A Litigious Private Equity Market

Peter Fuhrman, a venture capitalist at San Vicente, leaves his office before 9:00 a.m. for a day of depositions. Attorney Kevin Abrams sounded tired and deflated after he learned that inclement weather conditions would keep him from catching the last flight out of Chicago to his home. And Millennium’s Robert Knapp also sounded groggy after a full day of traveling. The venture capital business supposedly slowed down, but these guys are busier than ever. In part, that’s because they’re suing the pants off VCs. In an industry that hasn’t historically seen very much litigation, PE Week research uncovered 14 recent or active lawsuits involving VCs.

“In good times any legal structure works,” says David Balabanian, partner in the San Francisco office of Bingham McCutchen LLP. “Only in bad times are structures put to the test, and this is really the first time overall stress and strain is being put on the venture capital structure.”

Balabanian expects litigation to fall in three categories: Disputes between GPs and limited partners, straightforward securities cases brought by public shareholders against post-IPO portfolio companies and, most interestingly, attempts by investors (including VCs) in portfolio companies to sue VCs for grievances, such as breach of fiduciary duty and fraud that fall outside the scope of typical securities law.

The GP/LP cases, while sensational, aren’t likely to end up in the courts. “Given the amounts involved and given the level of frustrated expectations, we have seen very little litigation in our client base between GPs and LPs,” says Jonathan Axelrad, chairman of the fund services group in the Silicon Valley office of Wilson Sonsini Goodrich & Rosati. He says this is because many private placement memoranda are air-tight and also contain private arbitration requirements, which keep the cases out of the courtroom.

Public securities class action cases will involve VCs to the extent the VCs are directors in the company or were instrumental in founding it. However, the biggest opportunity for unique litigation may be in Balabanian’s third category-private investors suing each other.

Kevin Abrams, a Delaware attorney at Richards, Layton & Finger PA who has represented both early round private investors and venture-backed companies, says he believes that further litigation over the procedural and financial fairness of down-round financings is likely, particularly in the event the startup achieves financial success. Abrams is also Benchmark Capital’s attorney in the case mentioned later in this story.

Balabanian points out that the environment for litigation in this downturn is different than past downturns, because the industry involves many more investors who don’t necessarily have the same interpersonal relationships that were around a decade ago. And, it also involves many one-time investors or investors that don’t plan to invest in VC in the future. Those folks may be well inclined to choose litigation if it offers them the only way to recover value from their investments.

The following is a look at a number of lawsuits that have recently or are still plaguing the venture community.

Benchmark Capital Partners IV, LP v. Richard Vague, et al.

Date Filed: July 2002

Court: Chancery Court of Delaware, New Castle

Plaintiff Law Firm: Richards, Layton & Finger P.A.

VC Connection: Suit involves the venture financing of Juniper Financial Corp.

Synopsis: In 2000, Benchmark Capital participated in Series A and B financing rounds for Juniper Financial, which together totaled $114 million. However, only new investor CIBC Holdings and Juniper CEO Richard Vague invested in the $150 million Series C round in September 2001, a transaction through which CIBC became the majority stockholder and gained the right to appoint six of the 11 board members.

The litigation focuses on class voting rights employed to protect original investors in the startup company against dilutive financings and the propriety of two complex transactions involving Juniper and CIBC, including a Series D round which effectively crammed down Benchmark and the original investors. A key to the case, which claims breach of fiduciary duty and violation of charter, is the allegation that Juniper management and CIBC engaged in a plan to deliberately dilute the original VC investors.

Status: On July 15, 2002, the judge on the case denied a preliminary injunction filed by Benchmark to prevent the Series D transaction from happening on grounds that the company faced substantial hardship if the financing did not happen. Interestingly, Benchmark did not raise the counts of breach of fiduciary duty in that injunction hearing. Benchmark is still awaiting a court date.

WPG Software Fund v. Hummer Winblad Venture Partners

Date Filed: Q3 2002

Court: Chancery Court of Delaware, New Castle

Plaintiff Law Firm: Kasowitz, Benson, Torres & Friedman LLP

VC Connection: Plaintiffs and defendants are venture firms

Synopsis: In March 2000, six Weiss, Peck & Greer LLC VC funds invested $3.1 million in the Series B financing round of Quiver Inc., according to the suit. Among the other investors in the round, three Hummer Winblad funds, which owned a controlling stake in the Series A round, also joined this round. The suit alleges that Hummer Winblad used its dominant position as a shareholder to unfairly cramdown WP&G during a Series C financing transaction which closed in March 2002. Because WP&G chose not to participate in that round, its preferred shares were converted to common, and its stake in the company was severely diluted. The suit states that the original three Hummer Winblad funds did not participate in the Series C round, but instead a new Hummer Winblad fund invested. However, the suit accuses Hummer Winblad of using its influence to create an unfair exception for itself, because the original funds’ stakes were not diluted. In July, Inktomi Corp. bought Quiver for $12 million, none of which will go to WP&G.

Status: No movement yet.


San Vicente Group v. Matulich, Jennings, et al.

Date Filed: December 2001

Court: Los Angeles County Superior Court for the State of California

Plaintiff Law Firm: Gibson, Dunn & Crutcher LLP

VC Connection: Case involves the control and assets of San Vicente Group (SVG), a Los Angeles VC shop.

Synopsis: On March 28, 2000, GlobalNet Financial.com (Nasdaq: GLBN, since acquired by NewMedia Spark PLC) raised $46.7 million for what would become the SVG, a venture firm it had founded and, at the time, controlled. Completing a hostile takeover in November 2001, 104 shareholders ousted SVG’s former management and installed a new board, charged with stabilizing the portfolio and liquidating its assets. The shareholders, which were mainly hedge funds, were able to complete the takeover because the company had not been established as a limited partnership, but as a Delaware corporation, a structure, which allows 51% of the shareholders to initiate a corporate change.

Following the takeover, the new board accused the old board of looting the company and sued the old board for breach of fiduciary duty. The old board has also allegedly retained control of SVG’s portfolio through a separate entity, and the current board has sued for control of that entity as well.

Status: This case has been through discovery and is expected to go to trial on Jan. 6. By April 2002, the new board had returned $18 million of the $22.5 million remaining in liquid investments.

Separately, the shareholders retained the same plaintiff law firm to pursue a class action suit against the former board, alleging 13 misrepresentations and omissions on the offering memorandum including the type of companies in which SVG would invest and its officers’ compensation plan. The related fraud charges carry penalties which can legally reach triple the amount of the alleged damages. The shareholders filed the original suit, Primo Capital Growth Fund LP v. Stanley Hollander, et al., on April 4, 2002 and amended it in September. No trial date has been set for that case.

Kline Hawkes California LP, et al. v. Bill Gross, et al.

Date Filed: January 18, 2002, Amended July 29, 2002

Court: Los Angeles County Superior Court for the State of California

Plaintiff Law Firm: Christenson, Miller, Fink, Jacobs, Glaser, Weil & Shapiro

VC Connection: Defendants are the directors and officers of venture incubator Idealab.

Synopsis: The plaintiffs represent 40 individuals, investment companies and corporations-including Spectrum Equity Investors III LP, Dell USA and the Travelers Insurance Group-which purchased $711 million of Idealab’s Series D preferred stock in December 1999 and January 2000. The suit levels allegations against Idealab’s chairman and CEO Bill Gross, his fiance at the time and Idealab’s president and COO Marcia Goodstein, his brother and former director Lawrence Gross and five other directors and officers including Benjamin Rosen, founder of Compaq Computer and Sevin Rosen Funds.

The plaintiffs allege the company should honor a liquidation preference which would give them control of the company, and they also accuse the defendants of dozens of acts of self-dealing including illegal loans, improper bonuses and abuse of corporate assets. In particular, the plaintiffs accuse Gross of receiving options that should have gone to Idealab to buy pre-IPO stock in Idealab portfolio companies, accuses Rosen of front-running Idealab’s investments in three companies (a practice where an affiliated individual benefits by investing ahead of a formal investment company) and alleges an improper $1.87 million stock repurchase from Idealab director and former General Electric CEO Jack Welch, who has not been named as a defendant in the case. The plaintiffs seek the return of their investment and the removal of the defendant directors and officers.

Status: Louis Miller, attorney for the plaintiffs, says this case is in discovery mode and that he expects to get a trial date in the next few months, but he will not comment beyond that. An Idealab spokesman says a judge “tossed out” six of the eight complaints during pretrial hearings but gave the plaintiffs the opportunity to submit an amended lawsuit by Nov. 7. On August 13, a group of the plaintiffs filed a related application to the Securities and Exchange Commission, asking the regulators to rescind exemptive relieve to certain provisions of the Investment Company Act of 1940 that the SEC had given Idealab. Such a rescission may force Idealab to return any money raised under that exemption. According to the spokesman, Idealab currently has several active portfolio companies and $350 million in liquid assets.

Contact Charles Fellers