Private Investment Funds & Capital Commitments: Force Majeure as Investors’ Defense Du Jour?
Investment funds continue to grapple with COVID-19, responding to fluctuating financial markets and the ongoing economic, strategic and practical challenges facing them. During this tumultuous period, the funds’ limited partners, perhaps struggling with liquidity issues of their own, may be at risk of defaulting on capital calls triggered by the funds and their general partners. These defaults could have a significant impact on the bottom line of investment funds that rely heavily on capital commitments.
Investors are likely to raise defenses associated with the pandemic – claiming the economic downturn excuses the investors’ nonperformance – in response to capital calls needed to stabilize or grow the funds. While these force majeure-related defenses may seem credible at first blush, especially under the circumstances, the defenses very well may be difficult to establish in the event of litigation.
Investors’ Obligation To Fund Capital Calls
An investor’s promise to fund a capital commitment, to the extent it agreed to do so, is enforceable as a matter of both contract law and statutory law.
If an investor has agreed to fund one or more capital commitments in the parties’ partnership agreement, the investor’s agreement should be enforced according to the terms of the partnership agreement. An investor ordinarily is held to its bargained-for promise to fund capital commitments and to contribute to the fund’s stability and growth – the same promise made by all limited partners to the fund. The investor’s failure, or refusal, to abide by its contractual obligations and to fund the capital commitment would likely subject the investor to liability for breach of contract.
Most investment funds are organized under New York or Delaware law. These bodies of law contain specific statutory provisions confirming limited partners’ obligations to fund capital calls when they have agreed to do so. Under New York law, a limited partner is liable to the partnership “[f]or any unpaid contributions which he agreed in the certificate [of limited partnership] to make in the future at the time and on the conditions stated in the certificate.” Likewise, Delaware law makes clear that “[e]xcept as provided in the partnership agreement, a partner is obligated to the limited partnership to perform any promise to contribute cash or property or to perform services…. If a partner does not make the required contribution of property or services, he or she is obligated at the option of the limited partnership to contribute cash equal to that portion of the agreed value (as stated in the records of the limited partnership) of the contribution that has not been made.”
Absent a valid defense, an investor will be liable for monetary damages, and potentially specific performance, for failure to pay its share of an agreed-upon capital commitment under the terms of the parties’ partnership agreement, and any other operative agreements, and in accordance with applicable law. In addition, private equity fund limited partnership agreements commonly include specific agreed-upon remedies for failure to fund capital commitments, which may include forfeiting some or all of a defaulting limited partner’s existing capital contribution to the fund.
Investors’ Potential Force Majeure-Related Defenses
When faced with capital calls in this difficult environment, and potentially as part of a litigation strategy, investors may resort to asserting defenses like force majeure or the doctrines of impossibility, impracticability or frustration of purpose, in an effort to avoid liability.
As discussed in our previous client alert, a force majeure provision is intended to allocate risk between or among contracting parties, such as general and limited partners, if unanticipated events render the agreement’s performance impossible or impracticable. Most force majeure provisions include a negotiated list of events that, if occurring, constitute a force majeure event. These events could potentially include floods, tornadoes, earthquakes, hurricanes, terrorism, riots, strikes, wars or (as applicable here) epidemics and pandemics. This type of provision, if applicable, potentially excuses an investor’s nonperformance of contractual obligations when an extraordinary, supervening event, beyond the control of the parties, prevents the investor from fulfilling its contractual duties.
The interpretation of what constitutes an enforceable force majeure event will vary on a case-by-case basis depending on the specific language of the provision and the jurisdiction and the law governing the contract. Under New York law, for example, courts narrowly interpret force majeure clauses, so that usually only the occurrence of events expressly identified in the clause will excuse a party’s nonperformance. When the parties themselves have defined the contours of force majeure in their investment agreement, those contours typically dictate the application, effect and scope of the force majeure provision.
In the event that a contract does not contain an express force majeure provision – and these provisions are not very common in fund partnership agreements – there are still ways that an investor, under common law, may seek to excuse its nonperformance or avoid its obligations under the agreement: the doctrines of impossibility (or impracticability) and frustration of purpose.
The doctrines of impossibility or, in some jurisdictions, impracticability may excuse nonperformance where a party establishes that an intervening event occurred, that the event was not foreseeable, and that the unexpected event made contractual performance impossible or impracticable. Many jurisdictions require not mere impracticability but true impossibility. This standard is a high one, ordinarily requiring that the subject matter of the contract and the means of performance have been destroyed by the unanticipated event. In contrast, some jurisdictions require only that the performance be impracticable so that performance of the party’s obligations would require excessive or unreasonable expense. Under both standards, the party asserting the impossibility defense must demonstrate that it took virtually every action within the party’s powers to perform its duties.
The frustration of purpose doctrine excuses nonperformance where the supervening event has rendered unattainable the primary reason for entry into the parties’ contract. This doctrine specifically requires that an event substantially frustrates a party’s principal purpose for entering into the contract, that the nonoccurrence of the event was a basic assumption of the contract, and that the event was not the fault of the party asserting the defense. The frustrated purpose must be so completely the basis of the contract that, without it, the transaction would have made little sense. While the focus of impossibility is the ability or inability of a party to perform its obligations, frustration of purpose instead deals with the fact that one of the parties will not receive the benefit of the bargain even if the other side performs.
The Viability of Investors’ Potential Litigation Defenses
Investors seeking to excuse nonperformance may rely on force majeure provisions or, if none, the doctrines of impossibility, impracticability and frustration of purpose, in light of the COVID-19 pandemic and the resulting economic downturn. Investors will have an uphill battle.
COVID-19 certainly is an extraordinary, unanticipated event, beyond the control of the limited partners and the other contracting parties. But market conditions and the financial health of the parties generally have not been considered basic conditions to the performance of contracts. Dramatic market disruption and parties’ liquidity constraints usually have been insufficient to excuse nonperformance. Courts, somewhat consistently, have been reluctant to allow parties to invoke force majeure provisions or their common law equivalents in order to avoid honoring contractual obligations following broad, economic turmoil, reasoning that force majeure clauses are not designed to buffer parties against the risks of a contract. While there were a few outliers over the years, including based on unique fact patterns, most courts following the 2008 financial crisis declined to excuse nonperformance unless the parties’ force majeure clause specifically listed financial crises, changes in financial conditions or the like. All things considered, financial hardship typically is not considered a valid reason for an investor, a market participant or other contracting party to circumvent its obligations under an agreement.
Even if a force majeure provision specified epidemics and public health emergencies and resulting government action as events of force majeure, an investor seeking to avoid compliance with its capital commitment still would need to show a nexus between the force majeure event and the investor’s nonperformance of its obligations. In most jurisdictions, the investor would need to demonstrate that COVID-19 effectively made it impossible to fund the capital call, a dubious proposition. Given that the investors would be seeking to avoid payment obligations – and not non-monetary obligations, such as a more garden-variety duty to manufacture or deliver a good or to provide a service – it is doubtful that the investors will be able to rely on the COVID-19 outbreak and force majeure provisions, or the doctrines of impossibility, impracticability or frustration of purpose, to avoid their contractual responsibilities.
Finally, in the event of capital commitment-related litigation, the cost of the parties’ legal fees necessarily impacts the parties’ decision-making process before and during the proceedings. While general partners always are indemnified by their respective funds, individual investors, or limited partners, may or may not be liable for attorneys’ fees and related expenses incurred by the general partners in connection with the enforcement of capital call commitments. This issue could have a huge impact on the parties’ strategic decision-making process, particularly if one or more of the parties are financially distressed. Clearly, there are many financial and strategic issues to factor into the decision to pursue an investor for breach of its capital commitment, most of which require analysis of the parties’ agreements and consideration of the general partner’s fiduciary duties and certain intangible and reputational elements.
Investors seem to be behind the eight-ball if they seek to frustrate investment funds’ efforts to enforce capital commitments. The general partners of these hedge funds, private equity funds, real estate funds and other funds are well positioned to enforce their rights for the benefit of the funds and their other investors.
In the meantime, fund managers are likely determining their capital needs and making strategic decisions as to whether to call capital and, if so, how much. As part of this process, fund managers, together with their counsel, should review their investor agreements for any force majeure provisions and, even if there are none, assess the parties’ rights and obligations in connection with the doctrines of impossibility, impracticability, frustration of purpose and otherwise.