The Case Begins: Conn. vs. Forstmann

Private equity moved from the boardroom to the courtroom last week, as Forstmann Little & Co. began defending itself against civil charges brought by the State of Connecticut.

The case – filed in February 2002 – accuses the New York-based firm of breaching its fiduciary responsibility to Connecticut, which had invested $198 million in a pair of funds managed by Forstmann Little. Connecticut also claims contract clause and securities law violations, and has publicly stated that it was hoping for restitution in excess of its original investment.

As Connecticut State Attorney General Richard Blumenthal said at the time: “We want more than the $100 million-plus they wasted and wiped out. We want to make Forstmann the poster child for fair-dealing in the investment community.” Forstmann responded, issuing a statement reaffirming its commitment to fiduciary responsibility, and argued that the bursting of the telecom bubble, not fund mismanagement, caused LP losses.

Most legal experts believed that the case would settle out of court because both sides had a lot to lose from a public showdown. If it loses, Forstmann would have a stain on its reputation and could be the target of copy-cat lawsuits. Connecticut has its own fiduciary responsibility to worry about, as its pension system could be viewed as litigation-happy, thus making it an unattractive LP in future funds.

“Most civil cases don’t go to trial, so the odds against this happening were pretty good,” says Carl Metzger, a partner with Testa, Hurwitz & Thibeault. “One of the differences here, however, is that the alleged damages are so high and the parties’ versions of events couldn’t be more different.”

He adds that a settlement could still occur up until a jury verdict, but sources say that neither side is known for its accommodating style.

“Teddy [Forstmann] hates to admit when he’s wrong, which is part of the reason he’s in this mess,” says a money manager familiar with Forstmann. “Blumenthal and [State Treasurer Denise] Nappier have dealt with these sorts of things aggressively in the past, and won.”

The case largely revolves around Forstmann’s continuing attempts to save telecom services provider McLeodUSA Inc., which filed for bankruptcy protection before reorganizing itself in late 2002.

Forstmann became involved with McLeod in 1999, when it invested $1 billion worth of convertible preferred stock for a 12% ownership. At the time, telecom was as cool as the Internet, and McLeod’s common stock was trading at more than $30 per share.

By the summer of 2001, however, everything changed. Rather than succumb to market pressures, Forstmann insisted that it could resuscitate a telecom portfolio that also included a sizable bet in XO Communications Inc. As McLeod’s stock dropped, Forstmann suspended coupon payments and pumped an additional $100 million into the company for a 20% position. The buyout firm made similar moves with XO, which is when the state began to get concerned.

Soon after the fall of 2001, McLeod began finalizing plans for bankruptcy. As part of the Chapter 11 plan, Forstmann invested an additional $175 million for a majority ownership stake.

Connecticut claims this final infusion allegedly did not involve any Forstmann funds in which it was an LP. The pre-bankruptcy deals, however, had used Connecticut funds, and the Constitution State argued that this fund-jumping arrangement resulted in an improper wipeout of at least half its original McLeod investments (via Forstmann).

Such losses are particularly difficult for Connecticut to swallow, because Forstmann funds do not follow the industry standard of aggregated returns. Instead, it pays carried interest back to its limited partners on a deal-by-deal basis.

This means that while both GPs and LPs are paid proportional carry on successful investments, an LP takes more proportional loss on bad investments than does the GP. Aggregated returns – added up wins and losses that are divvied up proportionally – were established at most firms 10 to 15 years ago in response to growing pressure from public pension funds. Kohlberg, Kravis, Roberts & Co., for example, instituted aggregated returns on its 1996 fund and has maintained them ever since.

At least one LP has asked Forstmann to suspend its practice as a goodwill gesture reminiscent of how VC firms accelerated claw-back provisions or reduced fund sizes. Forstmann, however, has argued that the deal-by-deal structure better aligns LP and GP interests. The firm did discontinue management fees charged on lost investments in XO.

When the six-person jury trial began last Tuesday in Rockville, Conn., the charges still included a breach of fiduciary responsibility and contract clause violations. Superior Court Judge Samuel Sferrazza had previously thrown out the securities law violations – considered to be among the most serious charges – but denied a defense motion to dismiss the entire case. The judge also ruled against a defense request to disallow the introduction of fund placement memoranda that included certain spending restrictions contained in side letter agreements. But he did prevent the admittance of a Power Point file used during Forstmann’s fund-raising presentation.

After opening statements, the prosecution called Ted Forstmann as its first witness. He acknowledged that the McLeod investment had not gone according to plan, but said that it eventually would make money for investors. He also said that his firm had followed the letter of its LP agreements, and that any internal disagreements over the McLeod investments were the normal course of business for a private equity partnership.

Future witnesses are expected to include other Forstmann executives and Connecticut Treasurer Nappier. The trial is expected to last around one month prior to jury deliberations, assuming no settlement is reached.

The case is being closely watched by many private equity investors and lawyers, not the least of which are other limited partners in Forstmann funds.

Sources say that a ruling for Connecticut could prompt similar lawsuits against the firm, and cause some public pensions – and some private ones – to be precluded from investing in future Forstmann vehicles.

This assumes, of course, that there will be future Forstmann funds. Ted Forstmann is rumored to be contemplating retirement, and it is unclear whether or not his younger partners would want to maintain the Forstmann Little name in his absence.

On a larger level, Metzger of Testa Hurwitz says that a finding against Forstmann could embolden LPs in other firms to pursue litigation, particularly if the claim of breach of fiduciary responsibility is confirmed. If Forstmann prevails, Metzger says that it will reinforce the idea that private equity is a high-risk asset class, and that losses are not grounds for lawsuits.