Among the many companies suffering from the current economic turbulence are portfolio companies of private equity firms. One recent study estimated that nearly 50% of all companies owned by private equity funds could default on their debt during the next three years.
While representing a private equity fund as shareholder, and particularly if you are serving as a director on the board of the portfolio company, you should start contingency planning at the first sign of potential financial challenges, long before it reaches a crisis stage. Important steps include:
- understanding your fiduciary duties as a director, and how those duties may shift as the company's financial condition deteriorates;
- reviewing the composition of the board of directors and the capabilities of the portfolio company's management team;
- understanding the company's debt agreements and business contracts that may require renegotiation; and
- reviewing the company's D&O indemnities and insurance policies.
Financial distress often requires directors to make difficult decisions, frequently under challenging constraints. By understanding your responsibilities and staying informed, you will be better able to address the portfolio company's needs and navigate the potentially conflicting demands you may face in these difficult times.
1. Understand Your Fiduciary Duties as a Director.
In the absence of financial distress, directors owe fiduciary duties to the corporation, which must be managed for the benefit of all shareholders. These duties include the duty to act on a reasonably informed and deliberate basis (the duty of care) and in the best interests of the corporation and its shareholders (the duty of loyalty). As long as the portfolio company is solvent, no duties are owed to creditors beyond those set forth in the applicable debt instruments.
The duties that a representative of a private equity fund serving as a director owes to the portfolio company and its shareholders are distinct from the duties owed to the private equity fund and its investors. While the portfolio company is performing well, these separate duties may not create a conflict because the interests of the private equity fund to maximize the value of its investment are generally aligned with the interests of the portfolio company and its other shareholders.
When a portfolio company becomes insolvent, its directors continue to owe fiduciary duties to the corporation. However, these duties can be viewed as shifting to include creditors, because maximizing the value of an insolvent company is necessarily for the benefit of its creditors. This shift can create conflicts because the interests of the private equity fund as shareholder may diverge from those of the portfolio company and its creditors. For example, a private equity fund shareholder may favor a transaction that is risky but has the potential to create long-term value for the shareholders, while creditors may prefer a more certain, short-term solution.
When a portfolio company experiences financial difficulty, the risk of litigation against the private equity fund and the portfolio company's board of directors is increased, as creditors and other parties seek to enhance their recoveries by pursuing claims against deeper pockets. Accordingly, the private equity fund and its professionals should take particular care to ensure that the board members comply with their fiduciary duties and take steps to address potential conflicts. Actions to consider include:
- Board members should ensure that they obtain sufficient information and follow proper procedures in making decisions, and maintain accurate records of steps taken and decisions made.
- Although it is always important for board members to carefully evaluate management's business plan, the potential for financial difficulties means that even greater "stress testing" is necessary, to try to anticipate challenges and consider possible alternatives.
- Representatives of the private equity fund should not offer assurances to creditors or other third parties unless the fund is prepared to stand behind those assurances.
- Private equity professionals should ensure that every communication is clear in indicating whether he or she is acting as a director on behalf of the board or the portfolio company or as a representative of the private equity fund shareholder.
- The portfolio company should consider engaging separate counsel that is independent from the private equity fund.
- The private equity professionals serving on the board of directors should ensure that actions are taken and decisions are made in the interests of the corporation, including its creditors, notwithstanding the duties owed to the private equity fund and its investors. For this purpose, it may be useful for the private equity fund to relieve the directors who are serving on the board from their responsibility to manage the portfolio company investment on behalf of the fund, and to assign professionals who are not serving on the board to manage the investment and make decisions for the fund in its capacity as a shareholder.
- The portfolio company, its board and private equity professionals representing the interests of the fund as shareholder should take care to protect the applicable attorney-client privilege - for example, communications by management or the board with company counsel should not be shared with private equity professionals who are not serving on the board, and communications by counsel to the private equity fund should not be shared with other directors or the portfolio company.
2. Consider the Composition of the Board and Management.
The prospects of a portfolio company's financial distress typically cause private equity professionals to question whether they should continue to serve on the board of directors. The pros and cons of remaining a director should be carefully weighed.
An important consideration for directors of a company facing financial challenges is the demands on the directors' time. The length and frequency of board meetings will increase, and the decisions that must be made may be more difficult. It will be necessary for the board to work more closely with the management team on strategy, considering potential alternatives and renegotiating debt and other contracts. And directors must accept the heightened possibility of litigation, for actions taken or not taken. Even if allegations prove to be groundless, the potential negative impact on a director's reputation, and the time and expense required to defend these claims, can be cause for concern. Moreover, in certain circumstances, board members may have personal liability for unpaid obligations such as taxes withheld from employees and certain unpaid employee wages. Directors should discuss with counsel whether these or other regulatory requirements may expose them to risk of personal liability.
On the other hand, times of financial distress are when the company most needs the expertise and guidance of experienced directors. It may be hard to find new directors, and resignations by multiple directors may leave the portfolio company with only members of management on the board. If the director's resignation would adversely affect the company, there is a risk of claims that the resignation itself may be a breach of the director's fiduciary duties. Moreover, resignation does not protect a director from litigation for past actions, whereas remaining on the board may allow the private equity professionals serving as directors to guide the company's destiny and thereby reduce the litigation risks. Directors who remain on the board are also more likely to obtain a release of claims by the portfolio company and its creditors in connection with a Chapter 11 plan of reorganization or other restructuring.
Directors should also consider whether the board composition and/or management should otherwise be modified to ensure that the portfolio company has the necessary experience and expertise to address the challenges it faces.
3. Know the Debt Agreements and Other Material Business Contracts.
Effective contingency planning requires a careful analysis of the portfolio company's debt agreements and commercial contracts in order to understand the parties' rights and obligations and the provisions that may be triggered by a change in the company's financial condition or control.
Debt covenants and default provisions should be reviewed with particular care. For example, a violation of a covenant in a debt agreement could give creditors a right to accelerate the portfolio company's obligations to repay or redeem the debt at par even if the debt has been trading at a deep discount, and/or increase the interest rate payable on the outstanding debt balance. A change in control of the portfolio company, which may result from a restructuring transaction, may also trigger mandatory prepayment or redemption obligations. Debt instruments may also contain cross-defaults.
Debt agreements permit amendments or waivers to prevent or cure defaults if sufficient holders of the debt consent. Debt holders can be expected to demand a fee in consideration for any material amendment or waiver. It is important to understand the percentage of the debt holders whose consent will be required - a majority, a supermajority, or 100%; a higher threshold can dramatically increase the difficulty and expense of obtaining a needed amendment or waiver.
Commercial contracts, including leases, should also be reviewed to determine whether deterioration in the portfolio company's financial condition or a change in control may trigger rights or obligations. These agreements should also be reviewed to consider whether modifications can be negotiated to help relieve some of the financial strain. A careful review of the rights and obligations of each party is critical to understanding the leverage that each party will have if a renegotiation becomes necessary.
4. Review Your Indemnity Protection and D&O Insurance Policy.
Particularly in light of the increased risk of litigation that goes along with financial distress, directors should ensure that they are protected to the extent possible by indemnification and D&O insurance. Directors should confirm that indemnification is provided "to the fullest extent permitted by law" by both the portfolio company and the private equity firm that designated the director to serve on the company's board. Directors should also ensure that indemnification provisions will extend to former directors and that they cannot be changed to adversely affect any director (or former director) without his or her consent.
While it is important for directors to review their rights to indemnification from the portfolio company, these provisions will have limited value if the company is unable to pay. Therefore, a director must also ensure that D&O insurance coverage is sufficient and available. Care should be taken to ensure that premiums are paid and deductibles met in order to ensure continuous coverage. It is also important to review the terms of the D&O policy and consider whether it is necessary to attempt to renegotiate some of the provisions, in particular to avoid unexpected gaps in coverage that may arise if the company eventually files for bankruptcy. For example:
- If the company also has a right to collect under the D&O policy, a bankruptcy court may block payments to directors under the D&O policy on the theory that the policy is an asset of the company that would be depleted by payments to directors.
- In a bankruptcy, creditors may object to payment by the company of deductible or retention amounts which, under some policies, is a condition to the availability of insurance coverage.
- If indemnity payments by the company are blocked, D&O coverage may be unavailable to a director if the wording of the policy requires that the company must actually pay the director the indemnified amount before insurance coverage applies.
- Many policies contain an "insured vs. insured" exclusion, which bars coverage for claims brought by one insured (e.g., the portfolio company) against another (e.g., a director).
All of the above provisions can potentially be renegotiated if brought to the attention of the insurance company in a timely fashion.
Financial distress imposes extraordinary demands on a portfolio company's management and directors. Advance planning, well before the crisis stage, is essential to a successful outcome.
If you have any questions regarding this newsletter, please contact any of the lawyers listed below or your regular Davis Polk contact.
Paul R. Kingsley, Partner
212-450-4277 | firstname.lastname@example.org
Nancy Sanborn, Partner
212-450-4955 | email@example.com
Mutya Fonte Harsch, Associate
212-450-4289 | firstname.lastname@example.org
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1. "Get Ready for the Private-Equity Shakeout," Survey by The Boston Consulting Group and the IESE Business School, December 2008.
2. For a discussion of a director’s fiduciary duties and potential conflicts, please see our private equity newsletter, “Your Responsibilities as a Director of a Portfolio Company.”
3. A Delaware Chancery Court ruling last year, Schoon v. Troy Corp., generated significant concern among directors by upholding a company's retroactive repeal of a former director's right to advancement of expenses in defending against fiduciary duty-based claims. The decision prompted many directors to request separate indemnification agreements and led to an amendment of the Delaware business corporation code to prohibit the retroactive repeal of an indemnification or advancement right unless a charter or bylaw provision expressly authorizes it. For a more detailed discussion of the recent decision and its implications, please see our newsflash, Delaware Court Ruling Puts a Spotlight on Indemnification/Expense Advancement Bylaws.