• Economic Turmoil Creates Litigation Risk for Private Equity Families
  • January 12, 2009 | Authors: Ann B. Laupheimer; Lawrence F. Flick; Alan L. Zeiger; Elizabeth A. Wilburn
  • Law Firms: Blank Rome LLP - Philadelphia Office; Blank Rome LLP - Wilmington Office
  • The significant downturn in the economy and the simultaneous credit crisis occurring in the United States follows an unprecedented period of private equity activity. Much of the debt associated with the wave of private equity acquisitions will come due smack in the midst of the current credit tightening. Refinancing may prove difficult or impossible. The convergence of these two trends gives rise to an obvious risk of instability and bankruptcy for the companies in which private equity firms invested. Indeed, big private equity players such as Apollo, Cerberus Capital Management and Sun Capital Partners have already seen bankruptcies of buyout targets Linens ‘n Things and Mervyns and this scenario unfortunately may repeat itself as the economic slowdown seeps through the real economy. The December 6 Wall Street Journal reported on the hardship of laid off employees in the wake of the bankruptcy of private equity-owned Archway Cookie.

    As night follows day, bankruptcy of a private equity portfolio company inevitably encourages “blame game” litigation, as the bankruptcy trustee on behalf of, or in addition to trade creditors, lenders and private equity firm investors hunt for the culprits they presume structured the deals in such a way as to burden the companies with excessive debt obligations in comparison to their assets, while simultaneously walking away with what may be perceived to be massive profits.

    Creditors and bankruptcy trustees can be expected to raise theories of liability evocative of those unsuccessfully advanced in VFB LLC v. Campbell Soup Co., 482 F.3d 624 (3d Cir. 2007), where the creditors of Vlasic Foods asserted that when Campbell spun off Vlasic, it assigned excessive debt obligations to Vlasic in proportion to its “value,” thereby rendering it insolvent. In 1996, Campbell decided to dispose of certain underperforming subsidiaries and product lines, the largest and most prominent of the lot being Vlasic, of pickle fame, and Swanson, the TV dinner manufacturer. The transaction was structured as a “leveraged spin.” As the Court of Appeals explained, “Campbell would incorporate a new wholly-owned subsidiary and the subsidiary would take on bank debt in order to purchase the Division. Then Campbell would give the stock in the subsidiary to Campbell shareholders as an in-kind dividend. Campbell would remove underperforming businesses from its balance sheet and get cash; Campbell shareholders would own roughly the same assets as before, albeit in different corporate packages.” Id. at 627. Vlasic paid $500 million for the assets assigned to it, and a lengthy trial took place as to whether those assets were worth the $500 million price. While Campbell ultimately prevailed, and the Court concluded that the Vlasic Division was worth in excess of $500 million, the proceeding was long and expensive.

    To date, litigation in this vein has been quite sparse. In one recent decision, Brandt v. Trivest II, Inc. (In re Plassein Int’l Corp.), 2008 Bankr. LEXIS 1473 (Bankr. Del. 2008), the Bankruptcy Court in Delaware refused to dismiss a claim that the fees charged in an LBO transaction, combined with the other terms of the transaction, were fraudulent transfers with little or nothing given in return, leaving the entities with unreasonable small capital. In July of this year, Ford Motor Company sued private equity firm Angelo, Gordon & Company L.P. and its fund Drive America Holdings, Inc. under a fraudulent transfer theory alleging that Angelo Gordon bought out a cash-rich entity and then systematically drained it of cash rendering it unable to pay its obligations. Shortly thereafter, in September 2008, Mervyn’s department store, in Chapter 11 Bankruptcy proceedings, sued a consortium of private equity entities, including Lubert-Adler, Cerberus and Sun Capital entities, alleging fraudulent transfers. The Complaint alleges that:

    “[v]aluable real estate assets—owned store locations and below-market leases—were stripped out of Mervyn’s and used to finance the leveraged buyout of Mervyn’s” with “[h]undreds of millions of dollars of loans” “made against those real estate assets,” and “none of the proceeds going to Mervyn’s.”

    Needless to say, it is not difficult to imagine the contours of a claim in this area under a variety of business tort, bankruptcy or even federal RICO theories. The suit may allege that the fund manager, the fund and some or all of its officers and directors, structured the private equity transactions in such a way that the portfolio company was insolvent or likely to become insolvent in all but the rosiest scenarios. Perhaps such a suit would include an allegation that in order to maximize the profit of the fund manager, the transaction terms were based on intentionally biased projections, which failed to account for reasonably likely unfavorable economic conditions.

    While we can hypothesize about likely claims, we can just as easily imagine many solid defenses, including the sophistication of the senior lenders and their ability to understand the financial performance of the target entity, the business judgment rule protection for directors and the likely contractual limitation of liability terms in various documents. One thing is certain, however, the process will be costly, win or lose.

    Because private equity investments in portfolio companies often entail a series of interlocking officers, directors and managers in the fund manager, the investment fund vehicles and the downstream portfolio companies, suits in this area raise important questions about corporate indemnification, advancement of defense costs and directors and officers insurance.

    Imagine the hypothetical situation where an executive of a fund manager sits on the board or advisory board of a fund organized to make an equity investment in a portfolio company. The fund purchases a controlling interest in a portfolio company and requests that the executive sit on the board of that company as well. Thereafter, the fund, through its controlling interest of the Board, causes the portfolio company to incur a significant amount of debt and to issue a dividend to the fund, based upon assumptions as to the future performance of the portfolio company. The company fails to live up to expectations, the economic downturn hits it hard and the company declares bankruptcy. Thereafter, the creditors of the portfolio company sue its directors, the fund, the funds advisory board and the fund manager and its executives.

    As the shared executive in the above hypothetical, your first question will be “who is paying my lawyer?” As a fund manager, you might ask “do I have any obligation to pay the fees of the directors of the portfolio company?”

    In a less complicated set of facts, the answer is usually simple. Following the dictates of the bylaws or the Articles of Incorporation, the company pays the fees of its officers and directors and then seeks reimbursement from its directors and officers insurance policy. But what happens when there is a more complicated structure and a loaned executive on multiple boards?

    Corporate Indemnification and Advancement of Defense Costs

    The obligation for “the company” to pay for the defense of its officers and directors ordinarily stems from its governing corporate documents (Bylaws, Articles of Incorporation, LLC Agreements, Partnership Agreements). These documents, whether they relate to a corporation, limited liability corporation (LLC), limited partnership or general partnership, invariably include an obligation by the entity to indemnify the officers and directors for losses, including both defense costs, settlements, judgments or fines arising out of claims against him or her by reason of his service as an officer or director. The laws of various states, and in particular Delaware, where many organizations are domiciled, encourage and permit such indemnification in all but the most egregious circumstances of fraud or bad faith. 8 Del. C. § 145. The Delaware legislature and courts have reasoned that it is in the public interest to have corporate officials resist what they perceive to be unjustified suits and claims, and to “encourage capable men [and women] to serve as corporate directors” secure in the knowledge that their fees will be paid. See Stifel Fin. Corp. v. Cochran, 809 A.2d 555, 561 (Del. 2002); 8 Del. C. § 102(b)(7).

    While virtually every business entity with organizational documents provides for indemnification of officers and directors, firms should, but do not always, include an explicit obligation that the defense costs be “advanced” by the firm as incurred. The two concepts are related; indemnification means the corporation must reimburse or pay the officer’s litigation expenses; “advancement” means the corporation must pay them up front. For the individual facing the prospect of continuing, costly bills from expensive (but highly talented) lawyers, the “advancement” piece is of critical importance. Under Delaware law, organizational documents must make the duty to advance explicit; such a duty will not necessarily be presumed from the use of the term “indemnify.” See Advanced Mining Sys. v. Fricke, 623 A.2d 82 (Del. Ch. 1992); VonFeldt v. Stifel Fin. Corp., 714 A,2d 79 (Del. 1998).

    It can be expected, therefore, that any individual named in the hypothetical suit will be entitled to indemnification for expenses and loss from one or more of the organizations in the corporate family and may also be entitled to advancement of those expenses. But from which firm will that indemnification come and can the fund require the indemnification come from the portfolio company? Is there a hierarchy that can be assumed? Can the fund take for granted that its responsibility will be at most secondary and required only if money is unavailable from the operating portfolio company and its insurance?

    Recent decisions from the Delaware Court of Chancery—where most corporate issues such as this are decided—suggest that private equity organizations can make no such safe assumptions. Rather, all firms should pay attention to this issue in advance and make sure that the governing documents of the entire private equity corporate family clearly state which entity is the “primary” indemnitor and which is the secondary indemnitor where there exist overlapping indemnification obligations. In Levy v. HLI Operating Company, Inc., 924 A.2d 210 (Del. Ch. 2007), Vice Chancellor Lamb addressed the situation where a litigant was owed complete indemnification by multiple entities. There, a private equity limited partnership fund manager, which was a 34% owner of a portfolio company, had designated certain of its representatives to sit on the board of the portfolio company. The portfolio company failed and declared bankruptcy. The representatives were sued in a securities fraud action stemming from their service on the board of the portfolio company. Both the fund manager’s limited partnership agreement and the portfolio company’s bylaws furnished complete indemnification to these representatives. Vice Chancellor Lamb concluded that in this situation, absent any specific hierarchy and co-equal obligations, the fund manager and the portfolio company had rights of contribution and should equally share the indemnity obligation. In another recent case, Sodano v. American Stock Exchange, 2008 WL 2738583 (Del. Ch. July 15, 2008), Vice Chancellor Strine reiterated that in the absence of documents evidencing a hierarchy of indemnity obligations, all indemnitors share the responsibility equally and may recover overpayments from each other.1

    In our experience, private equity corporate documents seldom contain the appropriate language to accomplish the desired result. Model bylaws and articles of incorporation and those typically used throughout the legal world, mirror each other and provide for complete indemnification, with no exception where an indemnitee can draw from multiple sources of indemnification. While the courts have thankfully stopped short of permitting double recovery, that is all the court will do. If the intent is to have primary responsibility rest with the portfolio entity, the corporate documents must explicitly so provide. We recommend a thorough review by your attorneys of bylaws, articles or agreements. These documents can be swiftly amended to make sure the appropriate entity bears the responsibility to defend and indemnify its officers and directors in suits relating to that entity’s business. While amendments are being considered, ensure that the indemnification provision includes an explicit duty to advance litigation expenses.

    Waiting entails risk. Were a lawsuit filed against an executive, a court might well determine that the indemnification provisions in effect at the time the executive begins to incur expenses would apply even if a later amendment were attempted.

    Directors and Officers Insurance

    In the same fashion that the corporate documents of the members of a private equity “family” of entities may not adequately address the allocation of indemnification obligations, the insurance programs covering the family may likewise not explicitly reflect the intent of the parties. Private equity firms ordinarily do not employ risk managers and frequently do not even have general counsel. Their choice of insurance carrier and coverage often stems from relationships with brokers and does not get the attention it deserves. Moreover, portfolio companies purchased by private equity firms arrive with their own directors and officers coverage. In our experience, little attention is paid to this important risk of ownership and control. We recommend that private equity firms comprehensively address insurance needs. Because suits involving directors and officers hit the firms hard in terms of dollars and management attention, with particular emphasis on directors and officers and errors and omissions insurance.

    A variety of carriers offer policies in the private equity market, including AIG, Hartford, CNA and Zurich. However, the forms often do not fit the particulars of complicated private equity structures and the coverage for the various levels—parent, fund and operating company—are seldom designed to fit together. Specific changes to the form policies can and must be negotiated to fit the needs of each private equity firm. In our experience, fund managers assume that a lawsuit such as the hypothetical above would, in the first instance, be covered by the stand alone directors and officers insurance issued to the portfolio company and its officers and directors. Only if the insurance is exhausted or provides no coverage to the shared/ loaned executive would the fund or fund manager expect the executive to be permitted to turn to the policy covering the executive in his or her capacity as an executive of the fund manager or the fund.

    While language exists or can be crafted that will accomplish the desired result, it behooves each private equity family to have their insurance program reviewed to make sure the policies include the appropriate, clear language. The policy should explicitly state that the fund manager’s policy will not respond except under the specified conditions of exhaustion or unavailability of the policy of the portfolio company. If the language is not included in the policy, courts construe policies in favor of the insured and coverage. Exclusions and carve outs are narrowly construed.


    In this dynamic environment, the risks inherent in the private equity structure, especially with respect to executive indemnification and insurance coverage, deserve careful attention.



    1. In Sedano, the Court found that the documents showed the parties intended one indemnitor to be primary and one secondary and therefore on the facts of that case rejected any contribution by one to the other.