NEW YORK – As if venture capitalists didn’t have enough trouble in front of them with the tech swoon and the capital markets virtually closed off as an exit strategy, another challenge is creeping up from behind: lawsuits by disgruntled investors. As the market valuation of investments falls, and as the doors are shut on companies that have run out of money, some unhappy investors can be expected to take their disappointment to court.
“Generally when you have a downturn in prices of stocks and companies going bankrupt, you have people finding ways to bring an action against them. Whether they are successful at the end of the day is another story,” said Anthony Carbone, head of the technology group in the New York office of law firm Richards & O’Neil LLP.
While investors in VC funds may be upset that their extraordinary gains have given way to large losses, it will take much more than a loss to successfully bring a lawsuit. Potential plaintiffs will have to allege evidence of factual misstatements, non-disclosure of information, waste, mismanagement or fraud.
VCs who serve on boards of their investment companies face shorter odds that a lawsuit will be filed against them and their firm. Investors could argue that the VCs made decisions that weren’t made in the best interest of the fund, and instead favored the company. Or, information that might be helpful for the fund to act on might not be disclosed or acted on in favor of what is best for the company. “We always get more concerned when VCs sit on the board of directors because they do have fiduciary responsibilities,” Carbone said.
In fact, VCs are increasingly asking about all that fiduciary responsibility. “I don’t think they focus as much (on fiduciary responsibility) in the good times as the bad times because there is a potential risk for a lawsuit when things aren’t going as well,” Carbone added.
Although the number of lawsuits is expected to rise, the court dockets aren’t expected to overflow just yet. That is because even though investments might appear to have lost money, until the investment is actually written off, damages won’t be known. Moreover, market downturns don’t automatically bring write-offs. “It will take a period of at least another year until we really know about how many lawsuits will be filed, said Jay Rand, partner in corporate finance at law firm Morrison & Foerster LLP.
The greater time between loss and lawsuit in the VC world contrasts sharply against the situation for publicly traded companies, where losses or missed estimates are identified each quarter. That means that the number of lawsuits filed against VCs are going to lag behind those filed against public companies because they didn’t make their numbers, Rand added.
Those selling professional liability insurance to VCs have seen a decided upturn in interest during the last six months. VCs were interested in getting their own insurance coverage, in addition to the directors’ and officers’ policies provided by their portfolio companies. “In years past they just didn’t worry about it [their own insurance] as much as long as their companies had it. Now, just because there is so much uncertainty in the marketplace, they are a little more concerned,” said Carolynn Burns, chief operating officer of Corporate Risk Inc., an independent insurance broker specializing in professional liability insurance.
Yet the smart-money VCs are taking creative action now to head off potential lawsuits. They are considering ways to make good on losses to investors, such as liquidating investments to provide a return to investors. Others are constantly talking to their own investors and apprising them of a bad situation. “People may be unhappy with the news but you at least want to keep them from being surprised,” said Richard Edlin, partner in the corporate securities department at Greenberg Traurig LLP.
However, some attorneys say the rash of lawsuits expected against VCs may turn out to be a mild case. The Private Securities Litigation Reform Act of 1995, which put more restrictions on the type of shareholder suits that could be filed, will help keep numbers down.
“This is the first major downturn where it will be tested,” said David Leffler, an attorney with his firm of the same name. “My guess is that it might not be as bad as you might otherwise think.”
For many potential claimants, there may be inadequate grounds for suits. What’s more, only qualified investors are allowed to invest in VC funds, meaning there is an inherent presumption of a higher degree of knowledge, hence less sympathy for their plight. All those factors could conspire to keep the number of lawsuits down, attorneys say.
“Companies generally aren’t going to want to be perceived as VC-unfriendly. Only in very egregious circumstances are you going to see suits,” said Michael Littenberg, partner and head of the Internet & new media group at law firm Schulte Roth & Zabel LLP.