The terms of the legal documents between an investment manager and an institutional investor are often heavily negotiated by both sides. However, when an institutional investor finds itself needing to enforce its hard-won legal rights, will it have the appetite for possible negative public attention?
If an institutional investor is compelled to bring a lawsuit against a manager, the prospect of media coverage must be carefully considered. Members of the media regularly search court filings to review new case filings and to identify the parties to those cases. Except in extraordinary situations, all federal court filings, as well as court filings in many states, are available online. For example, the PACER (Public Access to Court Electronic Records) website allows anyone, for a modest fee, to run online searches to determine whether a particular individual or organization has been a party to federal litigation (whether trial, appellate or bankruptcy) anywhere in the United States. PACER also allows downloading of detailed information regarding these federal cases, including copies of filings made by the parties. An institutional investor considering litigation to resolve a dispute with a manager should assume that the media will quickly become aware of any lawsuit that the investor files and, if the case is viewed as newsworthy, will closely review all filings in the case.
Many institutional investors with valid claims against a manager choose not to pursue those claims rather than face possible adverse media scrutiny. An institutional investor’s decision whether to pursue a manager who has failed to live up to its agreement is a complex one and typically involves a number of factors, including likelihood of success in litigation, projected litigation costs, projected time commitment to the litigation by key personnel of the investor, value of settlement offers or other solutions being offered by the manager and whether any of the manager’s other institutional investors are willing to participate in the litigation. It is true that institutional investors have become increasingly open to pursuing litigation in certain situations—for example, public securities class action cases. However, there is a lingering perception that institutional investors are generally reluctant to sue over their alternative investments, which can make negotiating favorable settlements with managers more challenging.
One solution associated with avoiding headline risk in this situation is to require (through a side letter, investment management agreement or otherwise) that all disputes between the investor and manager be resolved through confidential arbitration. While this technique is generally effective for endowments, insurance companies and family offices, many state and municipal pensions and similar governmental investment bodies are prohibited by applicable law from agreeing to arbitrate disputes. If this restriction exists, the institutional investor may wish to consider requiring confidential non-binding mediation prior to litigation. Although mediation will not result in a final resolution (unless the mediation leads to settlement), mediation at least provides the investor a forum for meeting face-to-face with the manager and its attorneys to present the investor’s legal arguments and view of the facts, and to convey the investor’s commitment to pursue its claim. Even with use of mediation as a dispute-resolution tool, if the mediation is unsuccessful, most public pensions would ultimately be required to disclose details of any ensuing litigation with the manager in response to an appropriately-focused Freedom of Information Act (FOIA) request.
Another approach that is used by some institutional investors is to hold their alternative investments through one or more generically-named special purpose investment holding entities (a Holdco). To simplify matters, many of these institutional investors create a master Holdco to hold all investments of a particular class (for example all private equity or hedge fund holdings). This solution not only provides an additional layer of potential limited liability protection, but also avoids an immediate connection by members of the media between a lawsuit and the ultimate investor.
The strategy may have only limited effectiveness. Certainly, it can prevent the institutional investor from being immediately associated with a lawsuit when a media representative performs a computer search of the named parties to litigation. However, because the parties to this type of litigation are likely at some point in their court filings to divulge the investor’s affiliation with the Holdco, this strategy is far from foolproof in protecting the investor’s identity.
Unfortunately, none of these methods is a perfect solution for eliminating headline risk associated with an institutional investor’s pursuing claims against a manager. Evaluating the possibility of media attention is yet another factor that an institutional investor must weigh in deciding the merits of pursuing a claim against a manager.
Luis F. Ruiz