Andrew Ross Sorkin wrote an interesting article in Tuesday’s New York Times regarding the practice of private equity firms designating the legal counsel to be used by its lenders in a leveraged buyout financing. In other words, the private equity firms engaging in this practice are hand selecting, and paying the fees of, the lawyers that will be on the other side of the transaction negotiating on behalf of the banks against the private equity sponsored borrowers. This practice constitutes a clear conflict of interest that tilts the negotiations of the financing in favor of the private equity sponsored borrowers.
In Mr. Sorkin’s article, the private equity firms assert that the rationale for selecting lenders’ counsel is that using the same counsel promotes an efficient and economic legal review of the financing documents, since many of the documents and issues will be the same in each transaction. I think there is a little more merit to this rationale than Mr. Sorkin gives credit to, but I ultimately agree with Mr. Sorkin that any purported benefit of this practice is eclipsed by the conflict of interest that occurs when the private equity firms and the lawyers representing the banks enjoy too cozy of a relationship.
I suspect that this practice will eventually be prohibited, whether by express regulations from the banking regulators, the attorney regulators, or as a result of a court decision (likely in the Delaware Court of Chancery given their scrutiny of conflicts of interest in the deal making process). I predict that in the next several weeks, some enterprising plaintiffs’ lawyer will read Mr. Sorkin’s article, find a private equity deal financing that has been impaired, and bring suit against the private equity firm, the arranging lenders, and lenders’ counsel asserting that the conflict of interest inherent in the practice of the borrower selecting the lenders’ counsel caused their loss (or alternatively prevented them from getting better terms in the financing).