Article

In Bankruptcies, Private Equity Becomes The Target

August 06, 2008

By Evan Weinberger

Law360, New York (August 06, 2008) -- When Mervyn's LLC, a portfolio company of Sun Capital Partners, filed for Chapter 11 bankruptcy protection last week, it joined a procession of privately and publicly owned retail chains felled by the sinking national economy.

While the mechanics for public and private equity bankruptcies are alike, the equity holders in a portfolio company face a higher risk level than shareholders in a publicly held company that files for protection.

The heightened risk comes from a perception that the parent private equity firms have deep pockets that provide a tempting target for creditors committees and court-appointed trustees, bankruptcy attorneys said.

Those parties looking for fault, the attorneys added, will scour any decisions that a board of directors or company management that have even a sniff of conflict of interest.

“A creditors committee or some other party with a different level of debt may go back and turn over all the stones on what happened and analyze the transaction where the company was acquired,” said Norman Kinel, a senior partner with Dreier LLP and founder and co-chair of the firm's 15-lawyer bankruptcy and corporate reorganization department.

“If there's any possible, conceivable or hypothetical cause of action that they can bring, the private equity firms increasingly become targets,” he said.

Potential conflicts of interest can grow out of the unique multiple roles a private equity firm plays with its portfolio companies, according to Mark Bane, a partner at Ropes & Gray LLP and a co head of its bankruptcy and business restructuring group.

Because a private equity firm is the majority owner of a portfolio company, it appoints the majority of the company's board of directors, Bane said.

The private equity shop will often also serve as a lender to the portfolio company, and that is where the firms can open themselves up to potential conflict of interest claims from creditors, Bane said, especially under the theory of “deepening insolvency.”

According to the deepening insolvency theory of law, any debt that a company takes on after it technically became insolvent should be added to the damages owed to creditors. At the heart of the deepening insolvency claim is a creditor's belief that the directors breached their duty of loyalty when they made deals that may have benefited the parent firm or added debt when a bankruptcy should have been declared.

After laying dormant for several years, Bane said, the theory has come back since a 2004 ruling in the bankruptcy of Brown Schools Inc., a for-profit education outfit in which private equity shop McCown De Leeuw & Co. held a 65% stake.

The creditors in that case alleged that MDC's actions in restructuring debt owed by Brown Schools immediately prior to the bankruptcy filing benefited the private equity firm.

The creditors said in court that McCown De Leeuw & Co. managed to collect some of the profits of a debt sale connected to the restructuring. The creditors said that the profits reaped by MDC should be a part of the damages claim and the judge ruled that those claims could not be dismissed, Bane said.

He added that deepening insolvency has been rejected as an independent cause of action in any lawsuits linked to a portfolio company, and so far has only been accepted as an argument for determining damages.

William Schorling, a bankruptcy shareholder at Buchanan Ingersoll & Rooney PC, said that as a matter of law, he agreed with the idea of using deepening insolvency to help determine damages in a portfolio company's bankruptcy.

He added that other conflict of interest claims could come to light in court, depending on the board's independence from the umbrella private equity firm in transactions.

“If the director is interested on both sides of the transaction, that transaction is subject to greater scrutiny,” Schorling said. “That's where I think there's a great deal of exposure for the private equity firm and the officers and the directors.”

Dividend payments from the portfolio company to its parent can prove to be fertile ground when creditors or trustees are searching for conflicts of interest and fault in a bankruptcy.

In a classic private equity transaction, the private equity firm will take out a highly leveraged position to acquire a company and then pass big dividends up the chain.

A creditors committee or secured creditors could look at the last few dividend payments a portfolio company makes to the umbrella organization and determine that a large dividend payment contributed to the bankruptcy and sue for that reason, Schorling said.

When creditors begin making conflict of interest claims, the best defense for a private equity firm is to provide information about any transactions the portfolio company entered into in the run-up to the bankruptcy, according to Yvette Austin Smith, a managing director at CRA International who specializes in corporate finance advisory services.

"At that point, you want to provide a financial indication that the company is solvent at the time of the transaction and that the transaction itself is not putting the company in insolvency," Austin Smith said.

With bankruptcies overall on the rise, attorneys in the field said they expected to see more portfolio companies of private equity firms seeking protection.

The consulting firm Bain & Co. recently said that it expected to see more than 100 companies with a market capitalization of over $100 million file for bankruptcy protection in 2009. There is a lag of between 12 and 18 months from the economy's trough and the crush of bankruptcy filings, the firm said.

The changing nature of business ownership is what will lead to a larger number of portfolio companies filing for bankruptcy, market watchers said.“You see more and more private equity funds being the owners of corporate America. Today they're common,” said Jonathan Friedland, the head of restructuring and insolvency service group at Levenfeld Pearlstein, LLC.

Friedland added that for the most part, the portfolio companies that are heading into bankruptcy are the same as the publicly traded companies running into trouble — retail chains like Mervyn's and the Sharper Image, Inc., as well as any company involved in the housing market. Bankruptcy, he added, was not something peculiar to the private equity sector.

That most of those bankruptcies have so far been retail and homebuilders that have borne the brunt of the housing and credit meltdowns probably won't stop the private equity firms from being rich targets, the attorneys contacted by Law360 said.

Bane said that creditors and private equity firms would have to compete to get their sides heard in court. “Putting aside the legalese, it's a psychological warfare game trying to get the attention of the bankruptcy judge,” he said.

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