Litigation and Investigation Risk: Did 2022 Signal a New Era?

Untested ESG representations. New SEC financial reporting and disclosure requirements. The rise of financial sanctions and the long global shadows they cast on supply chain disruptions and risk. Will we look back at 2022 as the start of a new period of volatility and uncertainty?

Private equity had a good run in 2022, all things considered. Although the pace of private equity transactions cooled since the heady days of 2021, buyout deal value and exits racked up new highs and PE funds provided higher returns for investors than any other asset class, at least by historical standards.

But hold on. Think back to the Great Recession, the most serious financial crisis since the Great Depression and, several years before that, the spectacular implosions of Enron, WorldCom and Arthur Anderson.

We haven’t really experienced debacles of comparable magnitude in the investor ecosystem since then, right? Well, at least until recent months – with Twitter’s wild ride, disruption across the technology industry, and disintegration of certain crypto companies leading to the reassessment of the regulation of the sector. Even more broadly, what does 2022 tell us about 2023 – and the litigation- and investigation-related risks private equity stakeholders should be considering? 

Six Key Risk Factors 2022 Helped Uncover

If you’ve been preoccupied with 2023 planning and projections on where the PE markets are headed in the new year, you may well be musing about whether PE investor confidence in the stability of the financial reporting market is thinning at a time when, it appears that almost any company can go from calm to chaos in mere days – or even minutes. 

We are. As independent advisors supporting companies facing high-stakes litigation, compliance investigations, and regulatory scrutiny, we’re preparing for 2023 by reviewing last year and capturing insights that will help our clients protect their enterprise value from sudden disruptions, unplanned events, and costly litigation and investigations.  

High interest rates, volatility, and political polarization have fueled a vicious cycle, weaponizing issues across the board and nudging many to lower their risk tolerance. Here are six issues that either emerged or escalated in 2022 that could impact private equity investments and precipitate litigation, fines and penalties, or other types of large-scale value destruction.

1. Corporate Failures: Crises at the Speed of a Click

Trouble unfolds quickly. Very quickly – especially in the quicksilver world of social media. Think how long it takes for a management team to understand what has happened, mobilize a crisis communications team, evaluate response options, and try to get ahead of events. Not only is Twitter and its policies and finances in the news cycle 24/7, but it is also a primary platform of the dissemination of “news.” In the crypto space, we have seen how information shared across social media can change the landscape for an industry or a few of its players overnight. After reporting weaker-than-expected first-quarter revenue in February last year, Facebook parent Meta lost more than $232 billion in value the following day. That was the largest one-day value drop in stock market history… although the stock has seen meaningful one-day gains since then. These are just a few of the countless examples of how quickly things can change.

2.  ESG Representations: An Uneven – and Untested – Array of Claims

Many PE fund managers, general partners (GP) and limited partners (LP) will look back on 2022 and ask themselves, “why didn’t we spend more time understanding risks related to environmental, social and governance (ESG) issues?” Financial reporting requirements around ESG issues are in their infancy – but likely to emerge in greater detail as the SEC expands disclosures. For example, consider the IFRS Standards and, specifically, Financial Instruments (IFRS 7 and IFRS 9): it’s not hard to anticipate that some portfolios could include investments vulnerable to changes in value due to ESG considerations. At the same time, audit committees are starting to incorporate ESG matters into their discussions of fraud risk. And new ESG management systems are emerging every month. All these protocols, platforms and controls are largely untested as we begin a new year.  It’s also not difficult to foresee specific ESG-related representations in stock purchase agreements as buyers realize ESG metrics are not always as strong as expected and start seeking legal recourse against sellers. Expect a rash of new ESG-related cases and investigations. It’s just a matter of time – and won’t go away soon.

3. U.S. Domestic Politics: New Fault Lines for Business Leaders

Arguably, the fault lines between the two dominant U.S. political parties widened in 2022. As Americans remain polarized on issues central to the nation’s cultural identity and future path, 2022 showed us that political risk can now extend to the C-suite and the boardroom – as well as to many facets of a company’s operations and what we traditionally consider “business only” arenas. This year’s “dust-up” between Disney and Florida Governor Ron DeSantis would have been unheard of just a few years ago. Tweets or off-the-cuff comments from CEOs can now alienate 50 percent of a company’s key stakeholders in one 24-hour news cycle. In one day, half the world may decide to “cancel” you. The new political minefields for corporate leaders range from diversity, equity and inclusion to climate change, law enforcement and firearms – and even a state’s policies on migrants or public statues. One of the most noteworthy examples from 2022? How some companies responded to the Supreme Court’s overturning of Roe v. Wade to cover costs for employees seeking abortion care out of state. In addition to the reputational considerations, expect to see more issues related to political risk in 2023 including increased litigation and investigations.

4. Regulatory Environment: The Shifting Sands of New Financial Reporting and Disclosure Requirements

Over the past decade or so, SEC enforcement has been viewed by many as lackluster. That trend may have changed directions in 2022. For example, the regulatory authorities – including the FTC – appear to be stepping up enforcement on issues like price discrimination and other forms of anticompetitive conduct through the dormant Robinson-Patman Act, a Great Depression-era law enacted to protect small businesses. At the same time, the U.S. Department of the Treasury is promoting several initiatives focused, in part, on increasing transparency for large private equity investors, such as potentially removing the anti-money laundering requirements exemption for the PE industry. Disclosures, however, sometimes run afoul of one state’s or another’s politics or policies and can alienate key investors or lead to other negative consequences.

5. Supply Chain Disruption: From Covid Impacts to International Sanctions and Geopolitical Pressures

Throughout 2022, the impacts of COVID-19 continued to ripple through global supply chains. These headwinds will continue to create uncertainty and instability in the new year. It’s one thing to deal with direct operational, financial and organizational obstacles such as logistics disruptions, production obstacles, supplier dependence, commodity pricing, and price inflation. When claims arise, however, it’s a burden of a much higher order to shoulder the high costs of litigation and forensic investigations. As companies adapt to supply chain issues – by, for example, redesigning supply chain flows, adapting inventory management strategies, and developing alternative processes for last-mile deliveries and product returns – they also need to be thinking about litigation risk. For instance, a new supply chain relationship could increase vulnerability to violations of regulations related to supply chain and human rights, with consequences such as fines and penalties, the freezing or seizure of cargo, public scrutiny, government hearings, and bans from public procurement.

2022 Suggests Volatility Will Continue in 2023 and Beyond

As we look further into 2023, filter your PE investment planning and decisions through a “litigation and investigation lens” before you lock in the year’s strategy and decide where to place your bets. If you start thinking about these now, you may not need to call our team in a crisis or, if you do, we’ll have a much better chance of protecting your assets, investments and interests.