In the following guest post, Brian Baney, Senior Vice President, Head of Management and Professional Liability Claims, Ascot Group, Peter Trochev, Senior Vice President, Financial Institutions, Ascot Group, Elan Kandel, Member, Bailey Cavalieri LLC and James Talbert, Associate, Bailey Cavalieri LLC, survey the current risk environment for private equity firms. I would like to thank the authors for allowing me to publish their article as a guest post on this site. I welcome guest post submissions from responsible authors on topics of interest to this blog’s readers Please contact me directly if you would like to submit a guest post. Here is the author’s article.
While the private equity industry is no stranger to risk, there are indications that 2023 will bring new and heightened risks for private equity and its insurers. This guest post explores such risks and considers how private equity policyholders and their insurers can brace for the metaphorical storm on the horizon.
II. Risk Analysis and Attendant Considerations
A. Liability for “Active Managers” Under Delaware Law
Private equity sponsors commonly appoint their partners or employees to serve as directors or officers of portfolio companies. This practice enables private equity sponsors to exercise control over portfolio companies’ strategic visions and day-to-day management. The tradeoff is that the sponsor-appointed directors and officers are often exposed to the legal risk associated with the portfolio company’s operations. While the industry accepts this risk and takes steps to mitigate it, the industry has generally assumed that personnel of the sponsor who are not formally appointed by the sponsor as director or officers of the portfolio company will not be held liable for their actions as de facto directors and officers of the portfolio company. However, a recent decision by the Delaware Chancery Court challenges this assumption. Specifically, Vice Chancellor Laster’s October 25, 2022 opinion in the longstanding litigation styled, In Re: P3 Health Group Holdings LLC holds that individual partners of the sponsor without a formal appointment or role at the portfolio company could be subject to exposure as “acting managers” of the portfolio company in connection with their management or operation of the portfolio company under Delaware law.[i]
The P3 Health Group litigation was commenced by a minority owner of P3 Health Group Holdings, LLC (“P3”), Hudson Vegas Investments, LLC (“Hudson”), which challenged P3’s de-SPAC merger.[ii] In its Complaint, Hudson named Chicago Pacific Founders Fund, L.P. (“Chicago Pacific”), which controlled P3, as a portfolio company, along with Sameer Mathur, one of Chicago Pacific’s principals who oversaw Chicago Pacific’s investment in P3. With respect to Mathur, Hudson alleged that he tortiously interfered with rights that Hudson enjoyed under P3’s limited liability company agreement based on his role in the deSPAC transaction.[iii] Mathur moved to dismiss the Complaint on personal jurisdiction grounds that he never held an official position with P3, whether as a manager, officer, employee or otherwise.[iv]
On October 26, 2022, the court denied Mathur’s motion to dismiss on personal jurisdiction grounds finding that Mathur had sufficient minimum contacts with Delaware.[v] The court also considered Delaware’s strong interest in providing a forum for disputes regarding the internal affairs of LLCs formed under its laws.[vi] Specifically, the court held that although Mathur was not a formal director or officer of P3, he could nevertheless be found liable as an “acting manager” under Section 18-109(a) of the Delaware Limited Liability Company Act (the “LLC Act”). Under the LLC Act, a person who participates materially in the management of the limited liability company, irrespective of whether the governing LLC agreement formally names such person(s) as a manager, constitutes an acting manager.[vii] In reaching its decision, the court relied on the fact that Mathur “had a history of taking action and making decisions on the Company’s behalf,” and noted, for example, that he attended P3’s board meetings and led negotiations on behalf of P3 in connection with potential M&A transactions, including the de-SPAC merger that gave rise to the P3 Litigation and directed P3’s outside counsel in connection with same.[viii]
The Chancery Court’s decision in the P3 Health Group Litigation decision is a stark reminder of the need for private equity sponsors to observe corporate formalities with respect to their portfolio companies. As noted above, Mathur did not hold any formal position with P3, but the court found that he nonetheless was an “acting manager.” Accordingly, private equity sponsors need to ensure that objectively reasonably measures are in place to document that there is a distinction in actions undertaken by their partners in their different capacities to obviate the risk of an adverse finding such Vice Chancellor Laster’s. From an insurance coverage standpoint, private equity sponsors and their insurers should ensure that the outside director or executive coverage of their general partnership insurance policies as well as the portfolio company’s insurance policies consider that certain individuals may constitute “acting managers” of a portfolio company and evaluate whether existing policy language is sufficient to account for such potential exposure.
B. Expansion of Scrutiny at the Federal and State Level on Private Equity Investments in Healthcare
- Anticipated Increased False Claims Act Investigations and Actions Ensnaring Private Equity Sponsors
According to PitchBook, there were more than 1,400 private equity deals in the healthcare sector last year, with a total value of $208.7 billion.[ix] While healthcare services are expected to remain a key investment focus for many private equity firms, the risk of False Claims Act (“FCA”) exposure associated with such investments has also grown.
Recently the Biden Administration and Department of Justice (“DOJ”) have closely scrutinized private equity’s control over healthcare providers. This sharpened focus was on display in President Biden’s March 1, 2022 State of the Union address, in which he noted that “as Wall Street firms take over more nursing homes, quality in those homes has gone down and costs have gone up. ”[x] If there was any doubt about the kinds of “Wall Street firms” President Biden was referring to, the White House issued a fact sheet one day prior to the address, which laid out findings that private equity-owned nursing facilities caused cost increases for government payers coupled with a deterioration in the quality of care.[xi]
In addition to intensifying scrutiny at the federal level, the private equity industry also faces the continued risk of private FCA litigation and enforcement actions by state attorney generals in pursuing actions under their respective state equivalents of the FCA. Further, private litigants have also had several significant successes in recent years pursuing private equity sponsors for FCA claims against portfolio companies.[xii]
As such, we anticipate that heightened scrutiny of private equity investments in healthcare will lead to an increase in state and federal investigations, enforcement actions and private relator actions in 2023. Thus, from an insurance coverage standpoint, the scope of coverage, if any, provided for FCA claims should be a key discussion topic during the underwriting process.
2. Healthcare Antitrust Concerns
On June 3, 2022, Andrew J. Forman, Deputy Assistant Attorney General of the DOJ’s Antitrust Division, announced that the Department is “[t]hiking a lot about enhancing antitrust enforcement around a variety of issues surrounding private equity.”[xiii] Specifically, Mr. Forman stated that the Department would be focused on: (i) “potential antitrust enforcement on private equity ‘roll-ups,’ namely, whether in particular circumstances a series of often smaller transactions can cumulatively or otherwise lead to a substantial lessening of competition or tendency to create a monopoly;” (ii) “whether certain private equity investments may either blunt the incentive of the target company to act as a maverick or a disruptor in health care markets or otherwise cause the target company to focus solely on short-term financial gains and not on advancing innovation or quality;” (iii) potential Section 8 enforcement to the extent that private equity investments in competitors leads to board interlocks; and (iv) potential Hart-Scott-Rodino premerger filing deficiencies.[xiv]
The DOJ’s private equity healthcare antitrust concerns have also been echoed by the Federal Trade Commission (“FTC”). In her memo entitled “Vision and Priorities for the FTC”, FTC Chair Linda Khan wrote that “the growing role of private equity and other investment vehicles invites us to examine how these business models may distort ordinary incentives in ways that strip productive capacity and may facilitate unfair methods of competition.”[xv] The FTC Chair’s attack on private equity-backed roll-up transactions, is already in full swing. For example, on August 5, 2022, the FTC issued final approval to a Consent Agreement regarding the acquisition of SAGE Veterinary Partners LLC (“SAGE”) by private equity fund JAB Consumer Partners SCA SICAR (“JAB”).[xvi] Not only does the Consent Agreement require JAB to divest from existing veterinary clinics in the affected area, in a “first of its kind Commission order,” the Consent Agreement requires JAB to seek prior FTC approval for several years prior to acquiring new specialty or emergency veterinary clinics in California or Texas and within 25 miles of a JAB-owned veterinary specialty or emergency clinic anywhere in the United States.[xvii]
In view of the government’s aggressive scrutiny of healthcare transactions and, in particular, roll-ups, private equity policyholders and their insurers should evaluate whether the return of the antitrust exclusion or an antitrust sublimit should be a discussion topic during the underwriting process.[xviii]
C. The Securities and Exchange Commission Threat: Private Equity Remains in Hot Seat Under Commission Chair Gensler
On November 10, 2021, at the Institutional Limited Partners Association Summit, SEC Commission Chair Gary Gensler indicated that he intended to “bring more sunshine and competition to the private funds space.”[xix] To achieve those lofty goals, Chairman Gensler indicated that the Commission was committed to increasing transparency in private fund fee arrangements. While scrutiny of disclosure of management fees has long been a focus of SEC scrutiny, Chairman Gensler also expressed an interest in “other fees” paid by private fund investors and portfolio funds, including “consulting fees, advisory fees, monitoring fees, servicing fees, transaction fees, director’s fees and others.”[xx] Chairman Gensler stated that he also has asked SEC staff to consider how to strengthen transparency regarding “inside” letters and fund performance metrics.[xxi]
In addition to developing greater transparency, Chairman Gensler stated that he has asked the SEC staff to focus on developing ways to mitigate the effects of conflicts of interests between general partners, affiliates and investors.[xxii] Further, Chairman Gensler has indicated that Form PF would be the subject of rulemaking to include more robust and contemporaneous disclosures.[xxiii] In this regard, we note that SEC rules regarding ESG disclosures are expected to be finalized next fall. However, some funds are already anecdotally reporting that the breadth of their ESG disclosures are the subject of SEC exams.[xxiv]
D. What About Crypto?
On January 6, 2023, Reuters reported that the SEC is probing the due diligence of FTX investors in the latest wave of scrutiny over cryptocurrency. [xxv] Although details of the SEC’s investigation are not public and it is unclear which private funds received document demands from the SEC, the subject of the investigation is reportedly whether funds acting are acting responsibly and did not breach their fiduciary duties owed to their investors when they invested in FTX.[xxvi] While the investigation is still in its early stages, as many large players in the crypto industry continue to crumble, other investigations and potentially lawsuits by disgruntled limited partners against fund sponsors may be on the horizon as funds are forced to write off, in whole or in part, some of their crypto investments.[xxvii]
Additionally, on a related note, on January 26, 2023, Reuters reported that the SEC is probing investment advisers over whether they are meeting rules regarding custody of client crypto assets.[xxviii] Apparently, the investigation has been ongoing for several months, but the investigation has gathered pace in the wake of FTX’s demise.
Considering the current volatility associated with crypto, it should be expected that general partnership insurers’ appetite for crypto related insureds will remain slim. Moreover, to avoid unintended exposure, at least some in the market may consider including express cryptocurrency exclusions in their policies.
As we begin 2023, there are clearly myriad risks facing the private equity industry and its insurers. Those private equity firms that continue to engage in thoughtful and prudent practices will weather those risks successfully in partnership with their insurers.
The opinions expressed in this article are solely those of the authors and not those of Bailey Cavalieri LLC or Ascot or any of its parent companies or affiliates. In addition, nothing in this article is meant to influence, convey or imply a coverage position by any insurance carrier on any past, current or future claim. This article also does not constitute or provide legal advice.
[i] In re P3 Health Grp. Holdings, LLC, 2022 Del. Ch. LEXIS 300 (Del. Ch. Oct. 26, 2022).
[ii] Id., at *2.
[iv] Id. Note that Mathur also moved for dismissal on the merits, but the court’s October 26, 2022 decision was limited to the personal jurisdiction question only.
[v] Id., at *32.
[vii] Id., at *18.
[viii] Id., at *22.
[xii] United States ex rel. Medrano v. Diabetic Care Rx, LLC d/b/a Patient Care America, et al., 15-cv-62617 (S.D. Fla.) (The DOJ alleged that Patient Care America’s controlling stakeholder, private equity firm Riordan, Lewis & Haden, Inc., managed and controlled PCA and participated in the charged misconduct. The case ultimately settled for $21 million.); United States ex rel. Martino-Fleming v. South Bay Mental Health Center, Inc., 15-cv-13065 (D. Mass.) (South Bay Mental Health (“SBMH”) allegedly billed the government for services of unlicensed, unqualified, and improperly supervised staff members at clinics. Relators pled that the private equity investor (H.I.G.) was involved in SBMH’s operations, its principals were on the board of directors, and were informed of the conduct that violated Medicaid regulations. In a settlement made public in October 2021, H.I.G. agreed to pay almost $20 million to settle.).
[xiv] Mr. Forman’s comments regarding the key areas of inquiry for the Antitrust Division were made on the heels of similar statements that Assistant Attorney General Jonathan Kanter, the head of the DOJ’s Antitrust Division, made during a May 18, 2022 interview with the Financial Times. See https://www.ft.com/content/7f4cc882-1444-4ea3-8a31-c382364aace1
[xviii] Antitrust liability concerns are not limited to governmental actions only. Many readers of this guest post will recall the Dahl, et al. v. Bain Capital Partners, LLC, et al. 07-cv-12388 (E.D. Mass.) (“Club Deal”) litigation.
[xxvii]By way of example, Sequoia Capital has written off its entire investment. https://www.thestreet.com/investing/galaxy-digital-sequoia-dont-expect-to-recoup-money