Private equity firms and hedge funds, flush with capital and desperate for high-return transactions, are now changing the landscape of corporate America by taking larger and larger companies private for some interim period of time or by purchasing a significant block of shares in a company for the purpose of quickly increasing share price. As discussed below, such investments can have both an aggravating and mitigating effect on D&O exposures for the portfolio company. Overall, though, the increased private equity involvement should increase at least the frequency of D&O claims, particularly in connection with going-private transactions or subsequent public offerings of securities which are part of the private equity investors’ exit strategy.
Large equity investors generally fall into one of two categories. First, some large private equity investors, such as KKR, Blackstone, Thomas H. Lee and Texas Pacific Group, acquire a publicly-held portfolio company with a view of owning the shares for several years and then selling the company for a considerable profit in an IPO. Second, hedge funds may purchase a large ownership interest in a portfolio company for a more short term time period, expecting to drive up the stock price through short term governance reforms or other interim strategies, then sell their shares in the open market.
The types of D&O exposures for the portfolio company arising out of these private equity investments are briefly discussed below.
A. Going Private Transactions
Typically, the private equity investors will acquire all of the publicly-held securities of the portfolio company, thereby converting the company from a public company to a private company. Both the frequency and size of these types of transactions by private equity firms have grown dramatically beginning in 2006, with virtually every major industry group being a target.
Proponents praise these types of transactions as allowing the portfolio company to operate in the largely unsupervised world of private companies in which long-term growth need not be sacrificed for short-term returns. Through aggressive management techniques, company value can be significantly increased without the expensive and burdensome regulation and transparency applicable to public companies.
Critics, though, condemn these transactions as the modern version of Barbarians at the Gate. After taking the company private, the private equity investors usually cut costs dramatically (including reductions in workforce) while heavily leveraging the company in order to fund huge dividends to the private equity investors. After some interim period of time, the private equity investors then take the company public again, reaping large returns on their leveraged investment. But most of the leveraged risk is borne by the portfolio company, whose assets are used to secure the debt which finances a large portion of the going-private transaction.
These going-private transactions can give rise to a number of D&O exposures, including the following:
1. Going Private/Acquired. The directors of a portfolio company which becomes privately held or is acquired can incur several types of liability exposures.
First, shareholders in the portfolio company can allege that the directors failed to disclose all material information regarding the company and the transaction. For example, shareholders may allege the directors failed to disclose information about the company’s future prospects, which would have resulted in a higher market valuation and buy-out price if that good news had been disclosed. This type of claim typically is in the form of a securities class action lawsuit and therefore any settlement in such a claim is likely to be indemnifiable by the company (i.e., potentially covered under “Side B” of a D&O policy).
Second, shareholders in the portfolio company can allege that the directors failed to adequately investigate, evaluate, negotiate and shop the proposed transaction. Even though the buy-out price is significantly above the market price for the company’s securities, courts have allowed shareholders to claim the price should have been even higher if the directors had performed their duties properly. This type of claim is usually brought directly by shareholders and seeks damages including a “bump up” in the price paid by the private equity investors for the portfolio company. A settlement in such a claim is usually indemnifiable since it is not a claim by or on behalf of the company, although as discussed below D&O insurers typically take the position any “bump up” is not covered loss under the D&O policy.
Third, shareholders in the portfolio company may allege that the private equity investors and their representatives who serve on the portfolio company’s board of directors breached their fiduciary duties and improperly used non-public and confidential information about the company in formulating and executing the transaction. These types of claim could be brought either as a shareholder derivative lawsuit (in which case a settlement or judgment is probably not indemnifiable, but would be potentially covered under “Side A” of a D&O policy) or a direct claim by shareholders (in which case the settlement or judgment probably would be indemnifiable and potentially covered under “Side B” of a D&O policy).
Fourth, directors and officers may be liable for breaching their fiduciary duties to shareholders and the company by exposing the company to excessive transactional costs or contractual liability arising out of the proposed transaction. For instance, the portfolio company frequently is permitted for a specific period to solicit “better” offers, but the portfolio company usually agrees to pay a large break-up fee if it accepts another offer. Such deals often also include a substantial termination fee if the buy-out is not finalized based on factors within the portfolio company’s control. A suit alleging waste in connection with that type of transaction or agreement would probably be derivative in nature, in which case any settlement or judgment would likely not be indemnifiable by the company and potentially covered under “Side A” of a D&O policy.
Fifth, directors and officers may face scrutiny and potential liability in connection with any purchases of portfolio company securities they make on the eve of the announcement of the transaction, as timing of such trades raises suspicion of improper insider trading.
Sixth and potentially most troubling, shareholders in the portfolio company could allege the directors and senior management breached their duty of loyalty by recommending the transaction based upon their own personal interests rather than the interests of the company. For example, shareholders may allege the directors and officers were motivated to recommend and approve an inadequately-priced buy-out to avoid accountability for past mistakes, to get indemnification from the deep-pocket equity investors, or to personally receive lucrative and long-term compensation packages. This type of claim could be brought either directly or derivatively, and may or may not be indemnifiable.
Going-private transactions instigated by private equity investors can also lead to surprising and unexpected liability exposures. For example, the U.S. Department of Justice is conducting an investigation into possible antitrust violations by numerous private equity firms in connection with their buyout of various publicly-held companies. In addition, in November 2006, a class action was filed in New York District Court on behalf of investors in dozens of going-private transactions against 13 private equity firms, accusing the defendants of antitrust violations. Both the Department of Justice investigation and the class action lawsuit arise out of allegations that the private equity firms “squeezed out” the public shareholders of the portfolio companies at artificially low values and that the various private equity firms collaborated in that scheme. To date, neither the investigation nor the class action is focused on directors and officers of the portfolio companies, although that is certainly a possible further development if evidence is discovered that some of those directors and officers knowingly participated in the alleged scheme.
2. Operating as Private Company. After the portfolio company becomes privately owned, traditional D&O exposures obviously decline dramatically, but potentially severe exposures remain. The risk of claims by outside investors is greatly reduced if not eliminated, thereby greatly reducing or eliminating the primary exposure faced by D&Os. However, the portfolio company will no longer be required to comply with various Sarbanes-Oxley provisions during that time period, which may weaken the internal governance practices of the company.
One of the most troubling exposures for D&Os of such a portfolio company is to creditors if the company enters the zone of insolvency. Insolvency of such portfolio companies is far from remote because the private equity investors frequently take money out of the company to help fund the acquisition costs. Creditors who are later harmed may allege the directors breached their fiduciary duties or otherwise committed wrongdoing by approving or allowing payments to the private equity investors to the detriment of the creditors. Conflicts of interest by the directors and officers when dealing with the investors are inherent and can lead to the appearance of wrongdoing.
3. Going Public. Typically, the private equity investors have an exit strategy following the acquisition of the portfolio company, pursuant to which the private equity investors hope to realize substantial profits. Most often, that exit strategy includes taking the portfolio company public again after some limited time as a private company. The subsequent going-public transaction can create significant D&O exposures. Like any public offering of securities, there is a significant risk that investors in the public offering will later allege that the company and its directors and officers misrepresented and/or omitted to disclose material information in connection with the offering. This exposure is particularly heightened in the context of the private equity investors’ exit strategy since those private equity investors typically will price the public offering very aggressively, thereby leaving little margin of error for the offering and increasing the likelihood that investors in the public offering will later be disappointed by a downturn in the stock price.
B. Large Ownership Interest
If the private equity investors do not purchase the entire company but only a large ownership (thus leaving the portfolio company a public company), the types of increased D&O exposures include the following:
1. Increased Shareholder Activism. Typically, the private equity investors will seek to become actively involved in the portfolio company’s strategic and management decisions. They frequently have a predetermined strategy to quickly drive an increase in the portfolio company’s stock price. To the extent directors and officers of the portfolio company disagree with or do not embrace that predetermined strategy, conflicts will obviously arise and the potential for litigation increases. Conversely, if the directors and officers adopt that predetermined strategy and if other investors believe that strategy is inconsistent with the long-term best interests of the portfolio company, the risk of claims by those other shareholders increases. These lawsuits could take the form of either a shareholder derivative suit (the settlement of which would probably not be indemnifiable and thus potentially covered under “Side A” of a D&O policy) or a direct shareholder claim (which should be fully indemnifiable and thus potentially covered under “Side B” of a D&O policy).
In any event, the private equity investors will likely monitor and scrutinize the performance of the portfolio company’s directors and officers much more aggressively than a typical investor. This increased scrutiny may in some instances lead to the discovery of wrongdoing which could serve as a basis for litigation, although the increased scrutiny could also reduce the risk of a scandal at the portfolio company since the directors and officers may be more careful and conservative in their behavior in light of the increased scrutiny.
2. Proxy Fights. The private equity investors frequently will seek to include on the portfolio company’s board of directors one or more representatives of the private equity investors. If the portfolio company or some of its other investors resist that attempt, a hostile proxy fight may ensue. Such a fight usually includes litigation against the portfolio company’s directors, seeking to either prohibit or require certain actions by those directors. Although that proxy litigation can be expensive to defend, typically there is little or no monetary settlement or judgment in that litigation. As a result, the financial exposure to directors and officers in proxy litigation is usually limited to indemnifiable defense costs.
3. Conflicts of Interest. If the private equity investors successfully place one or more of their representatives on the portfolio company’s board of directors, those constituent directors who were selected by the private equity investors may encounter difficult conflicts of interest and may attract criticism (or at least increased scrutiny) from other investors due to the private equity investors’ admittedly short term and self-serving interests. In addition, the constituent directors may participate in transactions by the private equity investors which allegedly violate the insider trading laws, thereby exposing themselves to claims at least in part arising out of their capacity as directors of the portfolio company.
These types of conflict of interest claims are most frequently asserted in shareholder derivative suits, and therefore any settlement or judgment amounts are probably not indemnifiable and thus potentially covered under “Side A” of a D&O policy.
C. D&O Loss Prevention Strategies
The following summarizes important guidelines for reducing liability exposures for D&Os of a portfolio company while evaluating, negotiating and approving a private equity buyout.
1. Independence. The directors and officers of the portfolio company who are analyzing, negotiating and approving a proposed private equity buyout should be completely independent of the proposed buyers. Usually, a committee of truly independent directors is formed to conduct the investigation and to make recommendations to the Board. That committee should retain independent legal counsel and other necessary experts and advisors. None of those persons and firms should have any past, existing or prospective relationship with the proposed buyers. If senior officers have or are expected to sign lucrative employment agreements with the private equity firm for continued management of the portfolio company after the buyout, those officers should not be involved in the Board’s consideration or negotiation of the buyout.
2. Fair Terms. The Board should document the process used to confirm that the buyout terms are fair and the best available under the circumstance. If at all possible, the Board should invite other prospective bidders so that there is a “market check” regarding the adequacy of the buyout terms. The Board should avoid committing to an absolute locked-up deal (without a so-called “fiduciary out”) prior to confirming the proposed deal is consistent with other potential deals. If the proposed buyer insists upon a termination fee, the Board should negotiate the lowest fee possible. In addition, the Board should avoid the appearance of preferring one bidder over another bidder, and should make available the same information and impose the same deadlines on all potential bidders.
3. Informed Decision. The Board should create a record demonstrating the directors carefully and thoroughly considered all relevant information regarding the proposed buyout and made an informed decision. For example, the Board should, among other things, (i) discuss the proposed buyout in numerous Board meetings and be closely advised regarding the status of the buyout negotiations and evaluations; (ii) receive and consider a formal opinion from a qualified investment banker regarding the fairness of the proposed terms; (iii) consider the portfolio company’s current and long-term prospects regarding business, operations, financial condition and earnings, as well as current and prospective general economic, market and industry environments; (iv) consider the proposed buyout terms relative to the current, historical and prospective stock market price for the portfolio company and other peer companies; (v) consider possible benefits from and detriments to the proposed buyout, including potential cost savings, reduced regulatory oversight and far fewer disclosure obligations; and (vi) obtain legal and other professional advice relating to the terms of the transaction, the transaction documents and compliance with the Board’s fiduciary duties.
4. Disclosures. The Board should seek advice from qualified legal counsel to avoid either premature or delinquent public disclosure of the buyout transaction. All public comments by or on behalf of the portfolio company should occur only through a designated spokesperson, who obtains the advice of qualified advisors before saying anything. Any communication obviously must be truthful and not misleading. In addition, disclosure of non-public information to a prospective buyer should be subject to a strict confidentiality agreement and all such disclosures by the company or any director, officer or employee of the company to a prospective bidder should be carefully controlled.
5. Business Operations. The Board should be careful not to allow the buyout investigation and discussions to interfere with business operations. The persons involved with the buyout proposal should be segregated from the management of the company’s daily operations so that neither important function is jeopardized by the other.
6. Financial Protection. Before the terms of the buyout transaction are finalized, advisors with expertise in D&O insurance and indemnification should be consulted to assure appropriate protections will exist following the transaction for former D&Os of the portfolio company. Typically, the portfolio company will purchase a long term, prepaid run-off D&O insurance policy which covers future claims against former D&Os for alleged wrongdoing prior to the buyout transaction. The terms and structure of that run-off insurance program can be complex, and general corporate counsel frequently lack the expertise to adequately identify and address many of those complicated issues.
D. D&O Coverage Issues
Depending upon the specific allegations in the claims summarized above, some of the D&O insurance coverage issues which could arise in these types of suits include the following:
· Capacity. The portfolio company directors who are serving as representatives of the private equity investors may be sued in their capacity as a portfolio company director or as a director/officer of the private equity investors or in both capacities. In many instances, it is difficult to distinguish between those two capacities, although coverage under the portfolio company D&O insurance program would apply only for wrongdoing in their capacity as directors of the portfolio company.
· Bump Up Amounts. In a claim by shareholders of the portfolio company seeking an increase or “bump-up” in the price paid by the private equity investors for the portfolio company, D&O insurers typically take the position that no coverage exists for the “bump-up” amount since such amount simply represents an increase in the purchase price paid by the private equity investors and/or should be allocated to the claims against the private equity investors (which are uninsured), and not allocated to the insured directors and officers.
· Insured v. Insured Exclusion. If the private equity investors bring a claim against the portfolio company’s directors and officers, the insured v. insured exclusion in most D&O policies may apply to that claim, depending upon the nature of the claim and the terms of the exclusion. For example, the representatives of the private equity investors who serve as directors of the portfolio company may participate or assist in the prosecution of that claim, in which case the exception in the insured v. insured exclusion for independently prosecuted derivative suits would not apply and the exclusion would apply. However, the much narrower insured v. insured exclusion in broad Side A policies such as the CODA Premier policy would likely not apply to this type of claim, thereby creating possible DIC coverage under the Side A policy.
· Indemnification Dispute. There is a reasonable potential for the representatives of the private equity investors who serve as directors of the portfolio company becoming antagonistic to the remaining directors and the management of the portfolio company. In the event a shareholder claim is asserted against those representatives, there is an increased potential that the other directors of the portfolio company will refuse to authorize indemnification for the claim against the private equity investors’ representatives. Conversely, the private equity investors who control the portfolio company may be inclined to deny proper indemnification requests from prior directors and officers. In those instances, the presumptive indemnification provision in the primary D&O policy could apply, which would require the defendant who is denied the indemnification to personally fund the large Side B retention under the primary D&O policy pursuant to the presumptive indemnification provision in that policy. A broad Side A DIC policy such as the CODA Premium policy would protect the defendant D&O in that situation by dropping down to fund the retention (subject to the Side A insurer’s subrogation rights against the portfolio company to enforce its indemnification obligation).
· Personal Profit/Remuneration Exclusion. If the senior management of the portfolio company allegedly received improper benefits or remuneration in connection with a going-private transaction, the personal profit and/or remuneration exclusions may be implicated depending on the trigger language in the exclusions.