Private equity funds are inherently optimistic—it comes with the territory. From the sponsor’s perspective, industry or operational expertise should enable a portfolio company to meet or exceed financial projections. However, not every investment is profitable. Indeed, a recent study found that nearly three-quarters of restructuring professionals believe that the default rate for a portfolio company is the same or higher than the default rate for a publicly-traded company in the same industry.
Aside from the obvious financial impact that these bankruptcies have on sponsors, there are attendant risks related to fiduciary obligations of officers and directors. Specifically, bankruptcy filings and general financial distress create an environment ripe for breach of fiduciary duty claims as out-of-the-money investors look to mitigate losses (and consider litigation to leverage a more favorable return). Given that sponsors typically appoint one or more board members for portfolio companies, these sponsors and their appointed directors must be keenly aware of directors’ fiduciary obligations and potential strategies for mitigating risk. These strategies may include:
- Evaluating and understanding the fiduciary duties that sponsor-appointed directors owe to portfolio companies and the fiduciary duties appointed directors may owe to the sponsor’s investors.
- Monitoring the financial health of portfolio companies and taking prophylactic measures at the first sign of distress.
- Diversifying the portfolio company’s board composition, forming subcommittees, maintaining corporate governance formalities, and retaining independent professionals to provide support through periods of financial distress.
- Reviewing the portfolio company’s D&O insurance policies to ensure that directors are sufficiently protected.
Implementing these strategies will allow a private equity fund and its appointed directors to better assess portfolio company needs and navigate potential conflicts between competing fiduciary obligations.
Understanding Fiduciary Duties
Absent distress, directors owe two fiduciary duties to the company and its shareholders: a duty to act on a reasonably informed basis (duty of care) and a duty to act in the best interests of the company (duty of loyalty). When a company is insolvent, these duties also extend to creditors. An appointed director’s role at the fund level may also give rise to fiduciary duties to the fund’s investors. These fiduciary duties may arise where an appointed director also manages or participates in the fund’s investment strategy with respect to the portfolio company. Thus, an appointed director should be mindful of his or her duties to both constituencies—fund investors and shareholders of the portfolio company—and make decisions in the best interests of the constituency with an interest at stake.
When a portfolio company is performing well, the duties an appointed director owes to fund investors and to shareholders of the portfolio company are generally aligned. However, if the portfolio company becomes insolvent, the duties may be in conflict, particularly with respect to duties that now extend to creditors (as opposed to just the company and its shareholders). Accordingly, private equity funds and appointed directors must be cognizant of the fiduciary duties owed by appointed directors and take steps to ensure no that fiduciary duties are breached. Actions to consider may include:
- Relieving an appointed director of any involvement with the sponsor’s decisions regarding the portfolio company and appointing separate fund-level employees to monitor the portfolio company and act in the fund’s best interests.
- Maintaining proper procedures regarding corporate governance of the portfolio company, including maintaining detailed, accurate minutes of board meetings, and timely dissemination of materials to be discussed at meetings.
- Disclosing potential conflicts involving an appointed director that may arise and having appointed directors recuse themselves from discussions relating to the sponsor.
Monitoring Financial Health
Monitoring the financial health of and strategic alternatives available to a portfolio company is a critical step to navigating financial distress. Spotting financial issues early provides a longer runway to identify and implement a solution. In turn, early detection allows for greater flexibility in pursuing strategic alternatives.
It is difficult to fashion a uniform approach to monitoring financial performance across industries. Yet, it is largely unnecessary. Many sponsors and directors specialize in a particular industry and are familiar with the early warning signs. Once these warning signs are identified, it is imperative that the sponsor and portfolio company review the company’s projections to make sure that the portfolio company is prepared to withstand potential financial distress. Engagement of outside advisers at this time is recommended.
Board Composition and the Use of Independent Professionals
Bankruptcy filings often give rise to breach of fiduciary duty claims against directors and officers. In the context of portfolio company bankruptcy filings, claims may be brought alleging that an appointed director favored alternatives benefitting the private equity fund to the detriment of others. Accordingly, a portfolio company should take prophylactic steps to minimize even potential conflicts of interest and develop a record of actions taken in the event of a bankruptcy filing or other litigation. Those steps may include:
Evaluating the composition of the portfolio company’s board of directors. If a majority of the board’s directors are not independent—and the board cannot expand to create an independent majority—the board should consider forming a special committee or subcommittee of independent directors and empower the committee with the authority to make decisions in circumstances where a potential conflict may arise (i.e., financial distress).
Maintaining corporate governance formalities. The board should follow proper procedure and keep minutes to create a record of each board meeting. Appointed directors should disclose any purported conflicts and recuse themselves from the discussion on certain issues as necessary if the conflict warrants recusal.
Monitoring management’s performance as well as the experience that management may have in distressed situations. Recently, the appointment of a chief restructuring officer to guide a company through the restructuring process has been viewed favorably by creditors and shareholders alike.
Retaining independent financial advisers and legal professionals to provide added expertise and input that is independent of the sponsor.
Directors & Officers’ Liability Insurance Policies
Even with the optimism that pervades the private equity market, it is important for sponsors and appointed directors to know that there is a safety net in place in the event breach of fiduciary duty claims brought against directors and officers. Generally, defense costs for such claims are paid by the company’s D&O insurer pursuant to its D&O policy. Additionally, the company’s formation documents may contain defense and indemnity provisions as a fallback. Yet, if the company files for bankruptcy, the type of insurance policy the company has may dictate whether proceeds from the policy will be made available to directors and officers and the automatic stay that arises upon filing may prevent directors and officers from turning to the company for defense costs. Accordingly, directors and officers should review their D&O policies to ensure that their interests are sufficiently protected. Considerations may include:
- Reviewing the named insureds under each policy and the definition of covered action or event.
- Reviewing the policy exclusions and determining whether the policy contains a self-insured retention or deductible.
- Reviewing the effect, if any, that a bankruptcy filing of the company or the dismissal/resignation of a director may have on coverage.
With corporate bankruptcy filings recently experiencing their first year-on-year increase since 2009, private equity funds and their appointed directors should consider the impact that continued financial distress may have on their investments. These strategies, which allow both funds and directors to better assess portfolio company needs and navigate potential financial distress, may mitigate the risk of breach of fiduciary duty claims in the event of a bankruptcy filing.
Timothy Walsh is the global head of McDermott Will & Emery’s restructuring & insolvency practice. He is based in New York. Darren Azman, a partner at McDermott Will & Emery’s New York office, focuses his practice on corporate restructurings, creditors’ rights and acquisitions of troubled companies.