Tuesday, September 05, 2006

MBOs: Another Example of Private Funding and D & O Risk

The D & O Diary has previously written (here and here) about the problems and conflicts of interests that can arise from the involvement of private fund investors (private equity firms, hedge funds and buyout firms) in publicly traded companies. In a September 3, 2006 column in the New York Times (here, registration required) entitled “On Buyouts, There Ought to Be a Law,” investment pundit and humorist Ben Stein explores yet another example of the risks arising from private financing. Stein decries the evils of management buyouts (MBOs), or “going private” deals. Stein’s view is sharp and specific; he says that “these deals ought to be illegal on their face. That is, they should simply not be allowed as a matter of law.”

Stein is concerned about leveraged buyouts of publicly traded companies involving senior members of the management team. His primary objection is that insiders will use their inside knowledge to buy the company from public shareholders on the cheap. He also is concerned that insiders may propose to buyout lenders or other investors business plans (and investment returns) that are undisclosed to public shareholders.

Stein’s concerns are legitimate, and they vividly illustrate the conflicts of interest that can arise in an MBO. However, his draconian solution to prohibit management buyouts is not the best solution from the perspective of the shareholders. There may well be times when a company may operate more efficiently as a private company (indeed, in this post Sarbanes-Oxley era, an increasing number of companies may be reaching that conclusion); and there may be times when the management’s buyout proposal is the best available alternative for shareholders. The problems arise not from the MBO itself, but when the information from which shareholders might make an informed decision about their best interest is withheld. The solution to Stein’s concerns is not to outlaw transactions that may make economic sense in some situations; the solution is to make sure that these kinds of transactions only go forward with adequate disclosure and shareholder protections.

The D & O Diary (which is influenced by the comments of Professor Dale Oesterle of the Business Law Prof blog, here) believes the perferred approach would be to require the would-be MBO participants to disclose their reasons for taking the company private, and the reasons why a private company rather than a publicly traded company should carry out their plans. In addition, management should be required to disclose their calculations for profit from the transaction (an indispensable element in determine whether the buyout valuation is fair). Finally, no management led buyout should go forward without the opportunity for an auction process (following the previously identified disclosures), to ensure that shareholders are getting the best possible price.

In any event, MBO transactions represent yet another example where the increasing influence of private investors in public company finance has the potential to create conflicts of interest that could generate disputes and trigger D & O claims. The possibility of shareholder claims against senior management who are pursuing an MBO presents particularly complex D & O issues, since the acquirers would not be acting in their “insured capacity” as directors and officers of the company. But to the extent that the claims allege wrongdoing in their capacity as directors and officers, their D & O policies would be triggered. As the D & O Diary has previously noted, it takes a particularly skilled hand to craft D & O coverages in light of the complex challenges arising from the increasing involvement of private money in public company financing.

Professor Larry Ribstein has a post (here) on his Ideoblog that is highly critical of Stein’s column.

Thanks to alert reader Marty Perry for the link to the Stein column.

Priceless: A perfect hangover cure, here.

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