Private equity and venture capital firms are responsible investors. Unlike many other asset managers, they have the wherewithal and financial incentives to ensure that their portfolio companies comply with legal rules and adopt best practices on a range of social and environmental issues. Many firms have invested significant resources to improve their ability to identify legal and regulatory risks before investing, and to act proactively to protect value (or take advantage of opportunities) in existing investee companies.

But responsible stewardship is one thing; being saddled with legal liability for the consequences of failures at portfolio level is quite another – especially if the firm has done everything possible to prevent the issue from arising in the first place. As we have recently highlighted, this is an ongoing issue with European competition law but, under UK domestic law, there has always been a more wide-ranging set of risks for firms that try too hard. Where an active investor gets too involved in the business of a portfolio company, it could inadvertently accept a duty of care to outsiders – for example, customers and employees of the investee.

The legal risks have, in the past, been simple to explain, but hard to quantify. That’s because the courts have not had many opportunities to apply the legal principles to financial investors. And, while that remains the case, some recent case law on corporate groups is instructive, and offers a clearer steer to private equity managers who are treading the line between responsible investment and unlimited, direct liability.

Three recent UK cases have reached the Court of Appeal, and together offer some guidance on the circumstances in which a parent company can be liable for the acts or omissions of its subsidiary. In all of these cases, the parent company, located in the UK, was being sued by claimants based abroad who claimed to have been harmed by the acts or omissions of a subsidiary.

The parent / subsidiary relationship does not itself give rise to liability (that would be to pierce the “corporate veil”, which is only possible in English law in very limited circumstances). Therefore, in order to succeed in their claims, the claimants needed to show that the UK parent owed them a direct duty of care, and should therefore be liable for the damage allegedly caused to them.

According to recent decisions of the English courts, a necessary (although not on its own sufficient) requirement for such a duty of care to arise is that the relationship between the parent company and those who claim to have suffered damage is sufficiently proximate. One key question in these cases has been whether a parent company that drafts group-wide policies and imposes them on its subsidiaries – often in an attempt to ensure that the group as a whole complies with supra-national guidance, such as the UN Guiding Principles on Business and Human Rights – thereby satisfies this aspect of the test, and creates a sufficiently close relationship with those affected by failings in a particular area to give rise to a duty of care.

So far in the UK, the Court of Appeal rulings have been comforting for companies that want to do the right thing, but don’t want to open themselves up to liability in the event that the underlying subsidiary does not do enough to prevent the harm. In one of the cases, involving Royal Dutch Shell, the court expressly said that group-wide policies would not, on their own, give rise to a direct duty of care. In that case, the English parent did not control its (indirect) subsidiary’s operations; nor did it have “direct responsibility for practices or failures which are the subject of the claim”.

However, although group-wide, high-level policies would not give rise to a duty of care, it is clear from the judgements in these recent cases that direct control of, or assumption of responsibility for, an important aspect of a subsidiary’s operations, or (perhaps) specific and detailed advice, could – if the various other requirements are found to be present – lead to direct liability for foreseeable harms that result.

Of course, investment funds are not parent companies, and private equity portfolios are not corporate groups. In those cases, the policy arguments against imposing liability are, if anything, stronger, and the likelihood of a proximate relationship being established is lower. However, private equity fund managers should be aware of the issue: if they go too far in seeking to control risks at portfolio company level, they may (at least in UK law) create a litigation risk for the fund and its manager.

Fund-level policies to deal with environmental, social and governance (ESG) issues are now commonplace, and there is nothing in these recent cases to suggest that they create additional risk. But portfolio company-specific interventions, particularly ones that subvert the role of the company’s board and management team, could increase risk, and need to be structured carefully. And this is an area of law to watch: at least one of the recent Court of Appeal cases may soon come before the UK’s Supreme Court.

European Funds Comment will take a break for August and will return in early September. We hope you enjoy the break!