Protecting the Private Equity Firm and its Deal Professionals from the Obligations of its Acquisition Vehicles and Portfolio Companies

In the countercultural attitudes of the 1960s, there was a lot of talk about the need to get behind the facade presented by one’s outward facing personality, and the physical shell of one’s body, to the real inward essence of one’s personhood.  The means that were sometimes used to accomplish this objective (however unsuccessfully) have caused many of the supposed participants in these means to proclaim that “if you can remember the 60s, you weren’t really there.”  Whether that proclamation has any validity is certainly open to dispute; indeed I am confident that there are many that both remember the 60s and either did not really think they needed to find their real selves, or employed other means of doing so.  But the idea that there is a real-self lurking behind the veil of the projected-self is a proposition on which experts in both theology and psychology would apparently agree.  Nevertheless, the law does not normally express a view on this topic, at least when it comes to the true personhood of human individuals.

When it comes to the personhood of the corporation (or any other limited-liability entity), however, the law has long held that courts have the equitable power (under the right circumstances) to disregard (or “pierce”) the outward manifestation (or “veil”) of the corporate personality, and thereby hold the so-called true personality behind that corporate form (i.e., its owners or its affiliates) responsible for the obligations undertaken by that corporate form.  Furthermore, because corporations, being mindless and soulless entities, can only act through human agents (i.e., their officers, who in turn are authorized by the corporations’ directors), the courts can also subject those human agents (under the right circumstances) to personal liability for actions undertaken by those human agents on behalf of the corporation.

Knowing the means and manner through which individual or firm liability can be imposed for contractual obligations that were otherwise intended to be confined to an acquisition vehicle or portfolio company (as well as the means of avoiding or mitigating that liability) should be top of mind for all private equity deal professionals and their lawyers. Traditionally, the existence and means of mitigating these risks have been so basic and fundamental to private equity deal practice that no one would consider the need to remind those involved in private equity deal making of these fundamentals.  But occasionally those of us who were both there and actually remember the beginnings of the modern private equity deal practice (in the late 80s and early 90s), and the reasons behind the development of the provisions designed to mitigate these risks, feel the need to provide a reminder of why we do what we do.

Accordingly, let’s begin with a review of the basic means and manner through which liabilities otherwise created by portfolio companies and acquisition vehicles can be asserted against a private equity firm or their deal professionals.

Piercing the Corporate Veil

Despite the fact that the law has long recognized that the corporation (and each other legally recognized limited-liability entity) is a legal person, separate and distinct from its officers and owners, there have always been those that have sought to characterize the corporate person as a mere instrumentality of those who control that corporate person.  “Piercing the corporate veil” (and some of its cousins like “alter-ego,” “sham,” and “single business enterprise”) is a doctrine created by the courts to impose the obligations of an otherwise separate limited-liability entity upon the affiliates, owners or controlling persons of that limited-liability entity.  Contrary to popular opinion, piercing the veil is not a cause of action, but an equitable remedy that allows the holder of a judgment against a limited-liability entity to collect that judgment from the persons that are deemed the real actors behind that limited-liability entity.

While the United States shares its common law heritage with England, the circumstances that the English courts will entertain as a basis for piercing the corporate veil appear to be much more limited than those entertained by their American counterparts. But the concept does apparently exist in England, albeit in a very limited form, because as Lord Sumption noted in a 2013 U.K. Supreme Court decision, Prest v. Petrodel Resources Limited, “recognition of a limited power to pierce the corporate veil in carefully defined circumstances is necessary if the law is not to be disarmed in the face of abuse.”  In U.S., the willingness of the courts to pierce the corporate veil has been described as “like lightning, it is rare, severe and unprincipled.”[i]   It is rare because U.S. courts appear to “acknowledge that their equitable authority to pierce the corporate veil is to be exercised ‘reluctantly’ and ‘cautiously.’”[ii]  It is severe because when applied it can do violence to the otherwise firmly recognized principle that “it is perfectly legitimate to create a corporation or other form of limited liability business organization such as an LLC ‘for the very purpose of escaping personal liability’ for debts incurred by the enterprise.”[iii]  And it is considered unprincipled because of the seemingly wide variety of factors that have been used to justify its imposition.  But consistent with Lord Sumption’s recognition of the limited need for the piercing remedy in the U.K., the overarching principle, in this otherwise unprincipled approach in the U.S., is the courts’ apparent effort to remedy what it perceives to be an “abuse” of the corporate form such that the corporation’s legitimate liability shield should not be permitted to function under the particular factual circumstances.

Because acquisition vehicles are formed with no or only limited assets, and with the specific, but legitimate, purpose of shielding the private equity firm from exposure to the acquisition vehicles’ obligations under the purchase and sale agreement, these vehicles have been targets of piercing claims in the past.  Indeed, before the Sungard and Neiman Marcus transactions in 2005, not only was the acquisition vehicle the only party to the purchase and sale agreement, but there was no limited guaranty signed by the sponsor standing behind the reverse break fee.  Indeed, there was no reverse break fee to stand behind and there was typically a funding out if the lenders did not fund the debt financing set forth in the debt commitment letter.  And to mitigate any claims of piercing (however inappropriate they would have been), there developed a standard non-recourse provision that contractually bound the seller not to seek recourse against the sponsor.  That non-recourse provision is now incorporated into the limited guaranty of the sponsor, with a proviso that actually voids the guaranty if the seller seeks recourse against the sponsor for more than the guaranteed reverse break fee.  A non-recourse provision is now not always set forth in the purchase and sale and agreement, but only in the limited guarantee.  But the better practice is for it to appear in both.

Human Agents Signing in a Personal Rather than Representative Capacity

Because corporations or other limited liability entities can only act through human agents, human individuals must sign on their behalf.  But, there is nothing in the law that says that a human agent signing on behalf of a corporation cannot also contractually agree to be personally liable for the corporations’ obligations.  An officer of a corporation is an agent of that corporation, and the corporation is that agent’s principal.  And under basic agency law in many states, an agent that fails to clearly indicate his or her representative capacity in signing an agreement on behalf of his or her principal is subject to potential personally liability for the obligation for which the agent signed—and this has nothing whatsoever to do with and is imposed without regard to whether the corporate veil should or is pierced.  New York appears to be a little more forgiving than some other states in this regard, suggesting that an agreement that otherwise indicates it is intended to be the agreement of a corporation rather than an individual officer will not personally bind that individual unless it was clear he or she so intended to be bound.  But best practice is to draft for the avoidance of litigation even when you are confident you would win an otherwise lengthy and expensive trial.  So, conventional wisdom is to clearly state your representative capacity when signing on behalf of an entity as follows:

Private Equity LLC
By: _____________
Name: Sarah Deal Professional
Title: President

You should avoid signing in the fashion set forth below as some courts have found this formulation a mere indication of Sarah’s identity, rather than the capacity in which she signed:

Sarah Deal Professional
President, Private Equity LLC

Adding “solely in her capacity as” in front of President would certainly fix this formulation, but the use of a well-crafted non-recourse clause in a contract that otherwise clearly specifies that only the named entities are parties can add a powerful defense against this type of claim.  It is surprising how much litigation there is over whether a corporate officer signed in a personal capacity or only in a representative capacity.

Personal Fraud or Misrepresentation

Even if an individual is acting solely on behalf of a corporation and clearly indicates his representative capacity, the law still holds that individual personally responsible for any tort, such as fraud or misrepresentation, committed by that individual on behalf of the corporation—and again, this is regardless of whether there is any basis to otherwise pierce the corporate veil.  In other words, an individual deal professional that is alleged to have made a false or misleading representation concerning an existing fact, either intentionally, recklessly, or even negligently, which the counterparty alleges was justifiably relied upon as an inducement to enter into the contract with the acquisition vehicle or portfolio company, may become a direct defendant in litigation brought by that counterparty.  A well-crafted non-reliance clause, supplemented by a non-recourse provision, is designed to eliminate this possibility to the extent reasonably practical depending on the state law involved in the transaction.  An earlier post available here details both the risks and the means of prevention available based on the deal technology created in the past and which continues to have value today.

Causing an Acquisition Vehicle or Portfolio Company to Make a Written Representation in a Contract

A 2010 decision by New York’s highest court, DDJ Management LLC v. Rhone Group LLC, illustrates this particular leak in the otherwise sacrosanct liability seal provided by the corporate form.  Unlike direct representations made by the private equity firm or its deal professionals, DDJ involved a loan agreement clearly signed only on behalf of a portfolio company owned and controlled by two private equity firms that contained a representation concerning the financial statements of the portfolio company.  There was no allegation that the private equity firms had themselves made the representation, but the lenders nevertheless sued the private equity firms, and certain of their partners, for fraud based on the allegation that the private equity firms and their partners had knowingly caused the portfolio company to make the written representations that were set forth in the loan agreement entered into solely on behalf of the portfolio company.  The court’s holding was that a party to an agreement with a corporate counterparty “is not unjustified in assuming that the corporation’s controlling affiliates ‘would not knowingly cause a company they controlled to make false representations in a loan agreement’ entered into solely by that corporation.”[iv]  Accordingly, the court permitted the case to proceed to trial to determine whether it could be proved that the controlling private equity firms in fact had knowledge that the representations were false when made by their portfolio company.

Most sponsors would never engage in such conduct and would therefore argue they have nothing to fear from such an allegation, but claims of this nature are “easy to allege, hard to dismiss on a pre-discovery motion, difficult to disprove without expensive and lengthy litigation, and highly susceptible to the erroneous conclusions of judges and juries.”[v]  While far from bullet proof (and if there was a deliberate, knowing action not necessarily protective), having the added defense of a well-crafted non-recourse clause might just make the difference in avoiding an expensive dispute, even when you know you are otherwise innocent.

Statutory Imposition of Personal Liability

There are a number of state and federal statutory regimes that effectively pierce through the corporate structure to impose liability on owners, officers and directors of limited liability entities, such as those applicable to environmental remediation (see this earlier post) and pension plans (see this earlier post), as well as those that impose personal liability on officers or directors of a corporation that fails to pay its employees’ wages under certain circumstances, those that impose liability on directors that declare an illegal dividend, and those that make the officers and directors of a corporation that fails to pay its state franchise taxes when due statutorily liable to the counterparty to any debt created by that corporation after those taxes were not paid.  All of these laws need to be understood and carefully navigated in any situation involving a financially troubled portfolio company, and a non-recourse clause would be of little value in many of these cases.  However, a well-crafted non-recourse clause should certainly be of assistance in potentially avoiding the statutory imposition of contractual liability in favor of a counterparty arising from nonpayment of franchise taxes.

The Non-Recourse Clause

A well-crafted non-recourse clause, designed to limit contractual liabilities to the entities specifically identified as parties to a contract, has long been a part of the private equity deal-making tool kit.  Non-recourse clauses can be elaborate and often are in the limited guarantees executed by the sponsor in connection with an acquisition agreement for which a reverse break fee is the sole remedy for failing to close because the debt financing does not fund.  But a simplified version of a non-recourse clause that can be adapted for almost any agreement to be entered into by an acquisition vehicle or a portfolio company is set forth below.  Obviously, exceptions can be inserted for any agreements (such as a limited guarantee) that are being entered into by affiliated entities in connection with an otherwise entity-specific agreement intended only to be binding upon a portfolio company or an acquisition vehicle.

No Third Party Liability.  All claims or causes of action (whether in contract, in tort, in equity, or otherwise) that may be based upon, arise out of or relate to this Agreement, or the negotiation, execution or performance of this Agreement (including any representation or warranty made in or in connection with this Agreement or as an inducement to enter into this Agreement), and any remedies in respect thereof, may only be made or pursued against the Persons that are expressly identified as parties hereto.  No Person who is not a named party to this Agreement, including any past, present or future director, officer, employee, incorporator, member, manager, partner, equityholder, Affiliate, agent, attorney or representative of any named party to this Agreement (“Non-Party Affiliates”), shall have any liability (whether in contract, in tort, in equity, or otherwise, or based upon any theory that seeks to impose liability of an entity party against its owners or Affiliates) for any obligations or liabilities arising under, in connection with or related to this Agreement or for any claim based on, in respect of, or by reason of this Agreement or its negotiation or execution; and each party hereto waives and releases all such liabilities, claims, obligations and remedies against any such Non-Party Affiliates. Non-Party Affiliates are expressly intended as third-party beneficiaries of this provision of this Agreement.

Knowing why these provisions were originally developed, and the fact that the law has not changed with respect to the risks they were designed to protect against, will hopefully encourage continued vigilance in protecting the firm and its deal professionals from personal exposure to obligations of acquisition vehicles and portfolio companies.


[i] Frank H. Easterbrook & Daniel R. Fischel, Limited Liability and the Corporation, 52 U. Chi. L. Rev. 89 (1985).

[ii] Jonathan Macey & Joshua Mitts, Finding Order in the Morass:  Three Real Justifications for Piercing the Corporate Veil, 100 Cornell L. Rev. 99, 100 (2014).

[iii] Id.

[iv] Glenn D. West & Natalie A. Smeltzer, Protecting the Integrity of the Entity Specific Contract:  The “No-Recourse Against Others Clause—Missing or Ineffective Boilerplate?, 67 Bus. Law.39, 53-54 (2011).

[v] Glenn D. West & W. Benton Lewis, Jr., Contracting to Avoid Extra-Contractual Liability—Can Your Contractual Deal Ever Be the “Entire” Deal?, 64 Bus. Law. 999, 1034 (2009).