WHO IS SUING VENTURE CAPITAL INVESTORS AND WHY?
By James Verdonik

When people are making money, they are too busy to think about suing one another.

With the recent downturn in the technology sector, however, some people are turning their attention to pointing their finger (and their lawyers) to blame others for the wreckage. Venture capital investors are increasingly finding fingers pointing at them. The result is a higher risk of law suits against venture investors.

For many years venture investors were not held in high regard. The term "vulture" capitalist was commonplace. The favorable equity markets of the 1990s changed the public image of venture capital investors for the better. Now, with equity markets in the tank, venture investors are taking part of the blame from all sides.

Law suits against venture investors are brought for a wide range of reasons:  

• Founders sue over financing rounds at very low valuations that dilute the founders' interests in the company. Since venture investors are on the Board of Directors that approve financings in which these venture investors buy stock, conflicts of interest open the door to litigation.
• Founders and other investors sue when a company is sold for a low price to another company in which a venture investor has an interest.
• Founders and other employees sue venture investors who urged the company to fire them. The allegation is that the venture investor interfered with the employee's contract.
• Investors sue venture investors for failure to make proper disclosure to investors about the risk of investment in their portfolio companies. This is particularly the case for venture investors who sit on Boards of Directors for dot coms that went public at high prices whose stock later tanked.
• Investors also sue venture investors who sell their stock into pubic markets alleging insider trading violations.
• Founders and other investors sue over how venture investors go about obtaining control of a company’s board of directors.
• Founders and other investors sue venture investors for mismanagement, corporate waste and other reasons.
• Institutional investors who committed to invest in a venture capital fund rarely sue the VC. However, when the VC seeks to make a capital call to raise more money, an institutional investor may use the threat of litigation or complaints about poor performance to delay or cancel its capital call obligation.
• Beyond law suits, some employees of internet companies that have folded or engaged in layoffs regularly attack venture investors publicly in chat rooms. Some websites specialize in attacks by former employees against both venture investors and management (almost daring them to sue for slander.)

To make matters worse for VCs, insurance coverage is often nonexistent. VCs often do not require portfolio companies to obtain director and officer insurance policies. Also, a company's D&O insurance carrier may disclaim coverage for the VC because the insurer says the VC was acting as an investor, while the VCs own carrier may disclaim coverage because it says the VC was acting as a director. Insurance is often a "Catch 22" situation.

The "holy grail" for founders and others who seek to sue VCs is to have the courts view VCs like they do banks. If a bank takes control of a borrower's Board of Directors, fires the CEO and decides to change the strategic direction of a borrower, the bank would face a high risk of liability under a line of legal cases that impose "lender liability." To date, courts generally have not extended the concept of lender liability to VCs. The primary reason for the distinction between bankers and VCs is that, as equity investors, VCs are in the business of exercising greater control over companies than banks do as lenders. Courts understand that they should not prohibit VCs from doing the things that VCs normally do as equity investors.

Despite initial successes in warding off lender liability, VCs should remember that banks also initially avoided liability successfully. The doctrine of lender liability evolved and expanded over time. The same may happen with VC liability. No VC wants to be the unlucky first case. Because legal liability trends often start in California, West Coast-based VCs seem to pay more attention than others to liability issues. It may be time for their East Coast brethren to start doing the same.

What's a poor VC to do?

Here's a list of defensive measures to consider.

• VCs should always be aware of what role they are playing each time they make any decision about a company or take any action. They need to be aware of what things they are entitled to do as a member of a company's Board of Directors and what action they are entitled to take as investors. Confusing the two roles is a common cause of trouble for VCs.
• If there is a low priced round of financing, VCs should document efforts to sell to independent third parties at a higher price, consider getting an investment banker to indicate the price is fair and offer to allow founders and others who might object to the low price to purchase shares at the same price.
• Avoid becoming a lender. Many VCs are making bridge loans to their portfolio companies. These loans are often secured by the assets of the company. If VCs become lenders, the courts are more likely to apply lender liability case law to their actions.
• Consider obtaining liability releases from founders and other possible plaintiffs as a condition to making bridge loans or other investments.
• Be aware that after its initial investment, a VC is often both a buyer and a seller of stock for securities law liability purposes.
• Look at the timing of an action. Is the action being done at a time when others are not able to protect their interests?
• Does the action have a legitimate corporate purpose that can be explained to a jury or will the action look malicious? Malicious acts often result in large punitive damage awards by juries.
• Avoid using language which suggests a transaction or event is unusually adverse to others. For example, a "cram down" financing is a term any plaintiff's attorney would like to put in front of a jury.
• Fully disclose in writing all conflicts of interest.
• Seek advice about your own liability risks from your own legal counsel, not just from the portfolio company's legal counsel.
• Preserve the attorney-client privilege by not discussing liability sensitive matters in front of people other than your own attorney.
• Examine insurance policies to determine what liabilities are actually covered.
• Make your insurance carrier aware of potential claims within the time limits set forth in the policies.

VCs often are required to make tough decisions quickly based on inadequate information. In the current difficult economic environment, this tough job has gotten tougher. Unfortunately, it is also likely to create liability problems.

By the way, before you bring a law suit against your VC, you should consider whether you ever will need to raise venture capital in the future or will want to work for a venture backed company. Law suits against VCs are probably not something you want on your resume. VCs have long memories.