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Knee-deepening insolvency20/08/2008. Source: Weil, Gotshal & Manges. Michael Weisser, Hayward Majors, Kyle Gann 
 Many private equity professionals have previously been schooled in keeping in mind the interests of all constituencies of a troubled portfolio company, including creditors, as it approaches insolvency. However, a recent United States Bankruptcy Court for the District of Delaware decision has potentially taken this mantra to new
heights and provides valuable lessons for private equity sponsors dealing with companies teetering on the brink of insolvency, especially with respect to engaging in self-dealing transactions and deepening the insolvency of a company to the benefit of the private equity sponsor, according to Michael Weisser, Hayward Majors and Kyle Gann of Weil, Gotshal & Manges.
Although many thought that "deepening insolvency" was a discarded judicial theory, and therefore not a material concern for private equity professionals, this case resurrects the jurisprudence in altered form. Under the court's ruling, deepening insolvency may not be brought as a standalone claim, but it is factored into the determination of damages for claims rooted in breaches of the duty of loyalty. From a practical perspective, a private equity investor may continue to run the operations of a portfolio company - even in insolvency - with limited exposure to the risks associated with the revived theory of deepening insolvency, so long as it observes its fiduciary duties and takes certain safeguards to protect against conflicts of interest (and the appearance of conflicts of interest). But if a private equity investor takes wrongful actions and breaches its duty of loyalty, the consequences are increased: sponsors can be on the hook for damages caused by extending the life of the company beyond the point of insolvency and these damages could exceed the sponsor's investment and transaction and advisory fees received in connection with the deal. Before finding themselves knee-deep in a precarious position with a troubled portfolio company and having courts analyze their every move with twenty-twenty hindsight, sponsors should take careful measures to avoid being caught in the cross-hairs of allegations that their actions breached their fiduciary duties and deepened the company's insolvency.
Deepening insolvency is a theory which seeks to punish investors (such as private equity sponsors) for prolonging the life of a company, to the detriment of creditors, in order to recoup the investors' investment or pay themselves fees. In good times, not many constituencies complain, or even pay much attention, to the affiliate transactions which are entered into between a private equity sponsor and a portfolio company, including equity and debt investments and the payment of transaction, advisory and director fees. However, when the tide turns and a company becomes insolvent or files for bankruptcy, those transactions may be viewed harshly and could have draconian consequences for the private equity sponsor.
Last year, in Trenwick America Litigation Trust v. Billett, the Delaware court seemed to tell investors they were insulated from such hindsight review, dismissing deepening insolvency as nothing more than "a catchy term [that]…does not express a coherent concept." The plaintiff in Trenwick was a litigation trust, who claimed that the restructuring actions approved by the independent board of a public company deepened insolvency, ultimately leading to bankruptcy and lessening the company's ability to satisfy its debts. Notwithstanding the fact that the plaintiff failed to demonstrate insolvency at the time of the restructuring, Vice Chancellor Strine (whose decision was affirmed by the Delaware Supreme Court), noted that Delaware law provides for claims based on fraudulent transfer and breach of fiduciary duties, intimating that deepening insolvency was little more than a quasi-fraudulent conveyance claim, and stating in no uncertain terms that "[e]ven when a firm is insolvent, its directors may, in the appropriate exercise of their business judgment, take action that might, if it does not pan out, result in the firm being painted in a deeper hue of red."
Then, in April of this year, the United States Bankruptcy Court for the District of Delaware created a new wrinkle in George L. Miller v. McCown De Leeuw & Co. (In re: The Brown Schools), holding that while deepening insolvency is not a viable claim, it is a viable theory of damages. The court's holding means that if a trustee or creditor can make a claim against a corporate officer or director for a breach of fiduciary duty, such as the duty of loyalty, it can recover damages for deepening the insolvency of the company, which could be measured by the diminution in value to the company's balance sheet. In other words, the damages can be catastrophic.
As such, it is advisable to understand the facts that drew the judge's ire. Unlike in Trenwick, the company in question, The Brown Schools, Inc., did not have a disaggregated shareholder base or an independent board. It was, in many ways, run like a typical private equity portfolio company - both while solvent and insolvent. In 1997 and 1998, McCown De Leeuw & Co., Inc. acquired 65% of the stock of Brown Schools for an aggregate purchase price of $63 million and, through its affiliates, entered into an advisory services agreement with Brown Schools. Brown Schools was, even at the time of McCown's acquisition, a heavily indebted company, having approximately $100 million in senior secured debt.
By the end of 2000 McCown's investment was at increasing peril. Brown Schools was under duress and had begun taking actions to meet its debt obligations, including: (i) obtaining additional loans from McCown, (ii) selling off $32 million in assets in order to pay down its senior debt and (iii) restructuring the terms of its senior debt.
Prior to a second round of divestitures in April 2003, the debt structure included significant obligations outstanding to third party lenders as well as $12 .5 million of unsecured, subordinated debt provided by a McCown affiliate fund (an increasingly common scenario in recent years, as many private equity sponsors are acquiring or developing lending funds to complement their equity funds). The second round of divestitures yielded an aggregate purchase price of $64 million, allowing Brown Schools to fully satisfy certain of its debt obligations and pay transaction fees, including $1.7 million to McCown.
The remedial actions taken by Brown Schools failed to put out the fire. In July 2004, in return for the waiver of certain events of default by a third party lender, Brown Schools restructured its debt once again, providing a first lien to a third party lender and a second lien to McCown on substantially all of Brown Schools' assets. The third party lender and McCown also entered into an intercreditor agreement, pursuant to which
McCown was entitled to receive up to $2.9 million of the monies thereafter received by the third party lender through asset sales. Brown Schools subsequently liquidated another $18 million in assets, paying the proceeds to the third party lender (which were then shared with McCown under the Intercreditor Agreement), and then filed for bankruptcy in March 2005.
In the context of a motion to dismiss, the bankruptcy court found that several of the transactions effected by Brown Schools, including the payment of restructuring transaction fees to McCown and providing security to McCown on its debt, raised questions of fact as to whether the Brown Schools directors had violated their duty of loyalty and that damages may extend as far as the theory of deepening insolvency would allow.
A subsequent decision by the Fifth Circuit in In re SI Restructuring, Inc. took a different view than Brown Schools, holding that Strine's decision in Trenwick rejects deepening insolvency as an independent claim and as a theory of damages. Much like Strine, the Court's argument was rooted in the view that deepening insolvency was untenable, even as a theory of damages, since it forced courts to look at the facts through a hindsight bias. While this reasoning may be applicable to instances where the courts are compelled to grant significant deference to business decisions (such as claims brought under a theory of a breach of the duty of care), it may be less applicable to claims rooted in a breach of the duty of loyalty.
The difference in opinion among the courts illustrates the point that actions taken in insolvency may be viewed generously by one court and negatively by another. For instance, McCown's actions may be seen as an effort to extend the life of the Company in order to allow the satisfaction of significant debt to a third party lender (with McCown being compensated for its services with respect to such transaction), but alternatively the payment of transaction fees to McCown could be viewed as an unjustified transfer of corporate assets to an insider. In the increasingly complex world of private equity, where a private equity group and its representatives often wear multiple hats, including that of board lender, creditors may be able to cast such typical transactions and conduct in a negative light. In the context of insolvency, creditors have a vested interest to do so.
The more hats a private equity investor wears, the more its risks increase. It is clear that a private equity group holding both equity and debt, as McCown did, will increase the likelihood its actions will be attacked. A prudent private equity investor should conduct itself in insolvency with a mind toward the interests of both stockholders and creditors and with a cautious eye to prevent second guessing of its actions and an increased risk of liability.
Private equity investors can protect themselves from the resurrection of deepening insolvency by consulting with legal counsel experienced at navigating insolvency and bankruptcy and by keeping careful corporate records that document the rehabilitative effort taken by the sponsor toward its portfolio company. In attempting to rehabilitate a failing portfolio company, the sponsor should be careful to avoid engaging in
actions which may construed as self interested, such as the payment of transaction fees for a distressed debt restructuring, the payment of director fees to private equity board representatives, the payment of advisory fees while the company is insolvent or otherwise troubled, or otherwise granting themselves benefits or opportunities not granted to other similarly situated stakeholders.
Balancing different roles as an investor and board member has always been a challenge for private equity sponsors. Several recent court decisions have fueled the fire and added to the risk equation for sponsors of troubled companies. In times of distress for portfolio companies, sponsors should be aware of the risks of "deepening insolvency" and consult with experienced counsel to navigate these rules.
Weil, Gotshal & Manges is a leading legal specialist in private equity services, with dedicated private equity lawyers in major financial centres throughout the world. For more information please visit www.weil.com.
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