Liquidity concerns are all too familiar to most private equity fund managers these days, and investors in their funds have not been immune. However, at the time of writing, there have been few significant public defaults by investors in the major private equity funds. There are a number of reasons for this: among them, changes to the credit environment and the consequent (and widely documented) drop-off in deal flow have meant that capital calls are simply not being made at their usual levels of frequency or size, providing a safety valve for investors who would otherwise be feeling the pinch. To date, General Partners have been able to manage the issue by either holding off on investments (whether by choice or circumstance), or by restructuring their funds (for example in a way that offers investors the ability to elect for the consequences of default without being subject to formal default proceedings).
There are some indications that the status quo is coming under increasing strain. A small number of investors with more liquid resources are starting to insist that General Partners put the committed capital to work. Investment opportunities at knock-down prices are emerging from the fall out in the debt and capital markets. For many General Partners, follow-on investments in the debt and/or equity of their portfolio companies are either necessary or are available at rates that are too attractive to ignore. These and other factors have meant that General Partners are considering more closely their rights and obligations in relation to actual and potential defaults by Limited Partners. This note examines some of the key legal issues from a Cayman Islands perspective.
This note is a summary of the relevant issues. However, these are complex legal and factual issues and this note is not a substitute for considered legal advice in relation to the specific partnership agreement in question, the particular circumstances of the relevant investors and the extent to which capital commitments have drawn down and invested.
Distinguishing between Limited Partners
It is helpful to divide Limited Partners into two broad groups: investors that cannot fund and investors that would prefer not to do so. Within those groups, it's probably worthwhile to draw a further distinction between those whose difficulties are temporary and those in respect of which the concerns are more permanent.
Selective use of remedies
Partnership agreements invariably provide the General Partner with a range of possibilities when faced with a defaulting Limited Partner. The first, and most common question, is whether it is available to the General Partner to apply those remedies selectively both generally and on a basis that treats a range of defaulting Limited Partners differently. Subject to what follows, the answer is almost certainly yes.
Scope of fiduciary duty
The key consideration for the General Partner is to act in good faith in the best interests of the Partnership. There is no reported authority in the Cayman Islands as a result of which formulates a test as to the standard of care applicable to a General Partner. In recent years the English and Commonwealth common law authorities have moved towards an objective test when establishing the standard of skill and care that should be exercised by directors. The Cayman Islands courts may look to these authorities for guidance.
It would be unusual for the default provisions of a partnership agreement to express the remedies available to a General Partner other than on the basis that they are cumulative rather than exclusive, and it is usually available to the General Partner to select from the remedies available to it. It is also usual for the partnership agreement to provide that the remedies are not exclusive of any remedy that may otherwise be available under applicable law. This latter provision is important to the extent that the default provisions constitute a claim for liquidated damages, because absent such a provision the General Partner may be restricted to the options enumerated in the partnership agreement: see the discussion in this regard that appears below.
Treating Limited Partners differently
In pursuance of its fiduciary obligation, there is nothing under Cayman Islands law to prevent the General Partner from distinguishing between defaulting Limited Partners and treating them differently in consequence on any basis that is relevant to the best interests of the Partnership. By way of illustration, treating a permanently insolvent investor harshly by applying a forfeiture provision, whilst at the same time simply charging an investor with temporary liquidity issues interest on an outstanding contribution on the basis that the General Partner reasonably considers that funding beneficial to the Partnership will be forthcoming in future, may be legitimately in the best interests of the Partnership. On the other hand, accommodating an investor solely on the basis that the General Partner wishes to manage the client relationship in order to secure commitments for future unrelated funds is unlikely to be a legitimate basis to draw a distinction.
These issues will inevitably become more focussed in circumstances where there is an actual or perceived conflict of interest on the part of the General Partner, and in those circumstances care should be taken to ensure that the actions of the General Partner are independently justifiable.
There are a couple of caveats worth noting:
- it will be difficult to censure a General Partner that chooses between two separate courses of action in relation to Limited Partners who are in similar position where the separate courses of action adopted are otherwise neutral to the interests of the Partnership, for reasons that may be unrelated to the interests of the Partnership;
- an allegation by a Limited Partner that a General Partner has acted in breach of its fiduciary duty practically carries a substantial evidentiary burden, and a Court will not easily substitute its own commercial judgment, or that of a Limited Partner, for actions taken by the General Partner in good faith.
As indicated above, it is important to draw a distinction between Limited Partners who cannot invest, and those who are simply reluctant to do so. In the latter regard, there is far less scope for a General Partner to exercise flexibility and, in theory, the full force of the partnership agreement must be brought to bear on such persons. Alternatively, and more constructively, Partnerships could be restructured in accordance with the amendment provisions of the relevant partnership agreement by an offer being made generally to all Limited Partners.
Restructuring has been the watchword in the world of hedge funds for much of 2008, and there is no reason to believe that 2009 will not bring the same for the private equity industry. Already we have seen a major investment manager agree a reorganisation with investors that has allowed them to reduce capital commitments to one of its funds in exchange for agreeing to transfer 25% of all future distributions to continuing investors.
Enforceability of Default Provisions; Penalties
Because the provisions of partnership agreements providing for the exercise of specific remedies on default have not been tested in the Cayman Islands courts, there remains a degree of uncertainty as to their enforceability. At common law, a clause in any agreement that provides for the payment on default of a pre-determined amount will be recoverable as liquidated damages. However, where the remedy does not constitute a genuine pre-estimate of the loss likely to be suffered by the Partnership in consequence of the default and is rather a device to deter a party from breaching an agreement, it may regarded as a penalty and so not enforceable. Having said that, courts in common law jurisdictions have shown an increasing reluctance to characterise clauses negotiated between commercial parties as penal and it is now evident that the power to strike down a penalty clause is a blatant interference with freedom of contract and will not be exercised unless necessary to provide relief against oppression.
There is little or no specific guidance in the Cayman Islands courts at present in relation to what remedies they might regard as penal in the context of a partnership agreement for a Cayman exempted limited partnership, but the following factors will be relevant:
- whether the clause was negotiated and freely entered into between parties of equal bargaining power;
- whether the enforcement of the provision would be oppressive to the defaulting party;
- whether the remedy specified is "extravagant and unconscionable" in comparison with the greatest loss that could possibly have been proved as a result of the breach;
- whether there is a commercially justifiable reason for the clause;
- whether the dominant purpose of the clause is to compensate the innocent party, or to deter the payer from committing the breach.
Practically, unless it is clear that the relevant remedy is entirely unrelated to the scope of the loss likely to be suffered by the Partnership, we would not ordinarily recommend that a General Partner seek to censure itself in enforcing the default remedies contractually available to it on the basis that any such remedy may be regarded as a penalty. Enforcement of its rights by a General Partner will not ordinarily require a determination to be made by a court, and it is only in the circumstances of a legal challenge to such enforcement that a court will be required to consider the matter. Apart from questions about the desire or ability of a financially embattled investor to engage in a difficult and uncertain course of litigation, the General Partner may adopt the strategy of not opposing any such application and simply abiding by the decision of the court: in that way, the court would ultimately determine the limits of the options available to the General Partner, and the General Partner would be free to apply any of the remaining remedies at its disposal.
Payment of an agreed sum
At its most simplistic, the claim against a Limited Partner for failure to pay a capital call comprises:
- the common law "action for payment of an agreed sum" which is a debt action; and
- a claim damages in respect of loss caused by the delay or omission in paying the debt due on time.
A debt action has certain advantages over a simple damages claim in that causation and remoteness are not relevant if the debt has become due
It is fair to say that the majority of partnership agreements currently in existence were drafted in a different context, and in anticipation of different threats than those currently presented. The threat of forfeiture and the loss of continued investment opportunities that would have been unconscionable for an investor at the time of its initial investment may now be viewed by it as a welcome relief. The ability to force the sale of interests is severely impacted by the current state of the secondary markets. Simply put, default provisions for existing Partnerships may not have been drafted to manage short to medium-term liquidity crises. Apart from simply suing for the payment of the capital contribution on the basis that it represents an agreed sum, contractually required to be paid, what alternatives may be available to a General Partner?
Reduction of Capital Commitment
Where a Limited Partner is actually in default, it is possible to consider how the General Partner might discharge its fiduciary obligation by compromising the claim of the Partnership for the full outstanding capital commitment and accepting instead a reduced level of capital commitment. However, where a Limited Partner indicates simply that it wishes to reduce its commitment in circumstances other than following the occurrence of an actual event of default, the considerations set forth above are apposite and a global offer of variation is more likely to be required.
Where an investor telegraphs to the General Partner that it will be in breach of any capital call that may be made in future, the General Partner may have to consider its obligation to mitigate the loss likely to be suffered by the Partnership as a consequence. The doctrine of "anticipatory breach" provides an extreme and rather inflexible remedy that may nonetheless, in certain circumstances, be of benefit to the Partnership. In order to qualify as an anticipatory breach there must be: (i) a repudiation of the partnership agreement by the Limited Partner; and (ii) the acceptance of such repudiation by the General Partner. The repudiation of the partnership agreement requires a fundamental breach of contract by the relevant Limited Partner, such as an unequivocal statement that it will not fund its capital call when due. In those circumstances, the General Partner may affirm the partnership agreement by requiring compliance by the Limited Partner with the provisions of the capital call in due course, or repudiate the agreement by terminating it entirely with regard to such Limited Partner.
Care should be taken in relying in circumstances of default or potential default on language in a partnership agreement drafted in a different context and for a different purpose. Excuse and exclusion provisions are ordinarily intended to address circumstances of regulatory concern to, or the underlying investment restrictions applicable to, Limited Partners. The provisions themselves, though, are often expressed in broad terms to refer to investments that would be materially adverse to a Limited Partner. A contractual party relying on the strict construction of a provision of an agreement negotiated and agreed amongst sophisticated persons always has a level of comfort that such a clause will be upheld on its face, but it is not without risk that a more narrow application of such a clause may be enforced by a Cayman Islands court.
Derivative Actions by Limited Partners
A Limited Partner will not ordinarily be in a position to enforce the contractual rights of the Partnership directly. In our view, this principle is likely to apply to any effort by a Limited Partner to enforce the capital commitment funding obligations of another Limited Partner directly, even though both are counterparties to the same partnership agreement. This is because the obligation to fund is one usually owed to the Partnership as a whole, and legal proceedings by a Cayman Islands exempted Limited Partnership may, subject to the nextfollowing paragraph, be instituted by the General Partner only.
There is however specific provision in the Cayman Islands legislation that grants to Limited Partners the right to bring an action against any person directly on behalf of a Partnership if the General Partner with authority to do so refuses to institute such proceedings "without good cause." 1 In our view, this statutory provision would enable a Limited Partner to proceed on behalf of the Partnership against a defaulting Limited Partner, and to exercise the contractual remedies that would be available to the General Partner, in circumstances where it is able to clear the statutory hurdle. It is not clear, though, that this adds a significant extra burden to the General Partner. If it properly discharges its fiduciary duty in electing not to proceed, the General Partner acts by necessary implication "with good cause" and it is difficult to conceive of a Court substituting the General Partner's judgement in those circumstances
Avoiding Liability for Capital Calls
It has been suggested that a defaulting Limited Partner may seek to avoid liability for a capital call on the basis that the General Partner is itself in breach of a provision of the partnership agreement, where such breach does not affect validity of the capital call itself. It is ordinarily provided for in the partnership agreement that the obligation to fund a validly-issued capital call is unconditional, in which event that defence is specifically not available. Subject to any provision of the Partnership to the contrary, there is no basis at common law upon which to assert such a defence. The remedies for a Limited Partner are either to seek specific performance to cure the alleged breach, or to sue for damages.
Unless provided for in the partnership agreement, set off is only available under Cayman Islands law as a statutory matter in the event of the insolvency of one of the contractual parties, and then only to the extent that both amounts are liquid sums.
1. Section 13(2) of the Cayman Exempted Limited Partnership Law (as amended)
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.