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Legal considerations arising from transactions in the private equity market

Liquidation preferences, warranty and indemnity insurance and special directors' liabilities on insolvency are some of the factors that currently affect private equity transactions. Here, Simon Beddow of Ashurst Morris Crisp offers an explanation of these issues and their significance in private equity deals.

Legal considerations arising from transactions in the private equity market

1. Role of Warranties and Indemnities

At time of economic uncertainty buyers tend to pay slightly more attention to the warranties to be taken on a company or business acquisition.  Confusion can arise as to the purpose of warranties and the difference between a warranty and an indemnity.

The basic rule in England and Wales on the acquisition of a company or a business is that the buyer "must beware".  There is no obligation on the seller to tell the buyer anything about the company or business to be acquired.  Warranties attempt to redress this balance by making the seller tell the buyer what it knows and by allocating the risk of the unknown between the buyer and the seller.  In this way the warranties can underpin the price being paid for the business because if something subsequently proves to be otherwise than as warranted the buyer may be able to recover damages from the seller covering the buyer's loss.  However, the buyer must prove loss and will usually also have to overcome a range of specifically negotiated warranty limitations.  The contrast with an indemnity is that the indemnity will cover a specific known actual or contingent risk.  The very fact of the happening of the indemnified event triggers the payment.  The buyer does not have to prove loss and will usually not be subject to the usual range of warranty limitation clauses. 

One of the particular dangers with warranties is the use of the words "so far as the seller is aware".  Unless a contract specifies otherwise, there is no obligation on the seller to make any enquiry so if the seller does nothing to find out whether the warranties are or are not true the risk of the unknown passes to the buyer.  Substantial risk can pass from the seller to the buyer by using these words.  A prudent buyer will, therefore, restrict the use of these words and will make sure that there is a positive obligation on the sellers to make "all due and diligent enquiries" or "all reasonable enquiries".  Often where buyer and seller are aiming for certainty the obligation to enquire will be defined as a list of specified individuals within the target company or business and a list of specified professional advisers.  Clearly, the buyer needs to satisfy itself that the list is comprehensive to ensure that all realistic risk areas are covered. 

2. Current Issues Affecting Private Equity Transactions

(a) Liquidation Preferences

Liquidation preferences work on the basis that the parties agree that until the venture capitalist gets an agreed multiple of its money back it will get everything that is available and the other shareholders will get nothing. 

When trying to enforce a liquidation preference on a sale you need to be very careful in relation to drag along rights and tag along rights.  These often require that the same offer has to be made to all shareholders if the right to drag or tag is to become effective.  If one shareholder is being given three times its money this can defeat the wording of the tag/drag rights.  In these circumstances you must exclude the need for there to be a like offer until A get its agreed multiple and then the like offer will only be required in relation to the amount to be shared between A and B in excess of the multiple due to A. 

A preference can often be expected on an IPO.  However, if A has the same number of shares as B but wants three times his money back this will not work on an IPO unless A holds three times as many shares as B. 

Assuming A does not want to put any more money into the business pre-IPO the usual way to achieve this is to give A some form of bonus issue of shares.  This bonus issue can either come from reserves available for distribution (but it is unlikely the company will want to use its reserves for this purpose) or from share premium account (but there may not be sufficient available).  An alternative is to plan for this eventuality from the initial investment by having a par value for the shares which are to have the multiple such that they can be subdivided so that A will hold the right number of shares at IPO.  For example, if A is to get a three times multiple on an IPO you could give A shares with a par value of 30p and B shares with a par value of 10p.  On an IPO you could then sub-divide each 30p A share into three 10p ordinary shares to make sure that the appropriate liquidation preference is delivered. 

(b) Warranty and Indemnity Insurance

This has become a feature of the MBO market over the last few years and is being seen increasingly in relation to sales to American purchasers (where they are reluctant to accept the traditional UK venture capital position that the VC will not give warranties) and also on secondary buyouts where there is no-one to stand behind the warranties being given.  This note does not go into the detail of warranty and indemnity insurance but highlights an issue which has become an area of concern. 

A fundamental principal of English insurance law is that the person buying the insurance must have an insurable interest.  B cannot expect to paid compensation if A crashes A's car.  The reason B cannot expect to be paid is that B will have suffered no loss.  Until fairly recently, if warranty insurance was being put in place the share purchase contract would provide that the person giving warranties would limit its liability for breach of warranty to amounts actually paid out by the insurers for any breach of warranty.  This meant the person giving the warranties never paid anything.  As a consequence the person giving the warranties could never actually suffer any loss.  This has given rise to the question of "where is the insurable interest for the person giving the warranties?"  A variety of approaches have been proposed to answer this question. 

(i) You could try to manufacture an insurable interest but this is very difficult to achieve in combination with a non-recourse position against the person giving the warranties.

(ii) You can create a single purpose vehicle which will give the warranties and which is liable to pay out under the warranties (thereby creating the insurable interest) and the single purpose vehicle then insures that contingent payment obligation.  This is a possibility and has been used on a number of occasions. 

(iii) Those giving the warranties retain an underlying liability for a small amount of any claim for breach of warranty, for example, one per cent. of the warranty liability.  This is probably the most desirable route because it does give rise to an insurable interest and means the policy will bite.  However, it is not popular on venture capital deals where it is usually the management who are being asked to give this one per cent.

At present there is no consensus on which is the correct solution to this problem but in the meantime care needs to be taken if putting in place warranty and indemnity insurance. 

(c) Special Directors' Liabilities on Insolvency

A topic which has been of increasing concern in the private equity sector with the failure of dot com investments in the last 12 months is the question of the liabilities on insolvency that can be incurred by special directors representing venture capitalists.  For the purpose of this note the focus is on wrongful trading. 

When a company goes into liquidation the liquidator will examine whether the directors knew or ought to have concluded that there was no reasonable prospect of avoiding an insolvent liquidation.  If such knowledge existed or such circumstances ought to have been concluded the directors must demonstrate that they took all reasonable steps to minimise loss to creditors.  If the directors fail to do so they will be guilty of wrongful trading.  There is both a subjective test (the director knew) and an objective test (he or she ought to have concluded).  The question will only be asked if the company goes into insolvent liquidation but if directors are found to be guilty of wrongful trading they will be personally liable to creditors for the failure to minimise the loss to creditors after the date at which they knew or ought to have concluded there was no reasonable prospect of avoiding that insolvent liquidation. 

The key issue is whether or not there is a reasonable prospect of avoiding insolvent liquidation.  As soon as investee companies start to look as though they might be running out of money it is worth considering whether or not there is a reasonable prospect of avoiding insolvent liquidation.  This key issue will involve the consideration of underlying issues.  These issues include whether the company can be sold, if it is possible to restructure a debt, if the company has a parent which can support it and if the company has a bank which will support it. 

Where having considered these factors a board does not believe there is a reasonable prospect of avoiding insolvent liquidation it should take steps straight away to minimise loss to creditors.  This usually means some form of voluntary winding up with a view to paying creditors as much as possible. 

Insolvency is one of those areas where it is particularly difficult to prove after the event quite what the facts were at the time decisions were being made and there is a danger that the point at which the board should have been seeking to minimise loss to creditors becomes clearer with hindsight.  To assist the directors in resisting claims for wrongful trading it is essential that the process of their deliberations is documented.  When the directors first consider the issue they should ensure that a board meeting is held and that appropriate board minutes are kept.  The board should then regularly review whether or not circumstances have changed such that the reasonable prospect of avoiding insolvent liquidation no longer exists.  Thought should be given as to whether advice should be sought from a qualified insolvency practitioner. 

Special directors should not forget that if an investee company becomes insolvent and wrongful trading is an issue then those special directors could find themselves being personally liable alongside the executive directors.  This is an area on which we are increasingly seeing special directors taking advice and we expect this trend to continue.

3. Dispute Resolution Methods

The internet and telecoms boom and bust of the last 24 months has given rise to a large number of instances where managers and venture capitalists have come into conflict.  Very often these have related to whether or not more money should be put into the business or the nature and rate of expenditure by the business.  This has highlighted on a number of occasions where the dispute resolution methods on venture capital transactions can leave the venture capitalists in a weak position.

On large buyouts the venture capitalist tends to have a majority stake.  This brings with it the ability to hire and fire directors (directors can be removed with a resolution of shareholders holding more than 50 per cent. of the voting equity).  In consequence, if there is a dispute between the venture capitalist and the managers, the venture capitalist could pass a resolution to remove the managers as directors (although this may of course trigger compensation payments for breach of service contracts with those directors). 

By contrast, on start-up and expansion transactions the venture capitalist is often a minority holder who cannot pass resolutions to remove directors.  It used to be fairly standard practice on venture capital and expansion capital transactions to provide for "disaster clauses".  These clauses gave the venture capitalist the right to cast a disproportionate number of votes at shareholder meetings if certain trigger events occurred thereby conferring the power to remove directors and appoint replacements.  These trigger events could incorporate matters such as the failure of the company to hit its targets, the inability of the venture capitalist and the managers to agree an annual budget or the managers taking action requiring investor consent without having first obtained such consent.  During the internet and telecoms boom of 1999/2000 many deals did not have a disaster clause because the competitive position of the managers enabled them to negotiate such protections away (if they were even asked for in the first place). 

Subsequently, some venture capitalists find that on disputes the minority position they find themselves in is not a strong one.  Without the ability to change to the board the venture capitalists have to look at alternative ways of resolving disputes. 

Firstly, the parties can always negotiate.  However, the managers may appreciate the weakness of the venture capitalist's position and negotiation may prove fruitless. 

If negotiation does prove fruitless and the managers wish to take action of which the venture capitalist does not approve, the venture capitalist is forced to look at its rights under the shareholders' agreement and see whether the strict enforcement of these rights can prevent the managers from taking a particular action.  This process will include examining and vigorously enforcing the requirement to obtain investor and special director consent for certain actions.  The venture capitalist could try to delay actions by not attending board meetings.  If a quorum was not present at the board meeting it would have to be adjourned thereby delaying the approval of the relevant action.  This may be only of limited effect because the articles will often have a fall back provision which will enable a board meeting be treated as having a quorum present if it is reconvened for a later date and the special director still fails to attend.  Venture capitalists can also have regard to the "class rights" of the shares that they hold.  In practice this can be of limited use because the range of actions that are likely to breach class rights is determined by law and is not extensive (or certain).  However, this could prevent such matters as further issues of shares, reorganisations of share capital and buybacks of shares by the company. 

Allied to the strict enforcement of rights under the shareholders agreement is the ability of the venture capitalist to increase the management role of its special director.  This might involve a change in the identity of the special director to bring in a more "hands on" appointee. 

If the relationship has reached the stage where the venture capitalist believes the best course of action is to part company with the managers they may consider buying the managers out (possibly by a secondary buy-in) or sell out to management.  In extreme cases, a last resort would be petitioning the Court for assistance under the provisions of section 459 Company Act 1985 which aims to prevent a majority in a company acting to the prejudice of a minority.  However, section 459 actions are rare.  They tend to be costly and uncertain in outcome.  In many instances the Court does not have sympathy with shareholders in dispute using the Court as a forum rather than sorting themselves out.  Many practitioners believe that the most likely outcome on a section 459 application will be for the Court to order one party to sell its shares to the other rather than run the risk that the parties return to Court when the next dispute arises.  This risk dissuades many from following this route.

Copyright © 2001 Ashurst Morris Crisp

Simon Beddow is a partner at Ashurst Morris Crisp. For more information, please visit www.ashursts.com

Ashurst Morris Crisp is an international law firm with offices in Brussels, Frankfurt, London, Madrid, Milan, Munich, New Delhi, New York, Paris, Singapore and Tokyo, acting for European and other international clients.