Tuesday, August 08, 2006

Private Money and D & O Risk

The Wall Street Journal’s recent series on "Private Money" describes the "new financial order" arising from "the new rules of private equity game." According to the July 25, 2006 Journal article (subscription required) entitled "Cash Machine: In Today’s Buyouts, Payday is Never Far Away," the new power players are private financiers – hedge funds, buyout firms and venture capital firms highly skilled at quickly extracting cash from the firms they acquire. The private financiers collect dividends, fees for advising, and fees for stock underwriting and management. The magnitude of the cash hauled out can be stunning; the article describes the $22 million in professional fees and $448 million in dividends that the private investors pulled out of Burger King prior to its May 2006 IPO.

The article describes the sequence of events involving Dade Behring, Inc, a medical diagnosis company that found itself saddled with enormous debt that was incurred to buy out private investors’ equity stake. Eventually the debt burden drove the company to the brink of bankruptcy. Creditors formed a committee to examine the conduct of Dade Behring’s "owners, directors and advisors." The creditors considered bringing claims relating to "illegal dividends, illegal stock redemptions and impairment of capital." (The company later recovered and subsequently went public.)

Although the Dade Behring creditors ultimately did not bring a claim, the example provides a cautionary tale for those who must assess the potential risk of D & O claims arising under the new rules of the private equity game. The presence on company boards of representatives of the new power players whose interests may conflict with the interests of the company, other investors, or creditors, creates an environment where accusations of wrongdoing may more easily arise. These same risks are present even if the private equity investors do not have company representation; the board’s actions for the benefit of private equity investors could draw criticism of the board even if the investors do not have board representation. This risk could be particularly applicable where a debt-saddled company is driven into bankruptcy. Creditors may claim they are owed special duties while the company was in the "zone of insolvency." These claimants may assert that the private investors extraction of dividends, management fees, or equity buy-outs, represent a form of "looting" or "waste" or a violation of other legal duties, and that the other directors violated their duty of care for permitting these actions.

While the significance of private funding in the world of corporate finance has long been recognized, the Wall Street Journal series reflects a growing realization that the increasing influence of private funding has its consequences. Among those consequences is a potentially growing possibility of conflicting interests that could trigger D & O claims.

Crafting the appropriate insurance response when these risks are present requires a skilled hand. The presence of differing potential interests, and differing insurable interests, creates problems of program structure and of content. In terms of policy wordings, the formulation of the Insured versus Insured exclusion present particular potential concern. Policy definitions, particularly the definition of "Loss," as well as the conduct exclusions, also could be particularly important, as would common endorsements such as a Major Shareholder exclusion.

Zone of Insolvency: Stephen Bainbridge, UCLA Law Professor and author of the ProfessorBainbridge.com blog, has written an interesting paper examining (and questioning) the duties of directors of companies that are in the "zone of insolvency." The paper may be found here.

The One Sin Greater Than Plague or Death: In our time, we are comfortable thinking about issues such as debt or bankruptcy as strictly practical or legal concerns. But in an earlier times, debt was a moral issue. This is starkly illustrated in Henry Knighton's contemporaneous account of the Black Death in England; Knighton reports that "the Bishop of London sent word throughout his whole diocese giving general power to each and every priest...to hear confessions and to give absolution to all persons with full episcopal authority, except only in case of debt. In this case, the debtor was to pay the debt, if he was able while he lived, or others were to fulfill his obligations from his property after his death." Knighton's report appears in Eyewitness to History, a fascinating 1988 compilation of first-hand accounts of historical events, edited by John Carey.

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