In January, a federal court in California allowed federal securities law claims to go forward against a private equity sponsor based on the statements of one of its Managing Directors who was serving as Chairman of the Board of a portfolio company.1 This holding serves as a cautionary tale for private equity sponsors whose employees wear “two hats” by serving both the sponsor and the portfolio company simultaneously.
In 2011, a private equity fund purchased Rural/Metro, a provider of ambulance and medical transportation services, and funded the acquisition in part through a private placement offering of $200 million in senior notes. A sponsor representative was named Chairman of Rural/Metro’s Board. Rural/Metro subsequently issued additional senior notes in connection with its purchase of several other ambulance companies.
Plaintiffs, a group of funds collectively holding 92% of the outstanding senior notes, alleged that in early 2012, Rural/Metro executives learned of problems with the company’s revenue-recognition system, which potentially meant that the company’s revenues and EBITDA were overstated. Plaintiffs further alleged that on a series of quarterly note holder calls in late 2012 and early 2013, Rural/Metro’s CEO, the sponsor representative and a representative of a business advisory firm (which was brought in to resolve the portfolio company’s accounting issues) made false representations about the financial health of the company, downplayed the significance of a series of write-downs related to the revenue-recognition issue despite real uncertainty as to the extent of the problems, and fudged the company’s EBITDA to suggest financial health when in fact the company may have been in significant distress.
The sponsor representative eventually fired the company’s CEO, and in August 2013, Rural/Metro declared bankruptcy. Plaintiffs filed a complaint against the sponsor, the business advisory firm and the sponsor representative, claiming damages for purchasing the senior notes based on the representations and omissions of the defendants at prices far in excess of what they were worth. The complaint alleged that the sponsor violated federal securities law when its representative and the portfolio company’s CEO made false statements to the note holders, both as a “maker” of the statements by the sponsor representative and as the “control person” responsible for statements of the CEO and sponsor representative.
A Sponsor’s Potential Liability as “Maker” of Statements by Its Representative
Under Rule 10b-5, defendants are liable for federal securities violations if they are the “makers” of false statements made in connection with the purchase or sale of securities. Plaintiffs alleged that the sponsor representative made false and misleading statements on a May 2013 note holder call, shortly after he had fired the CEO. On the May 2013 call, the sponsor representative:
- Introduced himself as “a partner at [the sponsor] and also the Chairman of the Rural/Metro Board.”
- Announced a $35 million write-down (following two previous “one-time” write-downs announced on note holder calls by the company’s CEO) and told investors that the EBITDA from the previous 12 months was $70.1 million (just slightly above the $70 million EBITDA threshold the company’s analysts predicted would signal serious financial distress and inconsistent with the $64 million figure that the independent business advisory firm had previously calculated).
- Stated, when asked whether he would comment on whether the sponsor would contribute additional equity to Rural/Metro, “No reason to. The company’s in perfectly good liquidity position.”
The court found that the sponsor representative could be liable for all of the allegedly false statements he made on the May 2013 note holder call. The sponsor, however, could be liable only for the statement by its representative that Rural/Metro was “in perfectly good liquidity position.”
The court’s reasoning was based on United States v. Bestfoods, a 1998 U.S. Supreme Court decision that created a presumption that directors wear their “subsidiary hats” and not their “parent hats” when acting for the subsidiary.2 The fact that the sponsor representative introduced himself as “a partner at [the PE sponsor] and also the Chairman of the Rural/Metro Board” was not enough to overcome this presumption when he spoke about Rural/Metro’s financial condition on the call. Therefore, the PE sponsor was not directly liable for each statement its representative made.
However, the court found that when the sponsor representative was asked whether the sponsor would contribute additional equity to Rural/Metro, he was clearly responding as a representative of the sponsor. Because he was wearing his sponsor hat when he made the statement that the portfolio company was “in perfectly good liquidity position,” the court found that the sponsor could be held liable for that statement if proven to be false.
A Sponsor’s and Sponsor Representative’s Potential Liability as Controlling Persons for CEO Statements
Under Section 20(a) of the Exchange Act, a company may be liable for a securities law violation committed by someone under its “control.” The requirements for liability vary to some extent among the federal circuits, but generally, a plaintiff claiming a Section 20(a) violation must allege (i) a primary violation of Rule 10b-5 by the maker of the statement and (ii) control by the defendant over the primary violator.
The court found that the plaintiffs adequately pled primary violations of Rule 10b-5 by the portfolio company’s CEO and the sponsor representative. Because the sponsor owned and controlled 100% of the common stock of Rural/Metro, the sponsor representative was the Chairman of the Board of the portfolio company, and the representative ultimately fired the company’s CEO, the court stated that it is plausible that the sponsor and its representative had “control” over the company’s CEO. Thus, the court found that the sponsor and its representative could be liable under Section 20(a) for the CEO’s allegedly misleading statements on the note holder calls. In addition, since the sponsor was the sponsor representative’s employer, it could be liable under Section 20(a) for his allegedly misleading statements on the May 2013 call.
A control person may take advantage of an “escape hatch” from liability under Section 20(a) if the controlling person acts in “good faith” and does not “directly or indirectly induce” the securities law violation.3 The Court found this defense to be unavailable to the sponsor given allegations of intentional misstatements by its representative.
Best Practices for Reducing Risk
To reduce the risk of liability as “maker” of statements to portfolio company investors in violation of Rule 10b-5, private equity sponsors and their employees should be mindful of any affirmative statements made by those employees while wearing “two hats.” In order to reduce the risk of potential liability:
- Silence is golden. Avoid making statements directly to investors or potential investors in connection with the purchase or sale of securities. Silence is not actionable under Rule 10b-5 unless plaintiffs can overcome an extremely high bar set for non-speakers—that they had the “ultimate authority over the statement, including its content and whether and how to communicate it.”4
- Speak only for the portfolio company. When public statements by sponsor employees on behalf of a portfolio company are necessary, the speaker should make clear that she is speaking only in her capacity as a member of the portfolio company. To that end, she should avoid answering questions directed to the sponsor, or that would draw on knowledge obtained solely by virtue of her employment by the sponsor. That may, in some circumstances, mean expressly stating that she is speaking as a board member of the subsidiary and declining to speak on behalf of the sponsor.
- Nothing but the truth. Perhaps most obviously, avoid making potentially misleading statements on either entity’s behalf.
A sponsor can also mitigate risk of “controlling person” liability under Section 20(a) by ensuring proper management and supervision of the portfolio company, but avoiding involvement in the company’s day-to-day operations.
- Don’t micromanage. Avoid direct involvement in the day-to-day operations of the portfolio company. Being a controlling stockholder and having employees serve on the board of a portfolio company is not enough for a sponsor to be considered a “controlling person” for purposes of Section 20(a). Indeed, a federal court in California recently found that a sponsor did not act as a “controlling person” of a portfolio company, even with a 72% ownership stake and two employees on the board, because plaintiffs failed to allege the sponsor’s involvement in day-to-day affairs of the company or specific control over the preparation and release of the allegedly false statements.5 However, in the Rural/Metro case, the court found that plaintiffs alleged that both the sponsor representative and sponsor exercised sufficient control over the portfolio company’s CEO and the operations of the portfolio company such that they could be liable for the CEO’s statements.6
- Good faith, supervision and internal controls. Although a sponsor should not involve itself in day-to-day operations of a portfolio company, it should—in the ordinary course of managing a portfolio company—act in good faith and properly supervise the portfolio company. Section 20(a) does not apply if a controlling person can show that it acted in good faith and that it “did not directly or indirectly induce the act or acts constituting the violation” underlying the Section 20(a) claim.7 The Rural/Metro court largely brushed aside the “good faith” defense with little elaboration because plaintiffs sufficiently alleged the sponsor representative’s intentional misstatements. Other courts, however, have stated that to meet the burden of establishing good faith, the controlling person must prove that it exercised due care in its supervision of the violator's activities in that it “maintained and enforced a reasonable and proper system of supervision and internal controls.”8
1 Oaktree Principal Fund V, LP v. Warburg Pincus LLC, 2:15 Civ. 08574 (C.D. Cal. Jan. 17, 2017).
2 United States v. Bestfoods, 524 U.S. 51, 69 (1998).
3 Oaktree, at *33 n.1.
4 Id. at *20, quoting Fulton Cty. Employees Ret. Sys. v. MGIC Inv. Corp., 675 F.3d 1047, 1051-52 (7th Cir. 2012).
5 Welgus v. TriNet Grp., Inc., No. 15 Civ. 03625, 2017 WL 167708, at *12 (N.D. Cal. Jan. 17, 2017).
6 Observing corporate formalities and staying out of the portfolio company’s day-to-day affairs should also help insulate the sponsor from liability for other types of alleged violations, should plaintiffs seek to “pierce the corporate veil” and hold the parent liable for the wrongful acts of the subsidiary.
7 15 U.S.C. § 78(t).
8 Marbury Mgmt., Inc. v. Kohn, 629 F.2d 705, 716 (2d Cir. 1980).