Wednesday, August 30, 2006

Hedge Fund Hardball and D & O Risk

In a prior post (here), The D & O Diary commented on "Private Money and D & O Risk," noting the heightened potential for disputes to arise when the new "power players" (private equity funds, hedge funds, and buyout firms) have interests that conflict with those of management, other investors or creditors. An August 29, 2006 article in The Wall Street Journal (here, registration required) entitled "Hedge Funds Play Hardball with Firms Filing Late Financials" presents a particularly vivid example of the problems these conflicts of interest can create.

The article discusses the "new game of hardball" that hedge funds are playing with the companies in which they invest when the companies fail to file quarterly reports on time; the hedge funds are demanding immediate payment of debt or extracting substantial fees. This problem has been exacerbated recently as numerous companies have delayed filings as they deal with the accounting issues arising from options backdating problems. The Journal reports that of the 138 companies with market capitalizations over $75 that filed late second quarter financial reports, 48 companies blames options investigations. (The number of companies filing late apparently is a record, according to other news reports.)

In the past, bondholders would work with company management facing delayed reporting issues to let them work out their problems. This past forbearance was in part a result of a tacit agreement between bond investors that they would not force a problem that could trigger an acceleration of all of the company’s debt, potentially forcing the company into bankruptcy. Hedge fund investors, aiming to produce outsized returns for their investors if they can force a company to redeem its bonds (which the hedge funds purchased at a discount) at their face value. In the last 18 months, at least 25 companies have had their bonds accelerated this way or were forced to pay multimillion dollar fees to bondholders.

In at least one case cited in the article, this kind of dispute has led to litigation. The article reports that a trustee representing BearingPoint bondholders filed an a lawsuit against the company claiming that it was in default on two bond issues because it missed an SEC filing deadline due to accounting issues. BearingPoint's 8-K describing the litigation can be found here.

While the BearingPoint lawsuit was filed against the company itself, the threat of litigation surrounding these issues, as well as the larger threat of bankruptcy looming in the background, underscore the potential D & O risk these circumstances present. The conflicting interests between a company and its investors creates an environment where accusations of wrongdoing can more easily arise.

An August 30, 2006 post on CFO.com entitled "Backdating Sparks Bond Battle," (here) provides a detailed description of the actions that UnitedHealth Group's bondholders have taken, and the company's response, based upon the company's delayed second quarter SEC filing.

Delaware Court Rejects "Deepening Insolvency" Tort: The threat of bankruptcy arising from debt acceleration includes the threat of claims against the bankrupt companies' directors and officers. One bankruptcy related claim that has gained some currency in recent years is the allegation that the Ds & Os acted improperly while the company was in the "zone of insolvency" or that they were responsible for "deepening insolvency." While there is a body of case law supporting claims based on this legal theory, an August 10, 2006 decision (here) by Delaware Court of Chancery Vice Chancellor Leo Strine rejected deepening insolvency as an independent cause of action. Chancellor Strine stated that adoption of the this legal theory would "fundamentally transform Delaware law" by imposing liability on a board of directors who, "acting with due diligence and good faith, pursue business strategy that it believes will increase the corporation’s value, but that also involves the incurrence of additional debt." Rather, the board’s conduct should be evaluated based on "the traditional fiduciary duty rule," under which the fact of insolvency is a contextual consideration to be taken into account when evaluating the board’s conduct. The board would also be entitled to the protection of the business judgment rule.

Special thanks to alert reader Robert Benjamin for the link to the Court of Chancery decision.

William Smith and David Topol of the Wiley Rein law firm have written a good brief summary of the Court of Chancery opinion, here. Francis G. X. Pileggi has an interesting post (here) on his Delaware Corporate and Commercial Law blog rounding up the commentary in the blogosphere about the decision.

The August 2006 issue of CFO Magazine has an interesting article entitled "Delaware Rules," (here) discussing the role of the Delaware Court of Chancery in the evolving world of corporate governance. The article has interesting background about the Court, the chancellors, the important decisions that have become before the Court in the past, and the issues that will likely come before the Court in the future.

Lawyers, Boards and Options: Law.com has an August 30, 2006 post (here) entitled "Sonsini on Boards of Several Companies With Dubious Stock Awards." The article delivers less than the title implies, but it is still interesting.

Thanks to Adam Savett of the Lies, Damn Lies blog for the Law.com link (and for the link to the article on the Delaware Corporate and Commercial Litigation blog).

Chart of the Day: A scary look at what has happened to home values over the last few years, here. This looks a lot like the "before" view of the NASDAQ composite index chart (here), circa March 2000. If the "after" version of the home values chart has as steep a decline as the incline, we could be in for a very rough ride. A brief, interesting discussion of how a housing slump could affect the economy can be found here.

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