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Weekly UpdatesWhen times are good, the goal of private equity professionals serving as directors of portfolio companies is relatively straightforward-maximization of value for the corporation's shareholders. Moreover, the interests of the two constituencies that the private equity professional serves--his private equity firm employer and the portfolio company's shareholders--are typically aligned as the private equity firm is usually the portfolio company's largest shareholder.
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When a portfolio company becomes insolvent, however, the legal standard by which the actions of a private equity professional serving on its board are judged may be materially more demanding. Private equity professionals serving as directors of portfolio companies during the current economic downturn should therefore understand the duties they owe to the stakeholders in the corporations they serve and the impact of the corporation's financial condition on these obligations.
Directors typically owe the corporation and its shareholders a duty of care and a duty of loyalty. The duty of care requires that directors exercise the degree of care that an ordinary and prudent person would use in similar circumstances. The duty of loyalty requires that directors act in good faith in the best interests of the corporation and its shareholders and that they not engage in self-dealing.
Challenges to directors' decisions are generally difficult to sustain because of the protection afforded to directors by the "business judgment rule." So long as directors are not "interested" in the matter before them, they benefit from the presumption that they acted on an informed basis, in good faith and in the honest belief that their decision was in the best interest of the corporation.
But the business judgment rule does not apply where it can be shown that a majority of the directors were either interested in a transaction--by, for example, standing on both sides of the transaction or expecting to derive a personal and substantial financial benefit therefrom--or lacked independence such that the decision was not based on the merits of the transaction. In these cases, the burden of proof shifts to the directors to show the "intrinsic fairness" of the transaction--that the actions of the board were both procedurally and substantively fair. A court's determination as to whether to apply the intrinsic fairness test, given the higher standard to which this test subjects a director's conduct, may dictate the outcome of a challenge to a board's decision and, at the very least, whether the challenge will survive a summary judgment motion.
What is intrinsic fairness?
Courts have held that there are two aspects to the intrinsic fairness test: fair dealing and fair price. Fair dealing focuses on the actual conduct of the directors in effecting the transaction, including how the transaction was initiated, structured and negotiated. Fair price relates to the economic and financial terms of the transaction, including a review of the value that an otherwise arm's-length transaction would provide. Courts focus on both elements of the test as part of an integrated analysis of all aspects of the transaction.
When a corporation is solvent, the directors only owe fiduciary duties to the corporation and its shareholders. Generally, creditors are entitled to only those contractual rights set forth in their financing or other agreements. However, once a corporation becomes insolvent, the directors' fiduciary duties run to an expanded constituency that encompasses not only the corporation and its shareholders but also the corporation's creditors. The assumption underlying this expansion is that once a corporation is insolvent, the residual value of the corporation may belong to the corporation's creditors and not its shareholders. This shift can have a significant impact on the application of the intrinsic fairness test, particularly with respect to closely held corporations such as portfolio companies.
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When the constituencies to which a director owes duties is expanded, the range of transactions in which a director may be "interested" may also grow. For example, a private equity sponsor employee who sits on the board of a solvent portfolio company generally owes fiduciary duties to the sponsor, as the controlling shareholder of the subsidiary, and may therefore approve transactions that are beneficial to the sponsor without concern that his decisions will be reviewed under the intrinsic fairness test, assuming that minority shareholders are treated fairly. However, once the portfolio company is insolvent, the director also owes duties to the creditors of the portfolio company, and the director's relationship with the sponsor may render him interested with respect to any transaction benefiting the private equity sponsor even in its capacity as a shareholder.
In fact, the Bankruptcy Court for the District of Delaware recently found that a Chapter 7 trustee had sufficiently alleged a breach of the duty of loyalty against a private equity sponsor, its counsel and the portfolio company's directors to survive a motion to dismiss. In In re The Brown Schools, et al, the trustee successfully argued that a series of otherwise unsurprising restructuring transactions that preceded the portfolio company's bankruptcy should be evaluated under the intrinsic fairness test because the defendants had engaged in self-dealing.
The alleged self-dealing included the payment of certain advisory fees to the private equity sponsor and a grant of junior liens to secure loans the private equity sponsor previously made to the portfolio company. In so holding, the Bankruptcy Court turned what appeared to be a relatively standard duty of care case (reviewed under the deferential business judgment standard) into a duty of loyalty case (reviewed under the more rigorous intrinsic fairness standard). It is important to note that in tendering the Brown Schools decision, the Bankruptcy Court was required to accept the trustee's factual allegations as true and was precluded from considering defenses that the defendants might assert. However, the decision is nonetheless cause for caution.
What should directors do?
Given that an increasing number of corporations are or may be facing insolvency, the primary goal for the directors of any corporation should be the preservation of the protection afforded by the business judgment rule. To achieve this, a private equity sponsor should consider ensuring that at least two independent and disinterested directors sit on its portfolio company's board of directors and may even wish to constitute a special committee of disinterested directors to deliberate on matters that raise conflict issues for other directors. Where disinterested directors serve on the portfolio company's board, it is essential that these directors are fully informed concerning the transactions before the board and the private equity sponsor's interests in the transactions and participate meaningfully in the decision-making process. Finally, these actions should be reflected in the records of the board's deliberations.
If the board does not have independent directors, the sponsor and its portfolio company should assume that board decisions impacting the sponsor will be reviewed under the more demanding intrinsic fairness test and consider how best to structure board deliberations in that light. How frequently and when should the board meet? What advisors should be retained? What input should be provided by these advisors? What records should be kept of the board's deliberations?
Private equity professionals serving as directors of portfolio companies will want to be mindful that the current downturn may create complexities in fulfilling their legal obligations that are not present in a more favorable economic environment. Generally, the structure of board deliberations should be carefully managed to avert unanticipated challenges to the process and the result.
Richard F. Hahn and Jasmine Powers are partners and Jessica Katz is an associate in the New York office of Debevoise & Plimpton LLP. A version of this article originally appeared in the Winter issue of the Debevoise & Plimpton Private Equity Report.
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