Protect the record: Privilege strategy for PE portfolio investigations

Transcript:

Sid: Hey everyone, we're really excited to have you here today, and welcome to Reed Smith's next episode of Dealmaker Insights. I'm Sid Bale. I'm a partner in Reed Smith's Global Corporate Group. My practice focuses on mergers and acquisitions primarily for private equity funds and their portfolio companies. And today we're tackling a topic that sits at the intersection of my deal world and the regulatory enforcement world. Namely, what happens when a private equity sponsor needs to investigate potential misconduct or compliance failures? At a portfolio company and how to navigate the legal privilege and risk considerations that come with that. And I'm really excited to be joined by a colleague of mine, Rizzy Qureshi. Rizzy is a partner in our global regulatory enforcement group. He's a former federal prosecutor and a seasoned trial lawyer who represents companies, audit committees, and executives in white-collar defense, internal investigations, and securities enforcement matters. Rizzy, welcome. I'd love for you to introduce yourself.

Rizzy: Thanks, Sid. It's great to be here. as Sid mentioned, I'm a partner in Reed Smith's Global Regulatory Enforcement Group, resident in Washington, DC. I also spend a lot of time in New York. Before coming back to private practice, I was a assistant U.S. attorney at the U.S. Attorney's Office in DC, a component of the Department of Justice, where I spent a significant part of my career investigating and prosecuting complex fraud and cybercrime matters that usually involved a corporate target or a corporate subject. Today in private practice, I represent, as Sid noted, companies, boards, audit committees, as well as private equity sponsors and portfolio companies and executives when something has gone wrong or when they're trying to determine whether something has gone wrong. And I think that last point, Sid, is the important distinction here. An internal investigation doesn't necessarily mean that there has been an been misconduct very often the purpose of the investigation is simply to uncover facts quickly, incredibly, so that the company and its board can make an informed decision about what to do next. And in the discussion that we're gonna have today for private equity sponsors, that exercise can be particularly complicated because you have multiple constituencies, you have the sponsor, the portfolio company, you have management on both sides, you have the board or boards plural, lenders, investors, and and then potential regulators whose interests may overlap but are not necessarily identical. That is where privilege, independence, and careful investigation design become critically important, and that is pretty much what I do every day. So really happy to be here. Thanks for having me.

Sid: Rizzy, that's a great introduction. Really appreciate it. Definitely underscores the relevance of this discussion. And maybe let's just jump in. you touched upon it a little bit in the introduction, but would love to dive deeper on why private equity sponsors and portfolio companies really should care about this topic, you know, the regulatory environment, et cetera. it looks like regulators are increasingly focusing on private equity firms in their portfolio companies and would love to just explore a little bit about what conduct or control failures create. Meaningful exposure, what's driving the scrutiny from the government's perspective, and how should our listeners distinguish between portfolio company responsibility from the sponsor's potential?

Rizzy: Yeah, thank you. it's a great question. you hit the nail on the head. First, the reason why PE sponsors should care is because regulators are increasingly looking beyond the immediate corporate actor when they're determining sort of where the misconduct is, right? So if a misconduct occurs at a portfolio company, I can tell you in my experience as somebody who's defended and prosecuted, the inquiry doesn't just stop with the portfolio companies. The regulators are gonna ask who knew about it? What did they know? What did they do about it? Who exercised control? Which is where sponsors often come in, depending upon your level of involvement in the business. Were warning signs ignored? Did anyone benefit from the conduct? And that includes financially, right? And sometimes that can be investors or sponsors. And all those sort of questions and the answers to those questions in the private equity context naturally puts the sponsor in the picture. I mean, it's pretty heavily been reported upon in the last administration. Under Biden, Lisa Monaco, that Department of Justice signaled an intensified focus on corporate criminal enforcement that specifically extends to those who profit from and exercise control over potential corporate misconduct. That's directly from the DOJ's 2021 and 2022 corporate enforcement and voluntary disclosure policy. and this administration, albeit a very different administration. Doesn't see it differently. In addition to the Department of Justice, the SEC has also pursued enforcement actions against PE sponsors for failures in oversight or conflicts of interest and inadequate compliance infrastructure at their portfolio companies. And obviously, it's particularly around fee and expense practices or valuation issues. And then the final sort of point that I'll make, at least in terms of why and and sort of what the regulators are doing in this sort of reduced federal enforcement environment that we're operating in, we are seeing that state attorneys general are very active. so state attorneys general as well as sector specific regulators like the EPA or the CFPB or OFAC have also shown willingness to quote look up the chain at sponsor level involvement when portfolio companies either violate the law or may be accused of violating the law. And then I think it goes without saying for any portfolio company, there's also the reputational risk. A scandal at one of your portfolio companies can taint an entire fund, complicating future fundraising and deal making. So that to me are real examples of sort of why they should care. and th maybe this is what you were getting to Sid in the back part of your question. More and more these days, what we see in our experience when we're helping advise our PE clients on how to govern themselves and building their compliance programs, it becomes abundantly clear that PE firms possess much more information about their portfolio companies than sort of a passive investor would in a typical investor company context. they have board seats, they receive financial and operational reporting information. Sometimes management reports up and all those reasons, when you put all those together with an increased focus and more sophisticated multi-jurisdictional and multi-level federal, state, local enforcement regimes, that precisely is why PD sponsors should care and and should approach investigations and any allegation of misconduct with an independence and sort of a clear, kind of focused approach to mitigate against any future harm.

Sid: Yeah, that that all makes a lot of sense. really appreciate the color and the background of why this discussion is relevant to sponsors and their affiliates and really appreciate the background on some of the state regulatory enforcement mechanisms and just scrutiny in the marketplace. I'd like to transition a little bit to the investigations and what's triggering them. Rizzy are there classic examples or maybe recent examples of evolved scrutiny that are really causing kind of triggers of these types of investigations.

Rizzy: No, great question. I mean, there's common triggers, right? We have the typical whistleblower complaint. that can be internal, it could be done through the SEC or any number of regulatory regimes. But I will tell you, oftentimes where we see it in the PE context is you've gone through the transaction, you've made your investment, you've had your deal. Sid has done his expert work, which I don't know anything about on the transaction side. But then some suspicious findings are discovered in post-acquisition when you're integrating. or you know, there may be a complaint, which again, I represent a number of audit committees, including in the PE context, which, as you know, Sid better than anyone. PE companies, some of them, portfolio or sponsors, not sponsors, but definitely portfolios, may have aspirations to be public one day. So they also build themselves like public companies and have independent directors serving on the audit committees. as a result, audit committees function in such a manner where they're often contacted by internal parties as well as external parties like auditors about suspicious activities that require further scrutiny. common triggers again, I think, are whistleblower complaints, suspicious findings post-acquisition, audit committee concerns, regulatory inquiries or subpoenas. Of course, if you get a grand jury subpoena or an SEC subpoena or information request, that usually tips things off. And then there are other sort of uncommon things, but very common in my world. A media inquiry somebody who has some advanced information about the behavior of some C-suite person within the portfolio company and that may require the company as well as the sponsor to do their own investigation and kind of revisit certain due diligence around certain things to assess whether there's any red flags. So those are some of the common triggers. I'll stop there to see if you have any follow-up to that.

Sid: No, I think that was great. I mean, we set the stage for the kind of regulatory environment. You've done a really nice job of being clear on some of the common and frankly relevant recent triggers here. So let's say we're in this environment now, right? An investigation is required. let's talk a little bit about who should conduct the investigation, why it matters, and how we think about potential conflicts between the sponsor and the portfolio company and any guidance on how we might wanna navigate.

Rizzy: Sure. I mean I think that's literally the core of sort of our discussion here, which I think if people are gonna listen to five minutes of this, I think this is the part to listen to. Ultimately, I think I will tell you, and that this was very relevant to me when I was handling white-collar investigations and prosecutions when I was at the Department of Justice, is okay, company or target or subject has told me as a prosecutor that we have conducted an independent investigation, guys. We got rid of the bad actor, and all is good here, which is what every company's gonna say. but my first question is gonna be: well, who conducted the investigation? Was it done independently? So to me, that's the number one issue is that engaging independent outside council is critical when an investigation is triggered, and it definitely matters. One, of course, it strengthens the privilege claims by establishing that that investigation is conducted at the direction of counsel for the purpose of providing legal advice in this case to the sponsor and possibly to the portfolio company or some small group of people within that circle of trust. Second, to the point that I started with, it enhances credibility with the regulators. Regulators routinely discount findings of an investigation which is run by the same advisors who are involved in the underlying conduct. If I'm a lawyer who's investigating the conduct the CFO of a sponsor, and I regularly work with that CFO on day-to-day stuff because my partner Sid is their PE counsel, the DOJ or SEC regulator is gonna have a tough time believing that that my findings are if effectively independent because we have a long standing relationship. and then number three, it insulates the company from arguments that the investigation was a sham or designed to reach a predetermined outcome. The other thing is, you know, and I'll tell you, there are examples. I mean, we Sid you and I operate in a very large law firm. and it's not out of the ordinary that you may have a number of clients that I don't know from Adam, but they have a white-collar investigation matter and you pick up the phone and say, I want to introduce you to my partner, Rizzy. And I get involved in those situations. In those situations, you can create an effective paper trail to say this is an independent investigation. Sidbale and the deal layer lawyers are not involved in the day-to-day. Rizzy Kureshi has never interacted with this client previously and was brought in to independently handle this. There are instances where I think you can get the DOJ comfortable if you're dealing with a similar firm or same firm that's quite large. I mean the key really is is if existing outside council, whether it's MA Deal Council or Regulatory Outside Council conducts the investigation, adversaries and regulators would argue that the work was undertaken for business rather than legal purposes, again weakening the paramount issue that we need to protect here, which is the privilege. Because the investigation kicks off based on certain information that you have, that's very high-level information usually. And you need to peel the onion and you really need to get down into the weeds and understand what occurred here. and the important thing is whatever you learn, particularly whatever advice that you give as a result of what you learn, needs to be protected and protecting that privilege and doing everything in your power not to weaken that privilege should be of paramount concern for sponsors. And I will just end with the risks of sort of the conflicts that exist. It's pretty acute in the PE context. It's just the nature of how that business and that industry works. the sponsors council, the portfolio companies council, and then the individual directors or officers council may have very divergent views or interests. and I've had to deal with this personally where I'm dealing with a portfolio company investigation involving executive there. But the audit committee is composed, it's not truly independent, it's composed of sponsor representatives on the board on the audit committee. so in those situations, you have to ensure that you're creating a record of how you're preserving privilege, because all of those things are subject to piercing the privilege, and ultimately you want to be in the best position to defend against that.

Sid: No, that makes sense. So let's get a little technical now then on privilege. You know, in MA deals, on the buy side in particular, I think a lot of our listeners have experiences where you might have a diligence provider, it could be a phase one provider, it could be a regulatory consultant or somebody similar. And we typically will engage them through counsel. And part of that argument is so that we can keep the privilege. in this case, I think it's worth having some discussion here on best practices and navigating privilege and how that gets allocated between the sponsor and the portfolio company. And Rizzy, I'd love for you to talk a little bit about your experiences there, traps for the unwary, and who controls the privilege and the work product protection. You know, how do the board and the in-house team understand the limits of privilege? And how do we think about the sharing of information and best practices in that?

Rizzy: Yeah, I think those are really, really important questions. And it can be a trick bag and sort of a minefield if you're not approaching it thoughtfully. And honestly, you have to approach it honestly. And that includes sometimes engaging with a very important stakeholder, part of the entire operation, whether on the sponsor side or the portfolio company side, and explain to them why they're being kept out of the privilege or sort of temporarily being sidelined on information flow because it's necessary to protect the overall investment or the overall portfolio company, right? so on the issue of who holds the privilege, the privilege effectively would belong to the relevant corporation or corporate entity that's acting. in my situation in the sort of example that I shared a moment ago, it was the audit committee that controlled the privilege. And that audit committee was composed of investors in the portfolio company, right? as well as sponsor representatives, other sort of individual investors, but of course sponsor representatives on the board. They controlled the privilege. Now those sponsor representatives on the board felt they also had an obligation to go back to their sponsor entity, whoever that may be, whatever fund that may be, to inform them about the risks that are presented by the issue that I was investigating regarding a C-suite executive. And I had to keep a tight leash on that. So I was controlling information flow. I was not generating a lot of written work product, but was having oral discussions with members of the audit committee on giving them findings of what the investigation is revealing. then when it came to my sort of advice, particularly around the risks that were presented there. I provided that again, orally without creating something in writing that could be subject to disclosure inadvertently or intentionally. We did reach a point at the conclusion of our investigation where we determined that certain parties, including third parties, could be brought into the privilege because we had a common interest. So there's this concept of the common interest doctrine of the common interest privilege where parties can share and protect shared communications between, in this case, the sponsor and the portfolio, if they share a common legal interest. But again, it has to be carefully established. Sometimes it makes sense to memorialize it into an agreement. I don't always like to do that. and again, it's important to note for PE sponsors or portfolio companies that are listening to this right now is that a mere business or commercial interests is not enough to have a common legal interest. The shared interest has to be legal in nature. and then the sort of other point that I'll just note is there's also this concept of joint defense agreements that are appropriate in some circumstances, but obviously those are also very different, they have to be carefully drafted, and they can create complications because if the interests of the sponsor in the portfolio companies later may diverge, maybe the sponsor becomes a target, you're raising the prospect of that privilege being waived or pierced by virtue of the joint defense agreement not being operative anymore. I think an inadvertent waiver in this scenario is always a constant risk. But one of the things I like to do very early on without getting involved getting into the weeds of an investigation is have separate interactions with all the relevant parties, including those that I'll be advising on a day to day basis on what the investigation is revealing, and those who are not going to be in the room, and to articulate to them why it's in the best interest of the overall client in this instance, whether it's the audit committee or the portfolio company, or the sponsor, that we do an independent investigation that's not tainted by the privilege being somehow waived or weakened, if in the future. You know, God forbid this becomes a problem. There's a criminal matter that arises out of it or litigation that rises out of it. and then there's several sort of cases out there that obviously I could talk about, but I think it's better to just kind of discuss generally. But, I think having honest conversations with relevant stakeholders and ensuring that they'll get a readout if and when appropriate, I think usually does the trick and you're able to continue to preserve the privilege in the best way that you possibly

Sid: No, appreciate that. so we've talked a little bit about the best practices here on privilege. I want to stay not so much with privilege, but maybe with communication. Obviously, there's communications internally among stakeholders. That could be within the sponsor, that could be with the portfolio company, board, management, employees, outside council. There's also correspondence and cooperation with regulators. Can you talk a little bit, Rizzy, about practical ways in which to manage those communications? Some best practices, things that relate to work products and board updates. And how can the team keep decision makers informed without circulating more sensitive material than necessary and creating potentially risks of waiver?

Rizzy: So yeah, I think on communications Sid it's really important how communications are handled because that ultimately every effort that you took to protect the privilege will all be for naught if you're not disciplined in how you handle communications. Now, the common telltale thing that we often do as lawyers is we label things as privilege and confidential or attorney client communication or attorney work product. I think that is a basic thing that you should do, but it's really important that labels alone are not dispositive of that issue, but they at least evidence some intent on the part of the parties. Of course, a communication between two business people where there's not a single lawyer on it marketing is privilege and confidential does not protect it as privilege. So there has to be a communication that involves counsel that would then come with that label. So that's one thing that I would recommend. I would always root communications through council. The example that I just used a moment ago, again, investigation of a portfolio company, because of a red flag raised by an external auditor. Sponsor very concerned, board very concerned, audit committee very concerned. Let's run this independent investigation. The whole purpose of running that investigation was in part to figure out what the misconduct was and how to get the auditor comfortable with the financials. At some point that auditor will need a readout from counsel or from somebody, maybe the audit committee chair, on what the investigation revealed. so in that instance, you want to root those communications through council. So updates from the investigation to and whether it's the sponsor's deal team or the investment committee or in this case the auditor should flow through outside counsel, not directly from, for example, either the portfolio company's management or even the ultimate client, the audit committee or the board, or the audit committee or the board's representative. this keeps the communication within the scope of legal advice and it also, charges somebody and basically puts the onus on counsel to make sure he or she is walking through that trick bag to ensure that they're not unwittingly waiving privilege. You would also limit distribution. As I discussed at the outset, I very much early in an investigation determine who's within it the circle of trust or the circle of privilege and who's not. And it may not be because the people who are not within the circle of trust initially have done anything improper, but they may be too close to the conduct or they may be too close to the individual that's accused of misconduct. That you may need to sideline them temporarily while you navigate the facts and disclose and sort of determine the facts, and then at some point you may bring them under the umbrella of privilege. But you want to limit distribution and share those privileged materials only on a need to know basis, why distribution to investors and investor committees and all of that is just always problematic and can undermine privilege claims. you have to always separate business and legal advice. I think that's self-explanatory, but sometimes it's not. When council provides a report to the board, clearly delineate legal analysis from business recommendations. Sometimes boards will go in executive session and will just have a one-liner in their minutes that say privileged report from council, and you keep it moving other than that. and then I already talked about this, Sid. in scenarios like this where I know that privilege is going be very difficult to protect in light of the various stakeholders and parties of interest involved, I get an understanding from the client at the outset. How how eager are you and how determined are you to protect privilege? As a result, it may make sense for us not to generate too much written material. So interview memorandas. So council's interview notes and memoranda, although they're typically protected by attorney work product because they reflect the mental impressions of a lawyer and the lawyer's legal analysis, it's important to note that facts are not privileged. And what is the purpose of an investigation? To uncover facts. So it's important as counsel is putting together advice that you're weaving in the facts with the legal advice in such a way where there's a basis to argue if it gets before a judge, that's when it's ultimately up to challenge. this is privilege because it includes my mental impressions and my legal analysis where I wove in the facts. Now the facts alone may not be privileged, but that document that you may have generated which includes legal advice while relying on the facts would be privileged. So that's how I would view it Sid.

Sid: I appreciate that. that's really great color and appreciate the guidance there. I think as we come close to the end of our time here, Rizzy, there's one other question that I was hoping that we could get your guidance on. In particular, this relates to the private equity sponsor's unique position. as you know, they're expected by their investors, regulators, et cetera, to exercise oversight over their portfolio companies. But active involvement in the management decisions, in the day-to-day decisions in particular, can create a basis for direct liability under several theories. And I'd love for you to talk a little bit about how a sponsor can exercise meaningful oversight, you know, board representation, compliance, policies, et cetera, without stepping into day-to-day management or creating an enhanced risk of being viewed as having stepped into day-to-day management or blurring the portfolio company's separate governance lines. I'd love to just hear a little bit about some best practices and any other guidance you might have for our sponsor?

Rizzy: Yeah, I think that's an excellent question and I don't envy PE sponsors who deal with their own trick bag of this paradox where they're expected by their stakeholders on good governance or whether that's their limited partners or regulators that they need to exercise oversight over their portfolio companies, but we also know active involvement and management decisions can create a basis for direct liability under several theories and you've heard of piercing the corporate veil and alter ego claims and control person liability that comes up under the SEC Act and aiding and abetting theories, not to mention conspiracy theories. so on the issue of best practices, it's just really important that clear corporate separateness is key. So separate boards, separate counsel, separate decision making processes. You have to also ensure that that portfolio companies board has genuinely independent members as you may need them for some independent issue. and documenting that the sponsor's role is one of oversight rather than operational control. I can tell you this has become a real focus as a lot of our great PE sponsor clients are heavily investing in regulated industries, whether it's healthcare or cybersecurity government contracts of all types, right? And I think it's really important that when you are getting yourself involved or investing in an industry that's heavily regulated, one thing that prosecutors and enforcement lawyers at SEC are very good to cut through is okay, so you are this sponsor that's traditionally invested in, I don't know, in agriculture or in the finance space. And all of a sudden, this is your first company you've invested in on the healthcare side, and all of a sudden now you're exercising incredible oversight and control on day-to-day management affairs of the organization. I think that always raises some red flags for regulators because there's a recognition that certain industries are so unique and so technical and require such a level of expertise. So it's important that creating that corporate separateness, deferring as appropriate to portfolio management on the day-to-day management of issues, and making sure that you document in such a way that oversight is just oversight and you're not operating day-to-day management of the organization, I think you're in the best position to walk that tight rope and still be do what you're supposed to, which is, provide oversight and report back to your various stakeholders. So in my judgment, there is a practical way of going about this. and I think, talking to people like you, Sid, and in your experience and helping sponsors in their investments and portfolio companies on how to create that separateness is gonna be key because I don't think anybody, as much as I like being busy and a busy lawyer, I always have to tell every client that they that I meet like I'm sorry I'm meeting you in this circumstance and hopefully they never have to.

Sid: Yeah, that makes a lot of sense. I really appreciate both your time, Rizzy, and your insights here. I thought this was an incredible discussion. it's a topic that every private equity sponsor and portfolio company board needs to be thinking about before scrutiny, before a crisis hits. best practices, ensuring that their governance platform and their interactions with their portfolio companies doesn't enhance risk of scrutiny and look through. And I think you've done a nice job here of summarizing some key considerations and providing some key insights on best practices. And folks who are listening, I'd invite you to continue that conversation with Rizzy and reach out to him or any other member of the Reed Smith team you've interacted with. And thank you for tuning into Dealmakers Insights. We hope you found this episode valuable and we're looking forward for you guys to join future episodes. Thank you.

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