More About MBOs and D & O Risk

The D & O Diary has written on several prior occasions (here, here and here) about the increasing D & O risk arising from the public company involvement of private fund investors, such as private equity funds, hedge funds and buy-out firms. In a prior post (here), The D & O Diary discussed the increased complexity arising from the involvement of public company management in private investors' take overs, in the form of "management buy outs"(MBOs). In a September 8, 2006 article entitled “In Some Deals, Executives Get a Double Payday,” (here, subscription required) the Wall Street Journal focused on the conflicts of interests that can arise when management becomes involved in “going private” buy-outs of public companies; the article noted that private-equity firms will team up with management to improve their take-over bid, and that the private investors sweeten the deal by providing management with significant financial inducements:

In such cases, management with all its detailed knowledge of the company, goes from being a seller striving for a higher price to being a buyer looking for an attractive price. Usually the sale of a public company involves an auction or a competitive-bidding process. But when management joins private-equity buyers, there often isn’t such an open procedure, and the process is especially fraught with potential conflicts of interest.

The Journal article emphasizes that the conflict is all the more abrupt when private investors offer management lucrative compensation packages that could permit management to benefit significantly if the buy-out is successful. The compensation can involve ownership participation and substantial performance bonuses.

While many boards actively review the takeover proposals, the take-over bidder will also attempt to skew the process in their favor, for example by telescoping the period where the bid remains open, forcing potential rival bidders to act on short notice. Potential bidders (who do not enjoy the support of management, but who may present a proposal that is more to shareholders’ benefit) also may face a prohibitively high “break up” fee to try to get rid of the original bidder.

As may be expected, shareholders “sometimes revolt against such largess” as company management stands to gain in the buy-out transaction. The article cites the lawsuit Petco Animal Supplies shareholders filed in August 2006 against the company’s directors based on the directors' “attempts to provide certain insiders and directors with preferential treatment in connection with their efforts to complete the sale of Petco” to private equity investors. A more detailed description of the Petco transaction, including the company's decision to go with the management led bid even though the rival bidder offered shareholders a 13.3% higher proposal, and including a more detailed description of the lawsuits (and the substantial benefits that management stands to gain if the original bidder successfully completes its buyout), can be found here.

As The D & O Diary previously has noted, the increasing involvement of private financing in public company ownership creates an environment where conflicts of interest -- and accusations of wrongdoing -- can more easily arise. These claims possibilities also present an enormously complicated D & O exposure environment. These considerations also make it more important than ever for companies to involve knowledgeable and experienced insurance professionals in their D & O insurance acquisition.