and academic discussions. In the landmark ruling of State of Rajasthan v Gotan Lime Stone, the Indian Supreme Court summarised the jurisprudence on lifting the corporate veil. It was held that the doctrine is an exception to the distinct corporate personality. When public interest is involved, then the court can lift the veil to understand the substance of the corporate transaction and the objective it sought to achieve.
Courts have clarified that lifting the corporate veil and discovering the improper conduct of a company would notinduce liability of the individual shareholders. In Meekin Transmission Ltd v State of Uttar Pradesh, the Allahabad Hight Court held that the liability of a company is not synonymous with the liability of the shareholders and the latter cannot be made liable under a decree against the company through piercing the corporate veil. This position was affirmed by the Calcutta High Court Pashcim Gujarat Vij v Manibhad 2019 SCC OnLine Guj 6933, where it noted that personal assets of shareholders cannot be attached as company’s assets.
In a nutshell, being a separate legal entity, the jurisprudence on corporate veil in India protects the funds from the actions of the investee company. Corporate veils are rarely pierced, especially when the ownership of a company lies with a group of companies and not individual shareholders.
Rhythm of Risk: Exploring Global Beats in Private Equity Fund Liability: Grooving Through the Challenges
This situation is not unique to India but also jurisdictions around the world. In April 2022, a federal appeals court in the US was faced with this issue in a healthcare fraud dispute. The private equity firm HIG Capital and its subsidiary Surgery Partners Inc were accused in a whistleblower lawsuit of engaging in a scheme to overbill Medicare for unnecessary urine drug tests. The appeal filed against HIG Capital argued that it was involved in a distinct form of healthcare fraud driven by external capital. However, the appeal was dismissed due to similarities with a previous dispute. Notably, HIG Capital had previously settled whistleblower fraud claims involving another company it owned, South Bay Community Services, for $20 million.
In another case, Pearson v Component Technology Corp, the Court imposed liability on a fund manager as upstream liability and laid down elements to determine it. Those elements included commonality of directors, de facto exercise of control, and unity of personal policies emanating from common sources and dependency of operations. The component of de facto exercise of control has been used in Re Jevic Holding Corp, where the Court imposed liability for illegal employment practices due to the fund manager’s exercise of substantial control over the subsidiary. This de factocontrol test was further expanded in Richards v Advanced Accessory Systems. Here, the Court held that de facto control does not mean ordinary stock ownership but involvement in business and organisational strategy financial and investment management and advisory services for the subsidiary.
A similar legal position is also adopted in the European Union (EU). The courts use a heightened version of the de facto control test. For instance, in Imperial Chemical Industries v Commission, the European Court of Justice held that it is insufficient for the parent company to have the ability to exercise control over the group of companies, but it must be shown that the influence has impacted the decision-making ability so as to treat it as a single economic unit.
Hence, it can be inferred that the court’s discretion to lift the corporate veil implies that the subsidiary’s decision-making should be influenced by the funds. This influence is necessary to hold them accountable for any wrongful actions committed by the subsidiary companies.
Liability Remix: Unleashing the Legal Groove for Private Equity Funds in India
The Indian market has undergone a shift from being primarily focused on minority investments by funds to a situationwhere these firms now engage in major buyout transactions and seek control. However, in the current era of corporatisation, the traditional presumption of separate and distinct identities, as established in Salomon v Salomon, does not adequately address the liability of funds. This is due to the legal fiction that allows multiple investors to operate as a single economic unit. It is entirely reasonable for funds to exert control in order to implement effective policies that fulfil their legal and financial obligations.
The acquisition vehicles are used by funds to shield themselves from the obligations of these vehicles, which are ultimately the target of piercing the corporate veil. For instance, funds typically contribute only 20-40% of the acquisition price of shares in target companies while securing critical assets. The firm itself provides a relatively small amount of the funding capital but receives a significantly larger share of the returns. This form of extreme leverage, when combined with limited liability and corporate control, creates incentives to burden target companies with excessively high and unsustainable debt.
This situation differs significantly from investing in an established large company. Firstly, when investing in that company, one typically needs to pay the full price for the stock, without the option of acquiring it at a discounted rate of 10 to 30 percent. Even if one purchases the stock on margin, a minimum of 50-70 percent of the share price, and often more, must be paid up front. Secondly, unlike private equity investments, buying that stock does not come with the additional conditions that exists in private equity transactions. Thirdly, the acquisition of that stock does not inherently involve that company taking on substantial debt themselves. Lastly, when investing in such giant companies, one may or may not have control over the company, which means they cannot exploit the company, deprive it of resources for research and development, or withhold reinvestment to cover the debt from a leveraged buyout, and so on.
Therefore, the issue with private equity lies not solely in limited liability itself but in the combination of limited liability with other distinctive and inevitable aspects of private equity. Limited liability, when combined with extreme leverage, creates a significantly imbalanced risk/reward trade-off that incentivizes excessive risk-taking at the expense of good corporate governance.
One can argue that the liability for the wrongful actions of subsidiaries should not be extended to funds. Instead, the responsibility should be placed on the directors and decision-makers of the subsidiary, that is, the individuals who manage affairs the company. Nonetheless, blanket protection cannot be granted to funds. It is necessary to differentiate between controlling directors and passive directors in this context. This differentiation should be determined on a case-specific basis. We subscribe to the knowledge (actual and constructive) approach. Here, the plaintiff must demonstrate that the fund had prior knowledge of the wrongful activity of the subsidiary and failed to take any action to prevent it. The burden of proof should be set at a higher level to avoid imposing unwarranted liability on funds for the actions of their subsidiary companies. The law should consider the distinctions and roles of the participants in subsidiaries.
Knowledge here should be distinguished from actual participation or intention to commit the wrong. In order to hold a fund liable, the plaintiff must demonstrate the corporate distinctiveness of the entity and show that the fund exercised significant control over the decision-making processes of the board of directors. This is referred to as the “responsible corporate officer doctrine”, which holds controlling individuals or firms liable for corporate misconduct regardless of their actual participation. The knowledge of the wrongdoing is sufficient to establish liability in such cases. Therefore, the liability for corporate misconduct can be limited with regards to funds depending on the facts but cannot be extinguished completely in other circumstances.
– Rupam Dubey & Hrithik Merchant