Advising a Private Equity Fund

While most of the suggestions in this article are directed toward the fund's relationship with the portfolio company, the possibility that irreconcilable conflicts may arise is important to consider at the fund formation stage. Fund investors believe that the managers will manage the fund's affairs at all times consistent with their fiduciary duties to investors to maximize the fund's value. Many investors fail to consider the possibility that the fund managers could be duty-bound to manage the fund's portfolio companies in a manner beneficial to that company's creditors, rather than to the interests of the investors. In order to deal with the potential liability consequences of an investor's disappointed expectations in this regard, attorneys involved in the fund's formation should discuss with their clients including in the fund's offering statement a paragraph indicating that in the course of managing the fund's investments, fund managers may sit on the board of directors of portfolio companies and, in certain instances such as insolvency or near insolvency, will be duty-bound to exercise fiduciary duties for the benefit of creditors, the result of which is likely to be contrary to the interests of the fund's investors.

At the time the fund determines to make an investment in a particular company, it may wish to consider how best to structure its investment and role in the portfolio company to maximize its options and minimize its exposure to allegations of breaches of fiduciary duties in the event of insolvency. In this process, one should keep in mind that generally, creditors, both secured and unsecured, and holders of less than a majority of the voting stock of a corporation do not have fiduciary duties to either other shareholders or creditors. However, with a decrease in fiduciary duties owed to the corporation and its creditors comes a decrease in the control the fund can exercise over the company's actions. The balance between these two competing interests may vary with the investment.

In entering into a new investment, the fund should consider shaping its management and investment structures to balance these competing interests. If the portfolio entity is a corporation, the fund may wish to structure a portion of its investment as preferred stock. In turn, the holder of the preferred stock may be given the power to approve or disapprove certain corporate actions such as mergers, disposition of substantially all of the company's assets, or the filing of a bankruptcy case. Generally, except when a court finds undue control or influence, preferred shareholders do not owe fiduciary duties to a company's creditors. Thus, in a distress situation, the holders of the preferred stock can vote their interests, rather than those of a competing class of stakeholders. This preferred stock position could be in lieu of or in addition to a position on the company's board. Dual roles might result in an argument that the fund's representative on the board is not properly exercising his or her independent fiduciary duties if the fund can effectively negate the board members' actions through its preferred stock holdings. One way to address this concern is for the fund to not take a position on the board of early-stage ventures until the economic viability of the portfolio company has been established. In the meantime, rights to convert the preferred position into common stock along with the concomitant ability to appoint one or more members of the board would provide upside protection and control to the fund if the company is flourishing.

Appointing a Designee

If the fund does decide to appoint a designee to sit on the company's board of directors, the fund should insist that the certificate of incorporation contain all of the possible limitations of liability under the appropriate state law. For example, ' 102(b)(7) of the Delaware Corporation Code provides that the corporation's certificate of incorporation may include a provision that insulates its directors from a good faith breach of the duty of care. While there are some limitations on this waiver, and the waiver does not protect board members from breaches of their duty of loyalty, the waiver does provide an argument for extended protection of the director's actions. Although the certificate of incorporation is effectively a contract between the corporation and its shareholders, its reach was recently interpreted as extending to actions brought by creditors of the insolvent company. In Production Resources Group, LLC v. NCT Group, Inc., 863 A.2d 772 (Del. Ch. 2004), Delaware Court of Chancery held that since creditors' claims for breach of fiduciary duty are derivative in nature (they are based on the corporation's claims against its directors), a ' 102(b)(7) provision in a corporation's certificate will protect directors from suits brought by creditors based on a good faith breach of the duty of care. Of course, the directors should also ensure that the portfolio company provide directors and officers liability insurance when practicable.

Structuring for an LLC

If the structure of the portfolio entity is a limited liability company (LLC), rather than a corporation, possible structuring strategies can also be employed. Section 18-1102(c) of Delaware Corporation Code provides that a limited liability company agreement may restrict or eliminate all liabilities for breach of contract and breach of duties, including fiduciary duties, to persons that are parties to or otherwise bound by the LLC agreement, other than for bad faith violations of the implied contractual covenant of good faith and fair dealing. Based upon Production Resour-ces' determination that a creditor's claim for breach of fiduciary duty is derivative of that of the corporation's, a consistent interpretation of the rights of creditors against LLCs would result in the elimination of any liability for breach of fiduciary duties to creditors if the LLC's operating agreement restricts the manager's duties pursuant to ' 18-1102(e). While such a reading appears consistent with the Production Resources case, a court might not be willing to allow the organizers of the LLC to effectively eliminate creditor breach of duty claims. However, restricting the liability of managing members will likely lead to a better result for fund managers than if the operating agreement is silent on this point.

Additional Financing

When a portfolio company finds itself in financial distress, an area of particular concern to private equity fund managers is providing additional financing. The only thing worse than having to lend a portfolio company money to keep it operating is for that loan to later be re-characterized as an equity contribution, thus preventing the fund from foreclosing on the company's assets (assuming the loan is secured) and recouping some value for its ill-fated loan. Some pre-loan planning can help to improve the chances that the private equity fund will in fact have its loan treated as just that, a loan.

Virtually all attempts at re-characterizing debt as equity occur in the context of a bankruptcy proceeding. Many courts have held that an advance from a parent corporation or an existing controlling shareholder may be deemed a capital contribution if either the debtor was initially undercapitalized or the shareholder advances were made at a time when no other interested lender would have extended credit. Estes v. N & D Properties, Inc., 799 F.2nd 726 (11th Cir. 1986); In re Multiponics, Inc., 622 F.2nd 709 (5th Cir. 1980). Other courts have employed a multi-factor analysis of the specific loan transaction. See, eg, Bayer Corporation v. Masotech, Inc. (In re Autostyle Plastics, Inc.), 269 F.3D 726 (6th Cir. 2001). With no one factor being dispositive, these courts tend to analyze these factors on a case-by-case basis against the particular loan transaction.

The insider private equity fund should seek to satisfy as many of the factors in a manner to allow the court to determine that the particular transaction was in fact a loan. As to those factors that the lender cannot control, the lender should consider gathering the evidentiary support which may be necessary to defend the loan character of the transaction. The Autostyle factors and how they should be addressed to minimize the chances of re-characterization are indicated on the chart below.

One manner in which the private equity fund might consider loaning to a portfolio company is through a participation agreement with the existing senior lender. In circumstances where the credit line from the senior lender has either been fully exhausted, or more likely, covenants have been breached such that additional advances are no longer mandatory but discretionary, the private equity fund might well consider becoming a participant in the existing loan package. By advancing funds to the lender that the lender, in turn, will advance to the portfolio company under the terms of the existing senior loan agreement, the private equity investor can increase the likelihood that it will withstand a recharacterization attack and place its loan in an improved lien position. While the court in Autostyle chose not to re-characterize such a transaction, it nonetheless applied the above equity/debt multi-factor test, but found that none of the factors favored re-characterization. Often, the advance through the existing senior lender is done through a “last out participation,” where the lender's existing advances are repaid prior to advances made to the portfolio company by virtue of transfer to the lender by the insider.

Conclusion

While none of these safety nets will provide absolute protection, their use may limit some of the damage resulting from a misstep on the insider tightrope. Also, it should be remembered that every investment and all situations are different and require individual analysis. The example, and discussions in this article are illustrative. Other structure may be better suited in specific situations.

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As anyone who has advised a private equity fund in connection with the potential insolvency of one of its portfolio companies knows, reconciling the duty of the fund's designated directors sitting on the portfolio company's board with the fund's duties to its investors can feel like a high wire act at times. As fiduciaries for its investors, the fund's managers must act in a manner consistent with maximizing the return on invested funds. Yet, these same managers are often directors of the fund's portfolio companies. While a portfolio company is thriving, the duties to the fund's investors and the fund manager's duties as a director of the portfolio company are typically in harmony. However, when the portfolio company's business turns sour, and it approaches insolvency or is insolvent, the shifting of the directors' fiduciary duties to the company's creditors can cause irreconcilable conflicts of interest along with consternation on how to fund ongoing operations.

This article discusses possible structural mechanisms to address and potentially avoid these irreconcilable conflicts while still maintaining the ability to manage the fund's investment and fund the portfolio company's ongoing business. However, at the outset, it is necessary to address three important caveats: 1) the overwhelming majority of portfolio companies do not end up with their directors facing claims from the company's creditors and private equity funds should not base their structural decisions solely on this concern; 2) the law of fiduciary duties in connection with insolvent and near insolvent entities is continuing to evolve, is intensely fact-oriented and varies from jurisdiction to jurisdiction; and 3) the protections discussed in this article will be analyzed by courts in highly fact-sensitive and retrospective review and may not withstand scrutiny in each circumstance.

Fund Formation

While most of the suggestions in this article are directed toward the fund's relationship with the portfolio company, the possibility that irreconcilable conflicts may arise is important to consider at the fund formation stage. Fund investors believe that the managers will manage the fund's affairs at all times consistent with their fiduciary duties to investors to maximize the fund's value. Many investors fail to consider the possibility that the fund managers could be duty-bound to manage the fund's portfolio companies in a manner beneficial to that company's creditors, rather than to the interests of the investors. In order to deal with the potential liability consequences of an investor's disappointed expectations in this regard, attorneys involved in the fund's formation should discuss with their clients including in the fund's offering statement a paragraph indicating that in the course of managing the fund's investments, fund managers may sit on the board of directors of portfolio companies and, in certain instances such as insolvency or near insolvency, will be duty-bound to exercise fiduciary duties for the benefit of creditors, the result of which is likely to be contrary to the interests of the fund's investors.

At the time the fund determines to make an investment in a particular company, it may wish to consider how best to structure its investment and role in the portfolio company to maximize its options and minimize its exposure to allegations of breaches of fiduciary duties in the event of insolvency. In this process, one should keep in mind that generally, creditors, both secured and unsecured, and holders of less than a majority of the voting stock of a corporation do not have fiduciary duties to either other shareholders or creditors. However, with a decrease in fiduciary duties owed to the corporation and its creditors comes a decrease in the control the fund can exercise over the company's actions. The balance between these two competing interests may vary with the investment.

In entering into a new investment, the fund should consider shaping its management and investment structures to balance these competing interests. If the portfolio entity is a corporation, the fund may wish to structure a portion of its investment as preferred stock. In turn, the holder of the preferred stock may be given the power to approve or disapprove certain corporate actions such as mergers, disposition of substantially all of the company's assets, or the filing of a bankruptcy case. Generally, except when a court finds undue control or influence, preferred shareholders do not owe fiduciary duties to a company's creditors. Thus, in a distress situation, the holders of the preferred stock can vote their interests, rather than those of a competing class of stakeholders. This preferred stock position could be in lieu of or in addition to a position on the company's board. Dual roles might result in an argument that the fund's representative on the board is not properly exercising his or her independent fiduciary duties if the fund can effectively negate the board members' actions through its preferred stock holdings. One way to address this concern is for the fund to not take a position on the board of early-stage ventures until the economic viability of the portfolio company has been established. In the meantime, rights to convert the preferred position into common stock along with the concomitant ability to appoint one or more members of the board would provide upside protection and control to the fund if the company is flourishing.

Appointing a Designee

If the fund does decide to appoint a designee to sit on the company's board of directors, the fund should insist that the certificate of incorporation contain all of the possible limitations of liability under the appropriate state law. For example, ' 102(b)(7) of the Delaware Corporation Code provides that the corporation's certificate of incorporation may include a provision that insulates its directors from a good faith breach of the duty of care. While there are some limitations on this waiver, and the waiver does not protect board members from breaches of their duty of loyalty, the waiver does provide an argument for extended protection of the director's actions. Although the certificate of incorporation is effectively a contract between the corporation and its shareholders, its reach was recently interpreted as extending to actions brought by creditors of the insolvent company. In Production Resources Group, LLC v. NCT Group, Inc. , 863 A.2d 772 (Del. Ch. 2004), Delaware Court of Chancery held that since creditors' claims for breach of fiduciary duty are derivative in nature (they are based on the corporation's claims against its directors), a ' 102(b)(7) provision in a corporation's certificate will protect directors from suits brought by creditors based on a good faith breach of the duty of care. Of course, the directors should also ensure that the portfolio company provide directors and officers liability insurance when practicable.

Structuring for an LLC

If the structure of the portfolio entity is a limited liability company (LLC), rather than a corporation, possible structuring strategies can also be employed. Section 18-1102(c) of Delaware Corporation Code provides that a limited liability company agreement may restrict or eliminate all liabilities for breach of contract and breach of duties, including fiduciary duties, to persons that are parties to or otherwise bound by the LLC agreement, other than for bad faith violations of the implied contractual covenant of good faith and fair dealing. Based upon Production Resour-ces' determination that a creditor's claim for breach of fiduciary duty is derivative of that of the corporation's, a consistent interpretation of the rights of creditors against LLCs would result in the elimination of any liability for breach of fiduciary duties to creditors if the LLC's operating agreement restricts the manager's duties pursuant to ' 18-1102(e). While such a reading appears consistent with the Production Resources case, a court might not be willing to allow the organizers of the LLC to effectively eliminate creditor breach of duty claims. However, restricting the liability of managing members will likely lead to a better result for fund managers than if the operating agreement is silent on this point.

Additional Financing

When a portfolio company finds itself in financial distress, an area of particular concern to private equity fund managers is providing additional financing. The only thing worse than having to lend a portfolio company money to keep it operating is for that loan to later be re-characterized as an equity contribution, thus preventing the fund from foreclosing on the company's assets (assuming the loan is secured) and recouping some value for its ill-fated loan. Some pre-loan planning can help to improve the chances that the private equity fund will in fact have its loan treated as just that, a loan.

Virtually all attempts at re-characterizing debt as equity occur in the context of a bankruptcy proceeding. Many courts have held that an advance from a parent corporation or an existing controlling shareholder may be deemed a capital contribution if either the debtor was initially undercapitalized or the shareholder advances were made at a time when no other interested lender would have extended credit. Estes v. N & D Properties, Inc. , 799 F.2nd 726 (11th Cir. 1986); In re Multiponics, Inc., 622 F.2nd 709 (5th Cir. 1980). Other courts have employed a multi-factor analysis of the specific loan transaction. See, eg, Bayer Corporation v. Masotech, Inc. (In re Autostyle Plastics, Inc.), 269 F.3D 726 (6th Cir. 2001). With no one factor being dispositive, these courts tend to analyze these factors on a case-by-case basis against the particular loan transaction.

The insider private equity fund should seek to satisfy as many of the factors in a manner to allow the court to determine that the particular transaction was in fact a loan. As to those factors that the lender cannot control, the lender should consider gathering the evidentiary support which may be necessary to defend the loan character of the transaction. The Autostyle factors and how they should be addressed to minimize the chances of re-characterization are indicated on the chart below.

One manner in which the private equity fund might consider loaning to a portfolio company is through a participation agreement with the existing senior lender. In circumstances where the credit line from the senior lender has either been fully exhausted, or more likely, covenants have been breached such that additional advances are no longer mandatory but discretionary, the private equity fund might well consider becoming a participant in the existing loan package. By advancing funds to the lender that the lender, in turn, will advance to the portfolio company under the terms of the existing senior loan agreement, the private equity investor can increase the likelihood that it will withstand a recharacterization attack and place its loan in an improved lien position. While the court in Autostyle chose not to re-characterize such a transaction, it nonetheless applied the above equity/debt multi-factor test, but found that none of the factors favored re-characterization. Often, the advance through the existing senior lender is done through a “last out participation,” where the lender's existing advances are repaid prior to advances made to the portfolio company by virtue of transfer to the lender by the insider.

Conclusion

While none of these safety nets will provide absolute protection, their use may limit some of the damage resulting from a misstep on the insider tightrope. Also, it should be remembered that every investment and all situations are different and require individual analysis. The example, and discussions in this article are illustrative. Other structure may be better suited in specific situations.

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