The Legal Obligations of Private Equity Holders –

In December 2003, executives of Parmalat Finanziaria SpA, the Italy-based dairy and food giant, met with a private equity fund to discuss a possible leveraged buyout. Parmalat executives apparently disclosed that Parmalat’s cash and debt were misstated on the company’s most recent publicly filed financial statements. When the private equity fund reportedly insisted that Parmalat publicly correct its financial disclosures and Parmalat refused, the private equity fund walked away from the negotiations. Immediately thereafter, Parmalat imploded. By year-end, Parmalat had filed for bankruptcy protection, certain of its officers had been arrested in Italy and the SEC had filed a civil action in New York.

This international scandal raises the following questions: Did the private equity fund have a legal obligation to disclose publicly what it had learned? Was the private equity fund free to sell short the securities of Parmalat? Could the private equity fund have engaged in any securities or loan transactions with Parmalat without publicly disclosing what it had learned?

Affirmative Public Disclosure?

Private equity holders are not beat cops, patrolling the streets for securities fraud. The general rule is that a duty of affirmative disclosure exists only where such a duty is mandated by statute or a fiduciary relationship.

There is no general statutory duty that requires a private equity holder to affirmatively disclose the existence of a public company’s financial fraud. However, where a private equity holder already owns a large stake in the tainted public company or is planning a tender offer for control of the tainted public company, federal securities laws will likely require disclosure of the fraud in, for example, Schedule 13D filings and tender offers. In addition, under certain cases interpreting state corporation law, if the private equity holder is a “controlling” shareholder of the tainted public company, the private equity holder may be a “fiduciary” toward the minority shareholders, thereby triggering a disclosure obligation.

Shorting Opportunity?

Federal securities laws prohibit the sale of securities based on the seller’s possession of material, nonpublic information and where: (a) the use of that information breaches a fiduciary duty or other similar confidential relationship; or (b) the information had been misappropriated by someone in breach of a fiduciary duty. If the private equity holder discovers a financial fraud after entering into a confidentiality agreement to gain access to the tainted public company’s financial books and records and becoming a “temporary insider”, the private equity fund cannot sell securities short in the public market based on that information.

Similarly, the disclosure of the fraud to the private equity fund by an officer or director of the tainted company may also freeze the private equity fund’s ability to sell in the public market. If the private equity fund is not bound by a confidentiality agreement and did not receive misappropriated information, the fund should publicly disclose the information before engaging in any public market transactions.

Is Toughing It Out An Option?

Under certain scenarios, especially where the private equity holder is already invested in the tainted company, the private equity holder may be tempted to “manage” the situation, continue with an equity or debt investment, and worry about public disclosure later.

In the current regulatory environment, such an approach raise more than ongoing economic risks. Within the past year, the U.S. Department of Justice and the SEC have brought aiding and abetting charges against financial institutions that engaged in financial transactions with Enron while aware of only certain aspects of Enron’s financial fraud. Both DOJ and the SEC have publicly emphasized their desire to bring criminal and civil charges against “facilitators” of financial fraud, including charges against financial institutions where such institutions “should have known” that the transaction in question would be fraudulently misreported by the public company.

Thus, when effective due diligence leads to the conclusion that a public company has engaged in financial fraud, the private equity fund should walk away from negotiations even if the economics of the transaction could still be worked out.


Private equity funds that discover accounting irregularities before investing in a public company have no legal obligation to affirmatively disclose their discoveries. However, not only should private equity funds avoid any public market transactions in the tainted company’s securities without appropriate disclosure, but the recent aiding and abetting cases should discourage any financial transactions with the tainted company prior to full, corrective public disclosure.

Knuts and Beach are partners at Day, Berry & Howard LLP. Mr. Beach represents private equity funds and works in the firm’s Greenwich, Conn. office. Mr. Knuts is a member of the firm’s Government Investigations practice group and resides in the firm’s New York office.