Debevoise & Plimpton Private Equity Report · Geoffrey P. Burgess – London Marc Castagnède – Paris Margaret A. Davenport E. Drew Dutton – Paris Michael J. Gillespie Gregory

W H AT ’ S I N S I D E

3 One (Small) Step for PE Firms:Fed Loosens Restrictions onMinority Banking Investments

4 Buyer Beware: Purchasing Stockof a Consolidated Group MemberRecognizing a Tax Loss

5 Guest Column: Cautious Optimism Amid the Turmoil

7 More Deferred CompensationLegislation—Will It Ever End?

9 Sovereign Wealth Funds: The Santiago Principles

10 Electronic Filing (and Tracking)Comes to Reg D PrivatePlacements

11 Are New Private Equity and Hedge Fund Regulations on the Horizon in the EU?

13 How Bad Is “Bad Faith?”New Delaware Perspectives

15 Recent Legal Developments in Germany

17 Avoiding FCPA Anxiety: A Roadmap to M&A DueDiligence and Post-AcquisitionFCPA Compliance

19 Best Planning for the Worst:Assuring Insurance Coverage for Private Equity Sponsors and Portfolio Company Directorsin Bankruptcy

21 The Good, the Bad and the Ugly:Hexion v. Huntsman

32 Alert: Duties of Directors of DistressedCompanies—An Update and Refresher

Fall 2008 Volume 9 Number 1

D e b e v o i s e & P l i m p t o nP r i v a t e E q u i t y Re p o r t

CONTINUED ON PAGE 24

“Strategics, if you can't buy them, join them.”

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Economic crises make strange bedfellows.Historically, private equity firms andstrategics have vied for acquisition targets,with private equity firms becomingincreasingly competitive when financingmarkets were vibrant. One of the manyconsequences of the financial crisis andliquidity crunch has been a renewed interestof private equity firms teaming withstrategic investors (and visa versa) to acquireeven medium-sized targets. Although thesetypes of alliances are not new (see our priorarticle, “Mixed Clubbing: Do PrivateEquity Firms and Strategics Make GoodDance Partners” in the Fall 2007 issue ofThe Debevoise & Plimpton Private EquityReport), with the financing markets being

closed for many potential transactions, PEfirms are looking at strategic investors bothfor deal sourcing and sector expertise as wellas capital, while strategic investors areviewing PE firms as significant sources ofcapital as well as having deal executionexpertise. The advantages of the PEfirms/strategic investor alliance are nowmore evident than ever with respect toregulated industries, where having astrategic investor may provide comfort tothe regulators that the target company willbe operated prudently and in accordancewith industry standards.

Every PE firm and strategic investorcontemplating a joint bid for a deal haswondered what “market” is for private

Strange Bedfellows:Private Equity and Strategic Alliances

Private equity firms are known for flexibility, ingenuity and seeingvalue where others do not. Never have these skills been morerelevant than during the current economic crisis with leadingprivate equity portfolios being divested at huge discounts, financingfor new (and committed) deals nearly non-existent and portfoliocompanies facing hard economic challenges notwithstanding, inmany cases, forgiving capital structures. On the other hand, theconventional wisdom is that the best private equity investing isdone in uncertain times. We are believers!

In this issue, we take a look at how these difficult times areimpacting the private equity world from a variety of perspectives.On our cover, we note that economic crises make strangebedfellows. Since private equity firms and strategics have a renewedinterest in partnering rather than competing for transactions, weexamine the key issues inherent in these partnerships.

In our guest column, Mark O’Hare, a founder and ManagingDirector of Preqin, a leading source of data and analysis of thealternative assets industry, summarizes the findings of his firm’srecent informal survey of over 100 institutional investors. Markconcludes, despite some interesting cross currents in his findings,that many private equity investors are “cautiously optimistic,”notwithstanding the current economic turmoil.

Throughout this issue, we report on legal issues of specialconcern to the private equity community in these uncertain times.Heidi Lawson advises private equity professionals serving on theBoards of portfolio companies to make sure the insurance policies

designed to protect them will actually do so if the portfoliocompany goes bankrupt. And, members of our workout teamremind directors of the scope of their fiduciary duties in thetroubled company context.

Although you have all read about the Huntsman-Hexion disputein the business press, we reprise the story to focus on the lessons tobe learned for the “new deal” age.

Because deal activity will actually resume one of these days, ourtax team reminds you to be cautious under some new taxregulations to avoid unintended consequences if you are buying aconsolidated subsidiary where the seller is recognizing a loss. Wealso suggest that you review the compensation plans in any of yourportfolio companies that are organized as partnerships, LLCs orforeign corporations to make sure that the new draconian rules ondeferred compensation hidden in the bail-out bill do not createsome nasty surprises for unsuspecting employees.

In addition, we discuss a roadmap of steps to take if you are abuyer in a sales process where there is not enough time to diligencepotential Foreign Corrupt Practice issues of the target. These stepsmay reduce the risk of FCPA related enforcement actions post-closing, notwithstanding the possible existence of pre-closingbreaches.

We also highlight some proposed legislation in the EUimpacting private equity as well as some recent Germandevelopments and provide some insight into the recently-adoptedSantiago Principles relating to Sovereign Wealth Funds.

The Debevoise & PlimptonPrivate Equity Report is apublication of

Debevoise & Plimpton LLP

919 Third AvenueNew York, New York 100221 212 909 6000

www.debevoise.com

Washington, D.C.1 202 383 8000

London44 20 7786 9000

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Private Equity Partner /Counsel Practice Group MembersFrankfurt49 69 2097 5000

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Please address inquiriesregarding topics covered in thispublication to the authors orany other member of thePractice Group.

All contents ©2008 Debevoise& Plimpton LLP. All rightsreserved.

Franci J. Blassberg Editor-in-Chief

Stephen R. Hertz Andrew L. Sommer Associate Editors

Ann Heilman MurphyManaging Editor

David H. Schnabel Cartoon Editor

The Private Equity Practice GroupAll lawyers based in New York, except where noted.

Private Equity FundsMarwan Al-Turki – LondonKenneth J. Berman– Washington, D.C.Erica BerthouJennifer J. BurleighWoodrow W. Campbell, Jr.Sherri G. CaplanJane EngelhardtMichael P. Harrell

Geoffrey Kittredge – London Marcia L. MacHarg – Frankfurt Anthony McWhirter – London Jordan C. Murray Andrew M. Ostrognai – Hong KongDavid J. SchwartzRebecca F. Silberstein

Hedge FundsByungkwon Lim

Mergers & AcquisitionsAndrew L. BabE. Raman Bet-Mansour – ParisPaul S. BirdFranci J. BlassbergRichard D. BohmThomas M. Britt III – Hong KongGeoffrey P. Burgess – LondonMarc Castagnède – ParisMargaret A. DavenportE. Drew Dutton – Paris Michael J. GillespieGregory V. GoodingFelicia A. Henderson – Paris

Stephen R. HertzDavid F. Hickok – FrankfurtJames A. Kiernan, III – LondonAntoine F. Kirry – ParisJonathan E. LevitskyLi Li – ShanghaiChristopher Mullen – LondonDmitri V. Nikiforov – MoscowRobert F. Quaintance, Jr.William D. RegnerKevin A. RinkerJeffrey J. RosenKevin M. SchmidtThomas Schürrle – FrankfurtWendy A. Semel – LondonAndrew L. SommerStefan P. Stauder James C. Swank – ParisJohn M. Vasily Peter Wand – Frankfurt

Leveraged FinanceKatherine Ashton – LondonWilliam B. BeekmanDavid A. Brittenham

Letter from the Editor

Franci J. Blassberg

Editor-in-Chief

In September 2008, the Federal ReserveBoard issued a new policy statement onminority equity investments in banks andbank holding companies that was designed tomake non-controlling banking investmentsmore attractive to private equity funds byloosening the restrictions on suchinvestments in a number of importantrespects and clarifying how the Fed wouldinterpret certain of its existing regulations.However, the September policy statement didnot change the basic thrust of the Fed’sregulatory regime applicable to minoritybanking investments, which significantlylimits the attractiveness of the banking sectorto most private equity firms. Thus, whilehelpful in some circumstances, it seemsunlikely that the adoption of the Septemberpolicy statement will impact fundamentallyhow private equity investors look at potentialinvestments in banking organizations or leadto a significant increase in the level of suchinvestments in the near term, especially inlight of current market conditions.

The Federal Reserve Board, pursuant tothe Bank Holding Company Act (the “BHCAct”), regulates companies that control a

bank or a bank holding company (a “bankingorganization”). The BHC Act defines controlas the power (1) to vote 25% or more of thevoting securities of a banking organization,(2) to elect a majority of the directors of abanking organization, or (3) to exercise a“controlling influence over the managementor policies” of a banking organization. Anentity that controls a banking organizationmay be required by the Fed to provideadditional capital or management resourcesto the banking organization. This potentiallyopen ended commitment creates a particularproblem for private equity funds. In addition,the BHC Act limits the extent to which acompany that controls a banking organizationcan also control non-banking, commercialbusinesses. As a result, private equity investorswishing to invest in banking organizationshave, with very few exceptions, sought to doso only on a non-controlling basis.

Although the first two prongs of the BHCAct’s definition of control would appear toprovide a clear path to avoid control—keepyour ownership of voting stock below 25%and don’t control a majority of the board—the Fed has historically imposed a much

more restrictive view of controlthrough its interpretation of thethird prong of this definition—theprohibition on exercising a“controlling influence.” Forexample, prior to the adoption ofthe most recent policy statement theFed has generally not permitted anon-controlling investor to have anyrepresentation on the board ofdirectors of a banking organizationif it held more than 10% of theorganization’s the voting stock.Even where the investor has norepresentation on the board, the Fedhas generally limited non-controlling investments to less than25% of a bank organization’s total

equity (rather than solely voting equity). Under the new guidance set forth in the

September policy statement, the Fed hasindicated that it will not object to a non-controlling investor having up to one third ofthe total equity of a banking organization,provided that the investor’s voting interestdoes not exceed 15%. Generally, a non-voting equity security that is convertible intoa voting security, such as a non-votingpreferred instrument that is convertible intocommon stock, will be considered to be non-voting if it cannot be converted in the handsof the original investor (or an affiliate of theinvestor) and may be transferred only (1) toan affiliate of the investor, (2) to the issuer oran affiliate of the issuer, (3) in a widespreaddistribution, (4) in transfers of blocksrepresenting less than 2% of the issuer’soutstanding voting securities, or (5) to aperson that already controls 50% or more ofthe issuer’s voting securities.

More significantly, the Fed has indicatedthat it will allow an investor who owns morethan 10% of the voting stock of a bankingorganization to have a single representativeon the organization’s board of directorswithout being deemed to have control. Asecond director will be permitted providedthat the banking organization has another,larger shareholder that controls theorganization and is regulated by the Fedand the proportion of the entire boardrepresented by the two directors appointed bythe non-controlling investor is not in excessof the lesser of 25% and such investor’s totalequity interest. The representative(s) of thenon-controlling investor can be a member ofboard committees, but they cannot act as thechair of a committee or of the entire board.The September policy statement alsocontains helpful guidance as to the ability ofan investor to express its views to themanagement of the banking organization

One (Small) Step for PE Firms: Fed Loosens Restrictions on Minority Banking Investments

Debevoise & Plimpton Private Equity Report l Fall 2008 l page 3

Paul D. BrusiloffPierre Clermontel – Paris Alan J. Davies – LondonPeter Hockless – LondonAlan V. Kartashkin – Moscow Pierre Maugüé Margaret M. O’NeillA. David ReynoldsPhilipp von Holst – FrankfurtGregory H. Woods III

TaxEric Bérengier – ParisAndrew N. BergPierre-Pascal Bruneau – ParisGary M. FriedmanPeter A. FurciFriedrich Hey – FrankfurtAdele M. KarigVadim MahmoudovMatthew D. Saronson – LondonDavid H. SchnabelPeter F. G. SchuurMarcus H. StrockRichard Ward – London

Trust & Estate PlanningJonathan J. RikoonCristine M. Sapers

Employee Compensation & BenefitsLawrence K. CagneyJonathan F. Lewis Alicia C. McCarthyElizabeth Pagel SerebranskyCharles E. Wachsstock

The articles appearing in thispublication provide summaryinformation only and are notintended as legal advice. Readersshould seek specific legal advicebefore taking any action withrespect to the matters discussedherein. Any discussion of U.S.Federal tax law contained in thesearticles was not intended orwritten to be used, and it cannotbe used by any taxpayer, for thepurpose of avoiding penalties thatmay be imposed on the taxpayerunder U.S. Federal tax law.


page 4 l Debevoise & Plimpton Private Equity Report l Fall 2008

Selling stock of a subsidiary at a loss isregrettably more common these days thanany of us would like. That sad fact turnsout to be important not only to the sellerof a subsidiary in a consolidated group,but also to an unsuspecting buyer.

In September, the IRS issued newregulations that apply to the sale of stockof a member of a U.S. consolidated taxgroup in cases where the selling grouprecognizes a tax loss. The rules(commonly referred to as the “lossdisallowance rules” or “LDR”) make iteasier for the selling group to claim a taxloss in such a case (whereas prior lawmade it extremely difficult to claim such aloss). Unfortunately for buyers, however,the new rules may adversely impact thetax attributes of the purchased subsidiary(e.g., NOLs and tax basis of thesubsidiary’s assets) unless the selling groupagrees to make an appropriate electionunder the new regulations.

Simple in Concept but Difficult in ApplicationWhen the selling group has a tax loss inthe shares of a subsidiary (a “stock loss”)and the tax attributes of the subsidiary

exceed the value of the subsidiary (an“inside loss”), the new rules liberalize theability of the selling group to claim thestock loss but require a reduction in thetax attributes of the subsidiary to avoid a“doubling up” of the loss. Accordingly,the attributes of the subsidiary may bereduced by the lesser of the amount of thestock loss and the amount of the inside loss.

While simple in concept, the newregulations are spectacularly complicatedand extremely fact intensive to apply (somuch so that some have questionedwhether they will be administrable). As aresult, in many cases it may be difficultfor buyers (or selling consolidated groups)to know with complete confidencewhether or how the new rules apply orwhether the rules require a reduction inthe tax basis of the target company’s assetsor the target’s other tax attributes.Moreover, even post-closing IRSadjustments or challenges to the taxreturns of the target for taxable yearsthrough the closing date can impact theanalysis.

Electing out of the New RulesFortunately, the regulations allow theselling consolidated group to elect toreduce the loss it claims upon the sale ofstock of a member and thereby preservethe target company’s inside tax attributes.We expect that buyers from consolidatedgroups will begin requesting sellingconsolidated groups to make such anelection (including on a protective basis),particularly where the buyer is unable toquantify the potential attribute reduction.Of course, sellers may now ask to becompensated for foregoing the benefits ofthe new regulations.

Effective DateThe new rules are effective for salesclosing on or after September 17, 2008,except for sales made pursuant to abinding agreement between unrelatedparties that was in effect prior to theeffective date. If an existing agreement isamended on or after the effective date, itmay be subject to the LDR Rules.Therefore, along with seeking elections inpurchase agreements now beingnegotiated, purchasers that amend existingagreements should take care to ask theseller to make the election describedabove.

Still Not Out of the WoodsRegardless of whether the new rules applyto reduce the attributes of the target,those attributes may be impacted by otherrules. For example, section 382 of the taxcode reduces the ability of a targetcompany with NOLs or built-in losses touse those attributes after an ownershipchange.

David H. [email protected]

Peter F. G. [email protected]

Michael [email protected]

Buyer Beware:Purchasing Stock of a Consolidated Group MemberRecognizing a Tax Loss

…[T]the new rules

liberalize the ability of

the selling group to claim

the stock loss but require

a reduction in the tax

attributes of the

subsidiary to avoid a

“doubling up” of the loss.


Cautious Optimism Amid the TurmoilG U E S T C O L U M N

As financial advisors, Yogi Berra andJohn Maynard Keynes may not seem tohave much in common, but consider thefollowing quotes:

� “Predictions are difficult, especially asregards the future.”

� “Economists set themselves too easy atask if all they say is that once thestorm is passed the sea will be calmagain.”

(Sorry, no prizes for the correctattribution.)

The current dislocation in the globaleconomy is obviously having a hugeimpact on the private equity industry:what is the medium-term outlook, andhow can we expect the landscape tochange?

During October, Preqin completed asurvey of the views and strategies of 100institutional investors, representing $1.5trillion of AUM, and $93 billion ofallocations to private equity. Morerecently, I have had the privilege ofparticipating in several private equityconferences to gauge sentiment acrossseveral geographies and market segments:

� Global LPs and GPs (SuperReturnMiddle East, Dubai, October 14th)

� US General Partners (FRA ClientServicing Conference, New York,October 20th)

� US Lower Mid-Market PE Firms(NASBIC, Palm Beach, October27th)

Amid the uncertainties of the current financial crisis and liquidity crunch, GPs, LPs and the general public all are curious about privateequity’s future. We asked Mark O’Hare, founder and Managing Director of Preqin, a leading source of data and analysis for the alternativeassets industry, to share with us the results of his firm’s recent survey of institutional investors views of the future.

CONTINUED ON PAGE 6

Figure 1: Where are we currently in the global financial crisis?

50%

45%

40%

35%

30%

25%

20%

15%

10%

5%

0%Past the worst;quick recovery

to come

Past the worst;prolonged

downturn, slowrecovery

Worse to come Don’t know

6%

44%42%

8%

Source: Audience poll, PE World MENA, Dubai, November 2008

Figure 2: LP Return Expectations, Next 5 Years vs. Past 5 Years

50%

45%

40%

35%

30%

25%

20%

15%

10%

5%

0More than500 bpsworse

0-500 bpsworse

The sameas past 5

years

0-500 bpsbetter

More than500 bpsbetter

11%

45%

36%

7%3%

Source: Preqin LP survey, October 2008


� French LPs and GPs (Private EquityExchange, Paris, November 13th)

� Middle East LPs and GPs (PrivateEquity World MENA, Dubai,November 18th)

� Global LPs and GPs (SuperInvestor,Paris, November 20th)

In addition, we continue to trackfundraising trends and fund returns data.What are the LPs and GPs saying, andwhat can we infer about the next fewyears?

Where Are We in the Crisis? LPs and GPs have few illusions on theseverity of the situation (Dubai,November 18th, see Fig. 1, page 5). TheLPs and GPs at SuperInvestor in Paris(November 20th) felt much the same,with a consensus for a global recession oftwo to three years.

Return ExpectationsWell before the credit crunch hit, LPs andGPs recognized that the preceding five yearswere a period of unusually high returns forprivate equity investors, and manycautioned this couldn’t be expected tocontinue indefinitely. Unsurprisingly, amajority of the institutions in Preqin’s pollexpect returns to be somewhat lower overthe next five years (see Fig. 2, page 5).

Despite this, and a recognition thatmany investments made during 2006 and2007 may prove to be very difficult, thereis also a widespread appreciation thathistorically funds that have had theirinvestment periods during marketdownturns have often been among thebest-performing vintages.

With stockmarkets currently on multi-year lows, and sellers’ price expectationsdeclining, there is widespread recognitionamong GPs and LPs that we may beentering a very attractive time for makingprivate equity investments.

This is not lost on LPs who, despiterecognizing that it may be difficult tomatch the returns of recent years, arenevertheless reasonably bullish aboutprospective returns from private equityinvestments over the coming five years(see Fig. 3, below).

The median expected gross IRR is inthe 15%–20% range, and the averageexpectation among LPs polled is for17.4%.

Future Fund CommitmentsPrivate equity’s growth has benefited fromthe steady increase in LPs’ percentageallocations to the asset class over recentyears. Will this trend continue? Thefact that LPs expect reasonable returnsfrom their private equity investments overthe coming five years augurs well, and theaudience poll in Dubai on November18th confirmed this (see Fig. 4., below).

Guest Column: Cautious Optimism Amid the Turmoil (cont. from page 5)

Figure 4: Over recent years institutions have consistently increased

their allocations to PE. Will this trend continue?

60%

50%

40%

30%

20%

10%

0%No, % allocations have

peaked, and willdecline following the

credit crunch

17%

29%

54%

% allocations nearingtheir peak, and will befairly steady in future

Trend will continue:many institutions haveyet to make their firstinvestments, and most

are well below theallocations of Harvard,

Yale, etc.



Figure 3: LP Return Expectations—Gross IRR for Next 5 Years

0.4

0.35

0.3

0.25

0.2

0.15

0.1

0.05

010%

5%

28%

37%

23%

5%2%

10-15% 15-20% 20-25% 25-30% 30%

Source: Preqin LP survey, October 2008

PERCENTAGE OF RESPONDENTS


Hidden in the bail-out bill was a newdraconian rule that applies to traditionaldeferred compensation arrangements ofpartnerships and foreign corporations, andsome performance and management feearrangements of hedge funds. Deferredcompensation that is subject to the newrule, §457A of the Internal RevenueCode, must be included in income whenthe compensation will no longer besubject to a so-called “substantial risk offorfeiture” (meaning that the tax deferralwill not be respected and the serviceprovider may have phantom income).However, if the amount of the deferredcompensation cannot be determined atthat time, the amount will continue to bedeferred until the amount is determinable,at which time the service provider willinclude the amount in income and besubject to a 20% penalty tax, plusinterest.

Private equity fund sponsors shouldimmediately determine whether this newrule applies to them or any of theirportfolio companies and, if it does, shouldbegin formulating their compliancestrategies.

Who, Me? Section 457A applies to deferredcompensation arrangements of “non-qualified entities.” The first step in aprivate equity fund sponsor’s inquiry willbe to determine whether there are any“non-qualified entities” in its universe.The term is potentially very broad: unlessexpressly excluded, a “non-qualifiedentity” includes any partnership, whetherforeign or domestic, and any foreigncorporation.

In general, a partnership will be a non-qualified entity unless “substantially all”of its income is allocated to taxablepartners. Taxable partners generally donot include (1) tax-exempt organizationsand (2) non-U.S. persons whose income isnot subject to a “comprehensive foreignincome tax.” A foreign corporation willgenerally be a non-qualified entity if itsincome is not effectively connected with aU.S. trade or business or is not subject toa comprehensive foreign income tax. Wedo not yet know how Treasury willinterpret the “substantially all”requirement or the term “comprehensiveforeign income tax.”

Private equity fund sponsors have formany years invested in portfoliocompanies organized in partnership form,including operating partnerships andlimited liability companies. These entitieswill be “non-qualified entities” unlesssubstantially all of their income isallocable to taxable partners, which maynot be the case where the partnership orLLC is owned by a fund with a substantialnumber of tax-exempt or “offshore”limited partners, or where a “blocker”company in place is in a tax havenjurisdiction. Similarly, foreign companyportfolio investments may be “non-qualified entities.” The deferredcompensation arrangements of theseportfolio investments are subject to§457A.

In addition, many private equity fundswill themselves be non-qualified entitiesif, for example, they have a substantialnumber of tax-exempt or “offshore”limited partners. The management andperformance fee arrangements of such

funds may be subject to §457A.However, we believe that a partnershipprofits interest issued by a non-qualifiedentity is not subject to §457A.

What Arrangements Are at Risk? Once the non-qualified entities areidentified—be they portfolio investments,the fund manager, or the fund itself—thenext task will be to identify whether theyhave any problematic deferredcompensation arrangements. “Deferredcompensation” is very broadly defined forthis purpose to include any “legallybinding right”—that is, any promise—toa service provider to receive compensation

More Deferred CompensationLegislation—Will It Ever End?

CONTINUED ON PAGE 8

Hidden in the bail-out bill

was a new draconian rule

that applies to traditional

deferred compensation

arrangements of [many]

partnerships and foreign

corporations....Deferred

compensation that is

subject to the new

rule...must be included in

income when the

compensation will no

longer be subject to a so-

called “substantial risk of

forfeiture”....


that is payable to the employee in a lateryear for services performed in an earlieryear. Many private equity fund sponsorsare familiar with the types of deferredcompensation arrangements that aresubject to §409A. Well, think of §457Aas §409A on steroids —while the sametypes of deferred compensationarrangements are subject to §457A,§457A also affects certain equity-basedawards and performance-basedcompensation that are exempt from§409A’s reach. (The good news is thatwe expect that §457A will not apply topartnership profits interests, and thusmost private equity carried interestsshould not be subject to §457A.) On itsface, §457A appears broad enough toinclude,

� at the private equity fund andmanager level, phantom carryarrangements and deferredmanagement fee arrangements,including so-called “side pocket” feearrangements, and

� at the portfolio company level, stockappreciation rights, options, otherperformance-based compensation,severance agreements and other itemsof compensation not traditionally

understood as deferred compensation.

What Are the “Outs”? The main exception from §457A iscompensation that is paid shortly after itceases to be subject to a “substantial riskof forfeiture” (that is, it becomes vested).However, the only vesting restrictionthat works for this purpose appears to bethe performance of substantial services;it appears that vesting based on theachievement of performance conditionswill not be a sufficient vesting conditionto rely on this exception. Under thisexception, payments made within 12months after the end of the servicerecipient’s year during which vestingoccurs are not treated as deferredcompensation for purposes of §457A.The Treasury may issue guidance in thefuture that will provide additionalexceptions.

When Do the New Rules Apply? Section 457A applies to deferredamounts which are “attributable” toservices performed after December 31,2008. Deferred amounts which are“attributable” to services performedbefore January 1, 2009, will not besubject to §457A, provided that suchamounts are included in income no later

than (1) 2017 or (2) the taxable year inwhich the amount is no longer subject toa “substantial risk of forfeiture.” TheTreasury Secretary is charged withissuing, by February 2009, transitionrules that will permit service providersand service recipients to conform their

arrangements which are “attributable” toservices performed before January 1,2009 to these requirements withoutviolating §409A.

Note that §457A is not intended toreplace the other draconian deferredcompensation statute, §409A, and itremains to be seen how Treasury willintegrate the two statutes (and, inparticular, whether regulatory exceptionsunder §409A final regulations will beimported into the §457A regime).

What Should You Do Now? The new rules leave many questionsunanswered. While the IRS is expectedto provide guidance on §457A soon, it isimportant to remember that §457A goesinto effect January 1, 2009, so there isno time to delay. If you are potentiallysubject to §457A, we encourage you toimmediately take stock of yourcompensation arrangements and perhapsthe structure of the relevant partnershipor foreign corporation to consider anychanges that may be warranted ordesired to comply with the new rules.

Peter A. [email protected]

Jonathan F. [email protected]

David H. [email protected]

Charles E. [email protected]

More Deferred Compensation Legislation—Will It Ever End? (cont. from page 7)

The good news is that we

expect that §457A will

not apply to partnership

profits interests, and

thus most private equity

carried interests should

not be subject to §457A.


Policymakers’ frantic search for capital toprop up ailing financial institutions has led toa more welcoming environment for sovereignwealth funds (“SWFs”) in Washington andthe capitals of Europe alike. Beneath thisuneasy embrace, however, concern lingersover SWFs’ lack of transparency and thepossible use of their investment clout tofurther the geopolitical ambitions of theirsponsor countries.

In the hope of addressing these concerns,the IMF’s International Working Group ofSovereign Wealth Funds (“IWG”) recentlypublished its Generally Accepted Principlesand Practices for Sovereign Wealth Funds.Known as “The Santiago Principles” or“GAPP,” which establish voluntary practicesand principles for SWF governance andtransparency that are designed to demystifySWFs while ensuring that they invest on thebasis of economic and financial risk andreturn, rather than political considerations.

The IWG was established on May 1,2008 with a mandate to draft generallyaccepted principles and practices for SWFsand is comprised of representatives of the 26member countries of the InternationalMonetary Fund with SWFs. Given thedivergent structure and purpose of thevarious SWFs and the varying interests oftheir member countries, which includeseveral Gulf states, China, Norway, Russia,Singapore and the United States, this was noeasy task.

The Santiago Principles consist of 24principles and practices falling into threemain areas: legal framework, objectives, andcoordination with macroeconomic policies;institutional framework and governancestructure; and investment and riskmanagement framework. In each of theseareas, the objective is to promoteaccountability, transparency andindependence, and in doing so, reduce therisk of political influences on investmentdecisions of SWFs.

GAPP principles most prominentlyfocused on these aims include:

� GAPP 6, 7, 8 and 9, which are intendedto delineate a clear line of demarcationbetween SWF owners (i.e., the sovereignsponsor) and SWF managers, and toestablish principles for SWF governance.They require:� an effective division of roles and

responsibilities to facilitate operationalindependence of SWF management;

� that the SWF owner set the objectivesof the SWF and appoint members ofits governing bodies in accordancewith clearly defined procedures;

� that the governing bodies operate inthe best interests of the SWF, andhave clear authority to carry out theirfunctions; and

� that management implement SWFstrategy in an independent mannerand in accordance with clearly definedresponsibilities.

� GAPP 16, 17, 18, 19, and 21, each ofwhich is directed in part to ensuringtransparency by requiring publicdisclosure of:� the SWF’s governance framework and

objectives and of the manner in whichmanagement is operationallyindependent from the SWF’s owner;

� relevant financial information todemonstrate the SWF’s economic andfinancial orientation, including assetallocation, benchmark informationwhere relevant, and rates of returnover appropriate historical periods;

� the investment policy of the SWF,including qualitative statements oninvestment style, investment themesand objectives, and strategic assetallocation;

� the extent to which investmentdecisions are governed by other thaneconomic and financial considerations(e.g., social, ethical, religious or

environmental factors); and � the SWF’s general approach to voting

securities of public companies,including the key factors guiding itsexercise of ownership rights.

� GAPP 15, 18, 19 and 20, which allestablish norms of behavior for SWFs thatare designed to limit political influenceson, and the use of political influence in,SWF investments, including requirementsthat:� SWF operations and activities in host

countries be conducted in compliancewith local laws (including localdisclosure requirements);

� SWF investment policies be clear andconsistent with defined objectives, risktolerance and investment strategy, andbe based on sound portfoliomanagement principles;

� SWF investment decisions aim tomaximize risk-adjusted financialreturns in a manner consistent with anSWF’s investment policy and based oneconomic and financial grounds; and

� a SWF not take advantage ofprivileged information orinappropriate influence by thebroader government in competingwith private entities.

The GAPP principles are voluntary, butaccording to the IWF report, “members ofthe IWG support and either haveimplemented or aspire to implement” theprinciples. Although the SWFs themselvesand many observers argue that they havealways been economic and not politicalactors, the Santiago Principles, if widelyadopted, should go a long way towardsallaying residual fears about the politicalmotivations of sovereign wealth funds.

Andrew L. [email protected]

Liam F. Timoney [email protected]

Sovereign Wealth Funds: The Santiago Principles


Mandatory electronic filing has entered theworld of private placements. Although thisseems like a positive development, privatefunds in particular should be aware that theirplacement activities will be easier to trackthan in the past.

Form D should be familiar to privateequity sponsors as the notice required to befiled with the Securities and ExchangeCommission for a nonpublic issuer offeringin reliance on Regulation D under theSecurities Act of 1933, as amended.Beginning March 16, 2009, every Form Dfiled with the SEC must be filedelectronically on new Form D.1

This new electronic filing requirementwill require some issuers unaccustomed toelectronic filings to get up the learning curve.Issuers filing electronically must first obtainEDGAR (the SEC’s Electronic DataGathering, Analysis and Retrieval System)access codes from the SEC, generally by filinga Form ID electronically, and within the nexttwo days faxing the SEC a notarizedauthenticating document. While one-stopfiling is the goal and state regulators intend todevelop a system to electronically interfacewith EDGAR, even after March 15, 2009 itis likely that paper filings will be required bysome (or all) states for some time, and somestates may not accept new Form D even inpaper format.

Private fund issuers in particular may beunhappily surprised by the public’s easyaccessibility to their Form Ds. Form Dselectronically filed with the SEC will beaccessible from any computer with Internetaccess and the SEC will capture and tag dataitems to make them interactive and viewablein an easily-read format. To skirt the issue ofgeneral solicitation and advertising arising

from easy access to Form D, the SEC hascreated a safe harbor if the issuer makes agood faith, reasonable attempt to complywith Form D requirements. Filers concernedabout news coverage and general accessibilityof their filings should note this issue will onlyintensify and may want to consider carefullywhether structuring placements of securitiesunder the Reg. D exemption is the rightapproach.

When to File New Form D:When Is the “Sale”? If you are using new Form D either in paperor electronically, the period for timely filingwill be the 15th day after the first sale, or thenext business day if that falls on a weekend orholiday. The date of first sale is aninformational item on new Form D so it willbe obvious if the federal filing is late(although there is no specific penalty for alate federal filing); a state may separatelyrequest date of first sale in the particular state(some states have imposed additional fees orother penalties or measures for late filings).The SEC is interpreting “sale” as the date onwhich the first investor is irrevocablycontractually committed to invest, which,depending on the terms and conditions ofthe contract, could be the date on which theissuer receives the investor’s subscriptionagreement or check and not necessarily as lateas the closing date. Because practitionerswho have generally treated the closing date asthe trigger date are concerned about rollingadmissions, incomplete subscriptions, andmissed deadlines that might result from theSEC’s interpretation, the Committees onFederal Regulation of Securities and StateRegulation of Securities of the American BarAssociation have asked the SEC to reconsiderand instead make the trigger the closing date,and we will stay tuned for possible futuredevelopments.

Changes in InformationRequired by New Form D There are a number of differences in theinformational requirements of new vs. old

Form D. Thankfully, some of therequirements, such as the disclosure of netasset values for investment funds, are subjectto opt out. The new disclosures required withrespect to sales commissions and finders feesis likely to flag the use of unregisteredplacement agents and finders for regulators.In addition, private funds must disclose theexemption they rely upon under theInvestment Company Act of 1940.

Amendments to Form DCurrently, under old or temporary Form Dthere are no explicit requirements as to whenand under what circumstances to amendForm D. New explicit requirements forfiling amendments to Form D now apply toall filings on new Form D and, beginningMarch 16, 2009, to continuing offerings thathad been filed on old or temporary Form D.Amendments will be required, if the offeringis continuing, (1) annually, (2) to rectify amaterial mistake of fact or error, and (3) toreport any change in information (whether ornot material) subject to certain specificexclusions. For example, any new executiveofficer, a decrease of more than 10% in theminimum permitted investment, an increaseof more than 10% in the total offeringamount, or a new placement agent or finder,will require amendment as soon as practicable.

Also on the SEC AgendaThe SEC in separate releases had alsoproposed substantive changes to Reg. Dincluding a new exemption, across-the-boardbad actor disqualification provisions, changesin the definition of “accredited investor” andchanges in the treatment of accreditedinvestors in private pooled investmentvehicles. Those proposals have not beenfinalized but remain on the SEC’s agenda.The nation’s economic crisis and theanticipated departure of Commissioner Coxseem to have pushed those agenda items offthe front burner, at least for the moment.

Ellen [email protected]

Electronic Filing (and Tracking) Comes to Reg D Private Placements

1 During the transition period which beganSeptember 15, 2008, issuers have the option to file thenew Form D electronically or in paper with the SECor to file the “temporary” Form D in paper with theSEC (“temporary” Form D is basically the old Form Dwith a few minor, non-substantive tweaks).


European Union regulation of the privateequity and hedge fund sectors is likely onthe horizon, but only after what will be arelatively long gestation period. The EUParliament, which is the elected body thatoversees the work of the EU’s legislativebranch (the EU Council) and executivebranch (the EU Commission), voted in lateSeptember to adopt a report of the EU’sCommittee on Economic and MonetaryAffairs calling for stricter disclosurestandards for, and limits on, excessiveborrowing by private equity and hedgefunds.

Relying on its power to propose newlegislation projects to the Commission, theParliament has formally requested that theCommission prepare a draft bill by the endof this year. But both the timing and thecontent of any resulting EU legislation arehard to predict. The swift passage of thelegislation, as it winds its way through theEU Parliament and Council, is by nomeans certain, particularly since difficulteconomic times have presented morepressing problems.

More importantly, the current report,which essentially does not distinguishbetween private equity and hedge funds, isvague enough that even those deputies whosupported the recent resolution are likely tofind much to disagree about in the comingmonths.

The EU Parliament’s official “resolutionwith recommendations to the EUCommission” (which incorporates word-for-word the committee’s report) is onlyseven pages long and conspicuously vague.Its brevity, however, belies the extent of thework and discussions surrounding itspublication. In its final form, theresolution includes far fewer and lessonerous proposals than did previous draftsof the underlying report, due largely to

input from private equity groups andinevitable compromises among theParliament’s socialist, liberal andconservative members.

It took approximately six months tofinalize the report from the time its author,Parliament member Poul NyrupRasmussen, penned his first draft. Thosewho are familiar with Mr. Rasmussen, thepresident of the Party of European Socialistsand a former Prime Minister of Denmark,will appreciate that his personal perspectiveon private equity may not be particularlyobjective. (Rasmussen is well known forauthoring a recent book in Denmarkentitled grådighedens tid (which translates as“In the Age of Greed”) and for being avocal critic of pension fund investment inprivate equity, most notably in connectionwith the takeover of TDC, Denmark’slargest telecom operator, where aconsortium of five private equity groups(Apax, Blackstone, KKR, Permira andProvidence) acquired the company but wereunable to de-list it due to the refusal ofATP, a large Danish pension fund, to tenderits 5.5% interest in the tender offer.)

After the publication of Rasmussen’s firstdraft of the report, representatives of theEuropean private equity industry, includingJavier Echarri, secretary general of theEuropean Private Equity and VentureCapital Association, spoke out against therush to regulate the industry, highlightingthe numerous benefits arising from privateequity investment in Europe, such as jobcreation, the strengthening and revival offoundering businesses and the provision offunding for startups.

The final version of the report calls forthe following regulatory initiatives for theprivate equity and hedge fund industries inEurope:

� Heightened transparency and disclosurerequirements concerning debt exposure,risk-management systems, portfoliovaluation methods, general investmentstrategies, fee policies, source andamount of funds raised, as well asdisclosure of high level executives’compensation “systems.”

� The implementation of unspecifiedmeasures to limit the incurrence ofexcessive debt and asset stripping, as wellas a general call for a requirement in theprivate equity sector that leverage besustainable for both the target companyas well as for the acquiring firm.

� A review of the main EU directivecovering employees’ rights in order toensure that it sufficiently protectsemployees’ rights to be informed andconsulted when the control of a businessis transferred by owners who are privateequity and hedge funds, as well as thereview of the main pension funddirective to ensure that employees orstaff representatives are adequatelyinformed about the nature of theirpension investments and the associatedrisks. It is not clear from the reportwhether this review might lead, forexample, to the EU extending theobligation to inform and consultworkers’ councils about certaintransactions (which is common in someparts of continental Europe, but not inthe United Kingdom or Ireland), beyondits current scope.

In earlier incarnations, the report had calledfor extensive disclosure of compensation ofmanagers, directors and other staff ofprivate equity and hedge funds, and specificdisclosure requirements regarding debtexposure, managers’ past performance,

Are New Private Equity and Hedge FundRegulations on the Horizon in the EU?



valuation methods for portfoliocompanies, and the amount of fundmanagers’ investments in the funds. Itremains to be seen whether the deletion ofthese recommendations ensures that theywill not reappear when the legislature putspen to paper.

At this point, any new regulations arelikely to be delayed several months bypolicymakers’ competing agendas, themechanics of the EU legislative process, orboth. The EU Commission must nowdecide the terms of any draft legislationbased on the Parliament’srecommendations, but the process is notuniversally supported. Interestingly, the

European Commissioner for the InternalMarket and Services, Charlie McCreevy,has recently appeared to be trying to slowany rush to regulate. Among other things,McCreevy has emphasized that theregulation of private equity should moveat a controlled pace and be carefullyexamined in light of the manycontributions the sector has made to theEuropean economy. McCreevy recentlyobserved, for example, that “all knownregulatory concerns relating to the impactof hedge funds and private equity on thefinancial and economic system are alreadyaddressed—either in European or nationallegislation.”

For the moment, it’s still too early toanticipate the timing or the content ofany resulting new legislation and how itmight affect private equity in Europe.However, it is clear from the report andthe EU Parliament’s interest in the subjectthat, for better or for worse, private equityand hedge funds are now officially on theEU regulators’ radar and agenda. Staytuned for an update as the legislativeprocess unfolds.

E. Drew [email protected]

Gabriel [email protected]

Are New Private Equity and Hedge Fund Regulations on the Horizon? (cont. from page 11)

without being deemed to exercise acontrolling influence. The Fed has madeclear that a non-controlling investor mayadvocate changes to the bank organization’spolicies and operations. The Fed’s policystatement gives examples of the types ofthings that the investor may permissiblyseek to have input on, including changes tothe organization’s dividend policies,financing strategies, acquisition ordivestiture proposals, managementchanges, and change of controltransactions. While the investor may giveits views on such matters, and eveninitiate proposals, the ultimate decisionmust remain with the bank organization’smanagement, board, or shareholders as awhole. The banking organization cannotgive a non-controlling investor specificconsent rights as to such matters or itspolicies generally. In addition, the non-controlling investor may not threaten tosell its shares or to sponsor a proxysolicitation if its recommendations are notadopted.

As a result, while the September policystatement gives private equity investorssomewhat greater flexibility in makingminority investments in banks—forexample, by allowing director representationat investment levels above 10%, and byallowing total equity investments of up to33% (albeit with a substantial portion beingin the form of non-voting shares)—itdoesn’t allow the investor to take the type ofownership position, or to exercise the levelof control, that private equity firmstraditionally expect to obtain in respect oftheir portfolio company investments.

In certain circumstances, a private equityinvestor may be able to utilize a “silo”structure to effect an investment in abanking organization in a manner that givesthe investor control for BHC Act purposeswithout subjecting its associated fund to thefinancial commitments and investmentrestrictions applicable to bank holdingcompanies. It may also be possible tostructure contemporaneous minorityinvestments by multiple investors in a

manner that avoids attributing control ofthe bank organization, and hence bankholding company status, to any member ofthe group. Given the importance of controlrights to most private equity funds, theseapproaches may provide a more promisingpath to private equity investment in thebanking sector. However, the Fed’s Septemberpolicy statement specifically declined toaddress the issues raised by these structures.

Thus, while the September policystatement may make banking investmentsmarginally more attractive to private equityinvestors, a significant increase in suchinvestments is likely to await further Fedguidance on structures to accommodatecontrolling investments by private equityfirms.

Gregory V. [email protected]

Paul L. Lee [email protected]

One (Small) Step for PE Firms (cont. from page 3)


It is not uncommon for directors to benervous these days. The Delaware ChanceryCourt’s recent decision in Ryan v. LyondellChemical Co. exacerbated those jitters.

The case is troubling because it finds thatindependent directors, acting withoutconflicts of interests, could be heldpersonally liable for approving a high-premium cash merger with non-coercive,customary deal protection terms, which wasoverwhelmingly supported by stockholders.The decision, if upheld, could have far-reaching consequences for private equitybuyers and sellers alike, including anincreased level of overcautiousness by skittishdirectors, greater reliance on pre-marketchecks, and in the event exigencies precludea pre-market check, more extensive post-market checks. Luckily, there are some evenmore recent cases and the opportunity for areversal on appeal that may alleviate theconcerns over the Chancery Court’s decisionin the Lyondell case.

More than 20 years after the term“Revlon duties” first came on the scene, theDelaware courts continue to analyzeprecisely what those duties entail,sometimes with unexpected results. It wasonly a little over a year ago that wepublished an article in the Summer 2007Debevoise & Plimpton Private Equity Reportabout a trio of Revlon cases that had justbeen decided (“Applying Revlon to PrivateEquity Transactions: Lessons from RecentDelaware Chancery Court Decisions”).Recently, another trio of Revlon cases—inaddition to the Lyondell decision,McPadden v. i2 Technologies, Inc. and In reLear Corp. Shareholder Litig.—has beenadded to the burgeoning body of Revloncase law.

As we noted in our earlier article, “thereis no single formula for satisfying Revlon”duties. Directors must take care to analyze

the complete array of relevant facts andcircumstances in each case and tailor thesale process, including deal protectionmeasures, to meet Revlon’s command todirectors to act reasonably to obtain thehighest price reasonably available.Moreover, directors’ Revlon duties are likelyto evolve with changes in markets andperceptions. Today’s market environment,for instance, may call for different fiduciarymeasures—such as greater scrutiny offinancing conditionality—than may haveapplied before the current liquidity crisis.The three cases highlighted in our earlierarticle principally addressed the Revlonimplications of management’s potentiallyconflicted role in the diligence andnegotiation process.

The newer cases—Lyondell, McPaddenand Lear—focus on whether the directorsof the target companies in those casesviolated their Revlon duties to such anextent that they could be said to have actedin “bad faith.” Bad faith, as compared tomere negligence or gross negligence,implicates a director’s duty of loyalty. Thisis significant, because many Delawarecompanies have in their charters a provisionpermitted under Section 102(b)(7) of theDelaware General Corporation Laweliminating personal liability for directorsfor breaches of the duty of care. Thisexculpatory provision, however, can notextend to breaches of the duty of loyalty.Thus, while the negligent (or even grosslynegligent) director may be protected frompersonal liability, the disloyal director—including the director who acts in badfaith—may not.

Ryan v. LyondellIn April 2006, the Board of Lyondell, ahealthy company not looking to be sold,turned down an unsolicited offer from

Basell AF for $26.50 to $28.50 per share asinadequate. A little over a year later, aBasell affiliate put the company “in play” byacquiring an 8.3% stake and filing aSchedule 13D indicating an intent todiscuss various transactions with Lyondell.Lyondell’s Board met to consider the 13D,but decided that an immediate response wasnot required. In early June, 2007,Lyondell’s CEO suggested to Basell that aprice of $48 was justified. Only one otherparty had approached Lyondell since the13D filing, and its offer was rebuffed.Then, on June 26, Basell agreed to acquireHuntsman Corporation. When Basell’s bidfor Huntsman was topped, Basell’s CEO,under time pressure to decide whether tocontinue to bid for Huntsman, met withLyondell’s CEO.

At a meeting on July 9, Basell initiallyproposed a $40 price, but, during the

How Bad Is “Bad Faith?”New Delaware Perspectives

…[D]irectors’ Revlon

duties are likely to evolve

with changes in markets

and perceptions. Today’s

market environment, for

instance, may call for

different fiduciary

measures—such as greater

scrutiny of financing

conditionality—than may

have applied before the

current liquidity crisis.



meeting, raised the price to $44 to $45.When Lyondell’s CEO said he doubtedthe Board would support a deal in thatrange, Basell responded with a “best” offerof $48 per share, conditioned on signing amerger agreement in seven days with a$400 million break-up fee. Basell said itneeded a firm indication of interest fromLyondell by July 11, the deadline formaking a new bid for Huntsman.

As diligence and merger agreementnegotiations proceeded, Lyondell’s Boardmet and authorized the CEO to negotiatefor a higher price, a “go-shop” provisionallowing Lyondell to solicit alternativebids for 45 days after signing a mergeragreement with a 1% break-up fee duringthe go-shop period, and a reduction in the$400 million post-“go-shop” break-up fee.Lyondell’s CEO raised these points onJuly 15, but Basell flatly refused, agreeingonly to reduce the break-up fee to $385million (which represented approximately3.0% of the equity value of the deal) and

refusing to agree to a “go-shop” provision.Believing $48 to be a “blowout” price,Lyondell agreed to the deal, on July 16and its stockholders overwhelminglyapproved the merger.

The court used harsh language todescribe the conduct of the Lyondell Boardboth before and after the Basell offer. Itcalled the Board “indolent” for “languidly”awaiting overtures in the wake of the 13Dfiling and not hiring a banker or otherwisetaking active steps to prepare for a takeoverbid. The court criticized the Board, amongother things, for having “avoided an activerole” in the merger negotiations, whichwere conducted by the Lyondell CEO; fornot having conducted a pre-signing marketcheck; for failing successfully to negotiate ago-shop provision; for agreeing to a 3%break-up fee, a no-shop provision andmatching rights; and for considering,negotiating and approving the deal in lessthan seven days.

While the court acknowledged theconcept that there is “no single blueprint”for fulfilling a board’s Revlon duties, thecourt said that “in most instances” theboard will be required to engage activelyin the sale process, and that the exclusivesale processes previously endorsed arelimited exceptions to the general rule,applicable only where the board has “abody of reliable evidence with which toevaluate the fairness of the transaction.”

The court questioned the adequacy ofthe Board’s knowledge and efforts, despitefinding that the Board was “active,sophisticated and generally aware of thevalue of the Company”; that it had solidreasons to believe that a competing bidderwould not emerge; that it was presentedwith detailed analysis from managementand its financial adviser indicating that theBasell price was fair and that thelikelihood of a topping bid “was slight, ifnot non-existent”; that, although the filing

of the 13D had put the company in playtwo months before Basell made its offer,no other viable proposals were received;and that the most knowledgeable director—the CEO—believed that $48 was thebest price then available.

Similarly, although it found that thedeal protections may have been “typical,”the court was not satisfied that Lyondell’sacceptance of them, or its decision not toconduct a market check, was justified bythe record. In particular, the court wasnot convinced that the Board made anyserious effort to resist Basell’s dealprotection demands or that Basell wouldhave walked away if it had not received allthe protections it demanded.

The court concluded that the Boardmay have breached not only its duty ofcare, but also its duty to act in good faith,because the directors failed “to act in theface of a known duty to act, therebydemonstrating a conscious disregard fortheir responsibilities.” The court foundthat Lyondell’s exculpatory charterprovision could not protect the defendantsat the summary judgment phase, because“the Board’s apparent failure to make anyeffort to comply with the teachings ofRevlon and its progeny implicates thedirectors’ good faith and, thus, their dutyof loyalty.”

On September 15, the DelawareSupreme Court agreed to hear theLyondell directors’ appeal, and it ispossible that the lower court’s decisionwill be reversed, although that appeal willnot be decided until early 2009.Moreover, the Chancery Court’s decisionis not a decision on the merits: it is aprocedural decision not to dismiss thelitigation before the actual facts can beestablished at trial. It is certainly difficultto see how the Lyondell directors’behavior was so egregious as to rise to thelevel of bad faith. Indeed, the court’s

How Bad Is “Bad Faith?” (cont. from page 13)


While...there is “no

single blueprint” for

fulfilling a board’s

Revlon duties, the court

said that “in most

instances” the board will

be required to engage

actively in the sale

process, and that the

exclusive sale processes

previously endorsed are

limited exceptions to the

general rule….


This article focuses on some recent legaldevelopments in Germany that will be ofrelevance to the private equity communityonce the deal making climate improves.

German Corporate LawReform—MoMiGOn November 1, 2008, following extensivediscussion over the past few years, afundamental reform of Germany’s corporatelaws went into effect. The reform is laidout in the Law for the Modernization of theLaw on German Limited Liability Companiesand the Prevention of Mispractice (generallyknown under the acronym “MoMiG”).

Among other things, MoMiG easescapital maintenance rules and introduces anew regime for intra-group cash pooling.In the past, admissibility of intra-groupupstream loans in connection with a cash-pooling system had become legallyquestionable due to a restrictiveinterpretation of the relevant capitalmaintenance rules by the German courts.MoMiG introduces changes that are likelyto facilitate cash management within thetarget group as part of the day-to-dayoperations and that could also reduce theneed for bank financing in an acquisitioncontext because cash that was previously“trapped” in German subsidiaries, may nowbe used to satisfy the working capital needsof other members of the target group.

Moreover, MoMiG includes new rulesfor the subordination of shareholder loans,provides for a simplified incorporationprocess and facilitates share purchases.

Takeover-Related Squeeze-OutGoing private transactions in Germanycould become more expensive if a recentdecision of a Frankfurt Regional Court is agood prognosticator. The subject of thedecision is the “squeeze-out” of DeutscheHypothekenbank’s remaining shareholdersafter NordLB’s acquisition of a 97.4% stake

through a public takeover bid. Inimplementing the squeeze-out, NordLBrelied on a special takeover-relatedprocedure that was introduced inimplementation of Art. 15 of the EUTakeover Directive.

That procedure has several distinctadvantages: First, it can be launched uponsimple request by the main shareholderfollowing completion of a takeover bid,once at least 95% of the voting rightsbelong to the bidder without requiring aresolution adopted at the target’sshareholders’ meeting. The remainingshares are then be transferred to the bidderby operation of law upon order of thecourt.

Second, if a bidder has acquired at least90% of the target’s securities as a result ofthe takeover bid, the consideration paid inconnection with the takeover bid is alsodeemed adequate compensation for theminority shareholders in the subsequentsqueeze-out. Prior to the Regional Court’sdecision, the prevailing opinion inGermany had been that the adequacy of thecompensation to the minority shareholdersis irrefutably presumed. The RegionalCourt broke with the prevailing view andheld that the presumption is merely arebuttable one, citing a decision of theGerman Federal Constitutional Courtregarding the minority shareholders’constitutional rights to get full (market)value for the shares.

The Regional Court’s decision is widelycriticized as opening the floodgates forprotracted shareholder litigation and forrelegating the decision as to the adequacy ofthe consideration to be received byminority shareholders in a squeeze-out tovaluation experts. The decision has beenappealed.

Cash-Settled EquityDerivativesGermany’s financial supervisory authority,the BaFin, recently confirmed that cash-settled (as opposed to physically-settled)equity derivatives may be used to acquiresignificant positions in public Germanissuers without triggering disclosureobligations.

Generally, the German SecuritiesTrading Act requires any person whoacquires 3% or more of the voting rights ofa public German issuer to file a disclosurenotice. Such a notice must also be filedwhen a person acquires other financialinstruments that give it the right to acquireat least 5% of the voting rights. The term“financial instruments” is broadly definedand includes physically-settled equityderivatives, but does not include cash-settled options or cash-settled equity swaps.

Cash-settled options were used inPorsche’s building a stake in Volkswagen

Recent Legal Developments in Germany


MoMiG introduces

changes that...reduce the

need for bank financing

in an acquisition context

because cash that was

previously “trapped” in

German subsidiaries,

may now be used to

satisfy the working

capital needs of other

members of the target

group.


and cash-settled equity swaps inSchaeffler’s takeover of German DAX-company Continental. Cash-settledequity swaps are derivative instrumentsthat perfectly mirror the economics of theunderlying shares. In the case ofContinental, the swaps were backed by anumber of investment banks, none ofwhich held more than 2.999% of theunderlying shares, thus avoiding thebanks’ own disclosure requirements. In itsdecision, BaFin blessed Schaeffler’sstrategy, arguing that Schaeffler did nothave the legal right to direct the voting ofthe shares and that there was no evidenceof any further agreements with theinvestment banks on the basis of whichthe underlying Continental shares couldhave been attributed to Schaeffler.

It remains to be seen whether therecent events surrounding Porsche andVolkswagen will generate new momentumfor plugging what many perceive to be adisclosure loophole. Note that theGerman Finance Ministry, after earlierstatements to the contrary, recently hintedthat the German Federal Government wasconsidering new legislation concerningthis issue.

Foreign InvestmentRestrictionsGermany is planning new restrictions onforeign investments by investors basedoutside the EU and European Free TradeAssociation (EFTA), which may hamperinvestment activity. If enacted, the newrules would expand existing legislationfocusing on the defense and encryptionindustry, which was enacted following the2003 takeover of Howaldtswerke-Deutsche Werft, the world’s leading

conventional submarine-maker, by a U.S.private equity firm.

The main elements of the proposed billare:

� Any direct or indirect acquisition of astake of at least 25% of the votingrights in a company resident inGermany by a non-EU or non-EFTAinvestor may be subject to a formalinvestigation by the Federal Ministryfor Economics.

� There is no restriction to specificindustry sectors and the size of the dealis irrelevant.

� Investigations by the Ministry must beinitiated within three months aftersigning.

� The Ministry is entitled, within twomonths of having received therequested information, to imposerestrictions, in particular, to prohibitthe acquisition, if the transaction isconsidered to be a “threat to publicorder or security.”

Until the above time periods haveelapsed or a decision has been taken, theacquisition remains subject to a conditionsubsequent. While the proposed bill doesnot contemplate an express obligation onthe part of the acquiror to notify theMinistry, the bill entitles the GermanFederal Cartel Office to share mergercontrol information with otherauthorities. As a consequence, acquirorsmay voluntarily apply for a review prior tothe signing of the transaction.

The proposed bill, on its face, appliesto any non-EU or non-EFTA acquiror.Nonetheless, it is believed that the

primary targets of the bill are sovereignwealth funds that attempt to acquirepublic infrastructure, such as telecom andenergy networks. The low marketcapitalization of many public Germanissuers due the current financial crisis isexpected to accelerate the adoption of thebill. Whether and how the bill would beenforced vis-à-vis private equity sponsorsremains to be seen, though GermanEconomics Minister Michael Gloshastened to assure that “Germany is andremains open to foreign investments” andthat “the majority of foreign investmentswill not be affected by the proposedlegislation.”

The proposed bill has already attractedheavy criticism. The German FederalCouncil (Bundesrat) has asked for ashortening of the review and decisionperiods. Moreover, concerns have beenvoiced that the proposed legislation mayviolate the EC Treaty’s provisions on thefree movement of capital. The EUCommission has already requestedadditional information from the GermanFederal Government. The bill must stillpass a vote in the German Parliament(Bundestag).

Thomas Schü[email protected]

Peter [email protected]

Recent Legal Developments in Germany (cont. from page 15)


Many deal processes simply do not allowadequate time or access for customary legaldue diligence. This is particularly true in someprocesses involving public targets, especially inEurope. Not only are these facts of deal lifefrustrating, but they also can require privateequity and other buyers to make judgmentsabout potential enforcement risks withoutsufficient information. In a cross-jurisdictionalsetting, this can be particularly acute becausethe jurisdiction in which the target business islocated may not prohibit activities which areoutlawed under the U.S. Foreign CorruptPractices Act (“FCPA”) when the business isowned by U.S. persons. The U.S.Department of Justice (“DOJ”) has issuedguidance on what U.S. acquirors, includingprivate equity firms, need to do to avoidhaving the DOJ take enforcement action if itproceeds with an acquisition of a businesswith FCPA issues where appropriate anti-corruption due diligence cannot be completedbefore closing.

The DOJ guidance was issued throughits opinion review and was prompted byHalliburton Company’s (“Halliburton”)request for an opinion regarding the DOJ’sintention to take enforcement action whereit has insufficient time and inadequateaccess to information to completeappropriate FCPA and anti-corruption duediligence pre-closing with respect to a UKpublic company.1 DOJ made explicit itsexpectation that acquirors include thoroughFCPA-specific due diligence in their pre-acquisition activities and heed the roadmapoffered for situations when appropriate pre-acquisition due diligence and remediationcannot be negotiated or are otherwiseimpracticable.

Application of the FCPA to Private CompaniesBy way of background, FCPA applies tobroad general categories of entities andindividuals: (1) “issuers” (for conduct thatoccurs anywhere in the world in the case ofU.S. issuers, and for conduct that involvesuse of the mail or any means orinstrumentality of interstate commerce in thecase of non-U.S. issuers); (2) U.S. citizens,nationals and residents and entities with aprincipal place of business in the U.S. ororganized under U.S. laws (for conduct thatoccurs anywhere in the world); and (3) anyindividual or entity who engages inprohibited conduct “while in the territory ofthe United States.” The DOJ prosecuted twoprivate companies—Paradigm B.V. andOmega Advisers, Inc.—in 2007 and weexpect the trend in the prosecution ofdomestic concerns to continue.

Opinion Procedure ReleasesFCPA Review Opinion Procedure Releasesare important pronouncements in an area oflaw with few litigated cases and scant formalguidance from government regulators.Although, as standard practice, the releasesdisclaim their applicability to anyone otherthan the requesting party (in this case,Halliburton), it is widely accepted that theDOJ intends for all companies subject to theFCPA to act within the parameters set forthin the opinion procedure releases.

The Halliburton OpinionHalliburton requested assurances from theDOJ that its planned bid for ExproInternational plc would not result in FCPAliability. Halliburton represented that itwas unable to complete appropriate FCPAand anti-corruption due diligence becauseof United Kingdom legal restrictions

inherent in the bidding process for a publicU.K. company, and offered to implement arigorous post-closing plan instead.Halliburton specifically requested answersfrom the DOJ to the following questions:(1) whether the acquisition itself wouldviolate FCPA; (2) whether Halliburtonwould be held liable for pre-acquisitionviolations by Expro; and (3) whetherHalliburton would be held liable for post-acquisition violations by Expro prior toHalliburton’s completion of its FCPA andanti-corruption due diligence, where suchconduct is identified and disclosed to theDOJ within 180 days of closing.

The DOJ responded that, in exchangefor Halliburton undertaking andsuccessfully completing the extensive post-

Avoiding FCPA Anxiety: A Roadmap to M&A Due Diligence and Post-Acquisition FCPA Compliance


DOJ made explicit its

expectation that

acquirors include

thorough FCPA-specific

due diligence in their

pre-acquisition activities

and heed the roadmap

offered for situations

when appropriate pre-

acquisition due diligence

and remediation cannot

be negotiated or are

otherwise impracticable. 1 Op. Proc. Rel. 08-02 (June 13, 2008), availableat http://www.usdoj.gov/criminal/fraud/fcpa/opinion/2008/0802.html (“the Halliburton Opinion”).


Managers...should...weigh the impact

that an IPO will have on the culture and

day to day operations of what had been

a privately owned and managed firm.

Despite its many (in particular economic)

advantages, going public is unlikely to

be the right step, or even practically

possible,

for most

alternative

asset

managers.

1Note that clawbacks are not generally used in hedgefunds.

closing plan, it would not take anyenforcement action for the acquisition ofthe target itself or for any pre-acquisitionor post-acquisition unlawful conduct ofthe target that was disclosed, terminatedand remediated within 180 days after theclosing, or within a reasonable time period(in the judgment of the DOJ). Though itis important to note that the detailedpost-closing steps listed in the HalliburtonOpinion are not “requirements” foranyone other than the requestor,Halliburton’s post-closing plan does meritattention, as it provides insight into theDOJ’s due diligence expectations andserves as a roadmap for any private equityfirm considering the acquisition of acompany with operations outside theUnited States.

Halliburton Post-Closing PlanThe key aspects of Halliburton’sapproved post-closing plan can becategorized into four sections: (1) duediligence; (2) disclosure; (3) compliance;and (4) remediation:

1. Due DiligenceHalliburton was required to present theDOJ with a comprehensive, risk-basedFCPA and anti-corruption due diligencework plan within ten business days of theclosing. The plan was expected toaddress, among other things, the use ofagents; dealings with state-ownedcustomers; any joint venture, teaming orconsortium arrangements; customs andimmigration matters; tax matters; and anygovernment licenses and permits. Thedue diligence was to be organized intohigh risk, medium risk, and lowest riskcategories, and each category carried adifferent time frame for completion.

Halliburton was expected to retainexternal counsel and third-party consultants,including forensic accountants, to conductthe due diligence, and the due diligenceprocess was required to includeexamination of relevant records andinterviews with relevant individuals.

The due diligence and remediation,including investigation into any issues thatwere identified, was required to becompleted within various time periods.The plan required Halliburton to reporton high-risk due diligence within 90business days of closing; medium-riskwithin 120 business days of closing; andlow-risk within 180 days of closing. Anyissues that required more extensiveinvestigation had to be completed withinone year of closing.

2. Disclosure Immediately following the closing,Halliburton was required to disclose

whether any pre-closing informationlearned by Halliburton suggested that anyFCPA, corruption, or related internalcontrols or accounting issues existed at thetarget company. Halliburton was alsorequired to disclose any issues uncoveredduring the course of its post-closing duediligence.

3. ComplianceHalliburton was required to immediatelyimpose its own Code of Business Conductand specific FCPA and anti-corruptionpolicies and procedures on the targetcompany, including effectivelycommunicating the policies andprocedures to employees within defineddeadlines.

4. Remediation Halliburton was required to takeappropriate remedial action, includingterminating or suspending third partyagreements and/or disciplining employeeswhere necessary, within one year ofclosing.

As long as the post-closing plan wasimplemented and completed within oneyear of closing, the DOJ assuredHalliburton that it would not takeenforcement action against Halliburtonfor any pre-acquisition violations of thetarget or any violations that occurredwithin 180 days after closing thatHalliburton disclosed to the DOJ,assuming no Halliburton employee oragent was knowingly involved in theviolation. However, the DOJ did reservethe right to take enforcement actionagainst the target company for any FCPAviolations, regardless of disclosure, andHalliburton was required to maintain thetarget company as a wholly-ownedsubsidiary for so long as the DOJ wasinvestigating.

Avoiding FCPA Anxiety (cont. from page 17)


...[I]n exchange for

Halliburton undertaking

and successfully

completing the extensive

post-closing plan, [DOJ

agreed] it would not take

any enforcement action

for the acquisition of the

target itself or for any

pre-acquisition or post-

acquisition unlawful

conduct of the target

that was disclosed,

terminated and

remediated....


IntroductionIn the current environment, there is littledoubt that there will be more companiesentering bankruptcy proceedings in the nextyear or two, including private equityportfolio companies. Insurance can be a veryvaluable asset in a bankruptcy, amounting tomillions of dollars, potentially protecting theprivate equity sponsor, the portfoliocompany, and the funds managed by the PEsponsor. Historically, PE sponsors have oftenrelied on the D&O coverage purchased bytheir portfolio companies to address theirD&O insurance needs. Even so, manyprivate equity sponsors have not activelymanaged this coverage in ways best designedto ensure this coverage is always available to itin a bankruptcy scenario. As a result, somesponsors, as described below, have beenblocked from accessing this coverage when itmay well be most needed: upon thebankruptcy of its portfolio company.

Recently, it has become more common forsome private equity sponsors to protectagainst this risk by purchasing insurance atthe sponsor level to cover their own activitiesand those of the funds they manage. Whilesuch coverage may well provide additionalprotection to a sponsor and its managedfunds, it too, if not properly structured, canbe subject to important limitations oncoverage in the event of the bankruptcy of aportfolio company. As a result, sponsors arewell advised in the current environment toreview the scope of their current coverage tomake sure there are no gaps or conflictingterms between the insurance coverage at theportfolio company level, on the one hand,and any such insurance at the fund level, onthe other hand.

Unfortunately, many private equity firms

take their first close look at their owncoverage and the coverage at the portfoliocompany level only once a bankruptcy isimminent. In some cases, PE sponsors findthat any coverage they have purchased ateither the portfolio company level or fundlevel is not appropriately tailored forbankruptcy exposures. As a result, someprivate equity sponsors are findingthemselves financially exposed at a stagewhen it is too late to take remedial action.

Here are some of the questions thatprivate equity sponsors should be askingabout insurance when it comes toprotecting themselves and the funds theymanage from just such a fate.

Is the Portfolio Company Directors and Officers Insurance Policy an Asset of the Bankruptcy Estate under theBankruptcy Code? Pursuant to Section 541(a)(1) of theBankruptcy Code, assets of a debtor’sbankruptcy estate are subject to theautomatic stay. The automatic stay acts topreserve the estate and prevents distributionof estate assets without bankruptcy courtapproval. In the insurance context, to theextent a policy and the proceeds of a policyare determined to be assets of the estate, theinsurer is not permitted to pay defensecosts, settlements or judgments under thepolicy. Directors, who most likely cannotget indemnification from the financiallytroubled portfolio company, could findthemselves exposed.

For this reason, the first question that aprivate equity sponsor should be asking iswhether or not the portfolio companydirectors and officers insurance policy willlikely become an asset of the bankruptcyestate. The determination as to whether a

directors and officers policy and/or theproceeds belong to the estate is very fact-specific, and may vary depending upon thejurisdiction and the policy language. Thetypes of coverage (Sides A, B and C)1 aswell as the terms of the policy are crucial tothe determination. The fact-specific natureof the inquiry results in some uncertaintyregarding how a bankruptcy court woulddecide these issues.

For example, a policy may be an asset ofthe bankruptcy estate while the proceeds

Best Planning for the Worst:Assuring Insurance Coverage for Private Equity Sponsorsand Portfolio Company Directors in Bankruptcy


1 Side A: Provides coverage for directors and officersin cases when the company cannot indemnify theindividuals (e.g., because the claims are notindemnifiable under applicable law). Side A coveragehas no retention.

Side B: Provides coverage for the company whenthe company indemnifies the directors and officers.Side B coverage usually has a significant retention ofe.g., $1,000,000+.

Side C: Provides coverage for the company forliability arising out of certain types of claims madeagainst the company, such as claims brought byshareholders or creditors under the securities laws.Side C coverage also usually has a significantretention of e.g., $1,000,000+.

…[T]he first question

that a private equity

sponsor should be asking

is whether or not the

portfolio company

directors and officers

insurance policy will

likely become an asset of

the bankruptcy estate.


thereof are not. The policy is frequentlydeemed an asset of the estate because it isin the debtor’s name and the debtor paidfor it. On the other hand, if the policy issolely for the benefit of the directors andofficers and the debtor has no interest inthe proceeds of the policy (e.g., a policythat provides Side A coverage only),bankruptcy courts generally hold that theproceeds do not belong to the estate. Thedistinction gives directors and officers theability to access policies solely for theirbenefit despite the bankruptcy of thecompany.

A majority of the case law on this issueanalyzes Sides A and B coverage, resultingin relative clarity that proceeds of policieswith Sides A and B coverage only, are notassets of the bankruptcy estate. Foralmost a decade, however, most directorsand officers policies have provided Side Acoverage for the directors and officers, and

Side B and Side C coverage for thecompany, with one aggregate limit for allthree types of coverage. This complicatesthe analysis regarding “ownership” of theproceeds because any payment on accountof Side A coverage reduces the availabilityof the Side B and, in particular, Side Ccoverage—which has the effect ofdiminishing the property of the estate.

Based on the distinction between“ownership” of the policy and “proceeds”of the policy, depending upon the policylanguage, some courts have held that thepolicies with Sides A, B and C coverageand the proceeds thereof are assets of theestate, leaving the D&O claims ofdirectors subject to the automatic stay.On the other hand, some bankruptcycourts have taken a more practical viewand considered the distinction both in thecontext of defense costs and settlement.For example, some courts have allowedreimbursement of expenses (frequently upto a specified amount), reasoning thatdirectors and officers may be irreparablyharmed if reimbursement is denied.Other courts have allowed settlementswhen the debtor has not made a claim onthe policy, reasoning that a contingentright of the debtor should not precludeaccess by the directors and officers becausethe proceeds are not assets of the estateunless the debtor has the right to recoverthe proceeds.

It should be noted that the courts lookat the language in the policy very closelyand well-advised sponsors can negotiatefor the inclusion of certain provisions to aD&O policy to make it clear to thebankruptcy court that the policy isintended to protect the individualdirectors and officers and that coverage forsuch individual directors and officers takespriority over any other coverage provided.

Will the Private Equity Sponsor PolicyBe Deemed an Asset of the PortfolioCompany’s Bankruptcy Estate? Intuitively, one would think that D&O-related claims made by a PE sponsorunder any insurance policy purchased andowned by such PE sponsor (as opposed toa policy at the level of the portfoliocompany) would not be subject to theautomatic stay under Section 541(a)(1) ofthe Bankruptcy Code in the event of abankruptcy of such portfolio company.The last thing that a private equitysponsor expects is to have its own policy‘hijacked’ and made a part of the portfoliocompany’s bankruptcy estate, leaving theprivate equity sponsor and the fundspotentially uninsured. However, due toproblematic wording in the underlyingpolices, some policies of this kind haveindeed been deemed to be assets of theestate of the bankrupt portfoliocompany, thereby making claims by thesponsor under that policy subject to theautomatic stay.

One of the ways that the private equitysponsor policy can get dragged into theportfolio company’s bankruptcy estate isthrough poorly drafted definitions ofcertain terms, e.g., ‘insured entity.’ Often,in an attempt to cover all entitiesconnected to the private equity sponsorunder the private equity sponsor policy,the definition of what entities are coveredis inadvertently too broad. If the portfoliocompany is covered, by definition, underthe private equity sponsor’s policy(intentionally or not), then the privateequity sponsor policy can be accessed bythe portfolio company and arguably seizedby the bankruptcy court, inasmuch as theportfolio company is deemed an ‘insuredentity’ under the private equity sponsorpolicy.

Best Planning for the Worst (cont. from page 19)


…[W]ell-advised

sponsors can negotiate for

the inclusion of certain

provisions to a D&O

policy to make it clear to

the bankruptcy court that

the policy is intended to

protect the individual

directors and officers and

that coverage for such

individual directors and

officers takes priority over

any other coverage

provided.


Private equity firms approaching theclosing of a public company acquisitionagreed to before the current credit crisishave sometimes found themselves inthree-way standoffs worthy of The Good,the Bad and the Ugly: target companieshave tight contracts with no financingouts; buyers have firm commitments fromlending sources (subject to the absence ofa “Material Adverse Effect” (MAE)); andlenders seeking to rely on the MAE outhave strong leverage over buyers andtargets because the deal cannot closewithout their funding. M&Apractitioners have engaged in spiriteddebates about the rights and remedies ofthe parties in these situations, but haveshown a marked reluctance to explorethem judicially—probably because thestakes are high and the outcomeuncertain.

One buyer, however—Hexion SpecialtyChemicals, Inc., which had agreed to a$10.6 billion merger with HuntsmanCorp. —decided (to paraphrase EliWallach) to shoot, not talk. In theensuing litigation,1 the DelawareChancery Court, rejecting Hexion’s effortto back out of the deal, took the

opportunity to shed light on several of thetopics that have absorbed the M&Acommunity, including: how to determinewhether an MAE has occurred, and whichparty must prove it; what constitutes a“knowing and intentional” breach of amerger agreement; what is required by anagreement to use “reasonable best efforts”to complete a transaction; and what arethe consequences for failing to close adeal.

Like everyone in the private equitycommunity, you have probably beenriveted by the press reports at each stageof this dispute, but we thought it mightbe helpful to reprise the story to focus onthe lessons to be learned.

Hexion’s Agreement with HuntsmanHexion, a portfolio company of theprivate equity firm Apollo GlobalManagement, agreed in July 2007 toacquire Huntsman for $28 per share,topping Huntsman’s prior agreement to beacquired by Basell for $25.25 per share.Hexion had financing commitmentsrequiring a solvency certificate from theChief Financial Officer of Hexion orHuntsman or from a valuation firm, butthe merger agreement did not include a“financing out” excusing Hexion fromclosing if financing was unavailable. Themerger agreement required Hexion to useits “reasonable best efforts” toconsummate the financing, provided foruncapped damages for Hexion’s “knowingand intentional breach of any covenant”and for liquidated damages of $325million for other breaches and entitledHuntsman to obtain specific performanceof Hexion’s obligations under theagreement, other than the ultimateobligation to close the deal.

After Huntsman reporteddisappointing earnings, Hexion hired avaluation firm which opined that thecombined company would be insolvent.Hexion went public with the opinion andsought a declaratory judgment thatHexion was not obligated to close becausethe combined company would beinsolvent and because Huntsman hadsuffered an MAE, and that Hexion’spotential liability was limited to $325

million. The court disagreed with Hexionand found, as Huntsman claimed, thatHexion knowingly and intentionallybreached its obligations under the mergeragreement.

Insolvency Opinion FoundUnreliableThe court found the insolvency opinionto be “unreliable” because it was producedwithout consultation with Huntsmanmanagement, with a view toward its usein litigation, and was based on a “series ofpessimistic assumptions,” resulting in“skewed numbers.” In the court’s view,rather than embark on a “carefullydesigned plan to obtain an insolvencyopinion,” Hexion’s board had a duty “toexplore the many available options formitigating the risk of insolvency while

The Good, the Bad and the Ugly: Hexion v. Huntsman


In the court’s view,

rather than embark on a

“carefully designed plan

to obtain an insolvency

opinion,” Hexion’s board

had a duty “to explore

the many available

options for mitigating

the risk of insolvency

while causing the buyer

to perform its

contractual obligations

in good faith.”

1 Hexion Specialty Chemicals, Inc. v. HuntsmanCorp., C.A. No. 3841-VCL (Sept. 29, 2008).


causing the buyer to perform itscontractual obligations in good faith.”In any event, solvency was not acondition of the merger.

MAE Remains a High Hurdle in DelawareTurning to the question of whetherHuntsman had suffered an MAE, thecourt preserved the Delaware courts’streak of never having found an MAE tohave occurred in the context of a mergeragreement—a streak the court said was“not a coincidence.” The court rejectedHexion’s argument that the court couldfind an MAE by comparing Huntsman’sperformance with that of peercompanies, an argument based on theexclusion from the MAE definition ofchanges affecting the chemical businessgenerally except to the extent theydisproportionately affected Huntsman.Such an argument would put the cartbefore the horse: first, the court mustfind an MAE to have occurred; onlythen should it consider the“disproportionate impact” provision.

Instead, the court analyzed the MAEquestion under the framework set forthin In re IBP, Inc. Shareholders Litig.,considering “whether there has been anadverse change in the target’s business

that is consequential to the company’slong-term earnings power over acommercially reasonable period, whichone would expect to be measured inyears rather than months.” According tothe court, for a decline in earnings toconstitute an MAE, it “must be expectedto persist significantly into the future.”The court noted that buyers face a“heavy burden” in invoking MAEclauses, with the burden of proof, absentclear language to the contrary, falling onthe party seeking to excuse itsperformance.

Ultimately, the court decided therehad been no MAE. AlthoughHuntsman’s earnings per share (EPS)had decreased substantially, the court feltthat EPS was the wrong benchmarkbecause it was dependent on capitalstructure. Instead, the court comparedEBITDA with the prior year’s equivalentperiod and found the declines to berelatively modest. Similarly, the courtrejected Hexion’s argument thatHuntsman’s results should be comparedto its forecasts. The merger agreementexpressly disclaimed representations andwarranties as to Huntsman’s projectedresults, and at least one Apollo partnertestified that Hexion never fully believedHuntsman’s forecasts. The court alsonoted that Hexion’s own models at thetime the merger agreement was signedcontained EBITDA forecasts for 2009 inline with analysts’ current projections.The court agreed that futureperformance was also relevant to theMAE analysis, but found that Hexion’sprojections for Huntsman’s decreasingEBITDA were “overly pessimistic.”

Knowing and IntentionalBreach Exposes Hexion to Uncapped DamagesThe court next considered whetherHexion had engaged in a “knowing andintentional breach” of the mergeragreement, meaning that its liability forbreaches of the merger agreement wouldnot be capped at $325 million. Hexionargued that a “knowing” breach wouldrequire Hexion “not merely to know ofits actions but to have actual knowledgethat such actions breach the covenant.”The court said this was “simply wrong,”observing that “if a man takes another’sumbrella from the coat check room, itmay be a defense to say he mistakenlybelieved the umbrella to be his own,” butit is “no defense to say he had not realizedthat stealing was illegal” or that “it wasnot his ‘purpose’ to break the law.”

The court held that Hexionknowingly and intentionally violated itsduty to use reasonable best efforts toconsummate the financing and its dutyto avoid taking actions that couldreasonably be expected to materiallyimpair, delay or prevent consummationof the financing. Hexion did so byfailing to contact Huntsman to discussits concerns about solvency, by publiclyclaiming in a complaint and a pressrelease that the combined entity wouldbe insolvent, and by sending the leadlending bank a copy of the insolvencyopinion obtained by Hexion—actionsthe court found were intended to scuttlethe financing. The court put particularemphasis on Hexion’s failure to conferwith Huntsman, stating that it “bothconstitutes a failure to use reasonable

The Good, the Bad and the Ugly: Hexion v. Huntsman (cont. from page 21)


…[T]he court preserved

the Delaware courts’

streak of never having

found an MAE to have

occurred in the context

of a merger agreement—

a streak the court said

was “not a coincidence.”


best efforts to consummate the mergerand shows a lack of good faith.” Thecourt also found that Hexion was“dragging its feet” in obtainingregulatory clearances in a deal with a“hell or high water” antitrust approvalscovenant.

Finally, the court considered whetherspecific performance was available. Thecourt noted that the merger agreementcontained a provision generallypermitting a non-breaching party toobtain specific performance, but that in“virtually impenetrable language” thatprovision went on to prohibit Huntsmanfrom specifically enforcing Hexion’sobligation to consummate the merger.The court ordered Hexion specifically toperform its other obligations under themerger agreement, including itsobligation to use reasonable best effortsto obtain financing, which, the courtnoted, both lending banks had recentlystated they were prepared to provide “ifa customary and reasonably satisfactory

solvency opinion could be provided.”The court observed that Hexion wouldremain free not to close, but “if Hexion’srefusal to close results in a breach ofcontract, it will remain liable toHuntsman in damages.” Those damagescould be substantial: the mergeragreement expressly provided thatHuntsman’s damages for a knowing andintentional Hexion breach would be“based on the consideration that wouldhave otherwise been payable tostockholders of the Company.”

What Next?After the decision, the parties resumednegotiations and Huntsman shareholderschipped in another $217 million to tryto bridge the funding gap while Apolloagreed to put up an additional $730million – but, the day before thescheduled closing, the lendersannounced they would not fund becausethey believed that Huntsman’s profferedsolvency opinion and certificate were not

“customary and reasonable.” Thefollowing day, Hexion sued the banks inNew York State court seeking specificperformance of the banks’ obligations onan expedited basis. Hexion also sought aruling preventing the expiration of thefinancing commitments, which wasdenied. Huntsman has litigated inTexas, pursuing multi-billion dollartortious interference claims againstApollo (including claims against certainof its executives personally) as well asagainst the banks. The partiesreportedly have been in talks to re-pricethe deal, but, at the time of this writing,the stand-off continues.

Paul S. [email protected]

William D. [email protected]

The Good, the Bad and the Ugly: Hexion v. Huntsman (cont. from page 22)

Lookingfor a past

article?

A complete article index, along with

all past issues of the Debevoise & Plimpton

Private Equity Report, is available in the

“publications” section of the firm’s website,

www.debevoise.com.


equity/strategic bidding groups.Unfortunately, unlike the 2005-2007period when most players on the privateequity scene could articulate the marketterms for private equity “club”arrangements in large-cap transactions,our review of about a dozen recent privateequity/strategic bidding grouparrangements confirms that there has yetto develop any clear pattern of terms thatgovern the relationship between the PEfirm and the strategic investor in thesetransactions. While we know that newmarket terms will eventually develop withrespect to other PE transactions in thiscycle, we are less certain that standardmarket terms will become discernible inthe arrangements between private equityfirms and their strategic partners, becauseeach team is comprised of a strategicinvestor and one or more PE firms joiningforces for different reasons.

There are, however, several key issuesthat need to be addressed beforecontemplating any such partnership.These include material issues relating togovernance, exit, additional investment,commercial relationships and the role andincentivization of management.

GovernanceThe composition of the Board ofDirectors and consent rights for majordecisions set the framework for theallocation of governance rights. Usually,each significant investor, whether strategicor private equity, has representation onthe board of the joint enterprise, often ona basis roughly proportionate to its equityinvestment. In addition, the compositionof committees is often negotiated to beproportionate to board representation.The Board also generally includes theCEO. In many instances, a quorum forBoard meetings is not met unlessrepresentatives of each of the investors arepresent, providing additional comfort forstrategic and private equity investors alike.

Board rights are often subject to sell-down provisions, pursuant to which thenumber of directors to which an investoris entitled decreases as the investor reducesits investment. In some instances, theparties provide that independent directorsnominated by each (or a subset) of them(and as to which consent is not to beunreasonably withheld by the others) willserve on the Board even while it is aprivate company. The hiring and/or firingof the CEO is sometimes allocated to themajority or lead partner and sometimesrequires a super majority vote. Theminority investor (or sometimes eachinvestor) often has consent rights tocertain fundamental matters such asmerger, liquidation, material assetacquisitions and dispositions, issuance ofequity securities, option plans, incurrenceof material indebtedness and affiliate

transactions and, sometimes, such mattersas approving operating budgets. One ofthe more subtle issues is whether the rightto appoint directors is transferable withany permitted transfer of shares.

Exit IssuesAs would be expected, exit issues candominate negotiations between a privateequity and strategic teammates. PE firmsgenerally focus on medium-terminvestment horizons, while strategicinvestors may be more focused onbuilding a long-term asset withconnectivity to its core business.Although PE firms will often view thestrategic investor as a potential acquiror ofthe business, the strategic investor may bemore interested in keeping the asset out ofthe hands of the competitor than inowning 100% of the business itself. Insome transactions, in fact, PE firms andstrategics join forces to acquire apreviously wholly-owned subsidiary of thestrategic partner.

There is usually some period followingthe closing of the transaction (e.g., ranginggenerally from two to seven years) duringwhich neither investor may sell itsinvestment without the consent of theother investor. Even after that time, theremay be restrictions on sales to the strategicpartners’ competitors or other parties.After the “no transfer” period has elapsed,in transactions involving strategicacquirors and PE firms from differentjurisdictions, there may also be restrictionson private sales to a non-U.S. entity inorder to avoid making the company a“controlled foreign corporation” (with itsattendant deemed dividend issues) forU.S. strategics or PE firms organized inthe U.S.

Any sale of shares is often subject to aright of first offer (or, in some instances, aright of first refusal) by the other investor

Strange Bedfellows: Private Equity and Strategic Alliances (cont. from page 1)


…[W]hat [is] “market”

for private equity/strategic

bidding groups[?]

…[T]there has yet to

develop any clear pattern

of terms that govern the

relationship between the

PE firm and the strategic

investor in these

transactions...because each

team is comprised of a

strategic investor and one

or more PE firms joining

forces for different reasons.


or the company. Drag-along and tag-along rights with respect to share sales arealmost always a feature of this type oftransaction, with some negotiation aboutwhen either party can be forced to sell outor be dragged along if it is not willing tomatch or jump the offer.

Although only a few transactions giveone party the ability to put a business upfor auction, it is fairly common for asignificant minority investor to have theright to require the Company to effect aninitial public offering after the absoluteprohibition on sales without consent hasexpired. Other demand and piggybackregistration rights are common as well,with the ability to demand one or moreregistrations (after the IPO) often grantedto each major investor with therequirement to include the other investors’shares on pro rata basis.

PE firms sometimes are attracted tostrategic investors because they believe thestrategic investor will grant them certainliquidity with a put right. Such provisionsare more frequently proposed than agreedupon, but are sometimes included. Inother instances, the strategic investor mayhave a call right that may or may not becoupled with the put right. The key issuein both of these circumstances is obviouslypricing. Some of the most commonoptions include independent valuations atfair market value, the application of fixedmultiple formulas to EBITDA or someother metric and a fixed multiple ofcapital invested. We have also seen atleast one transaction that includes asomewhat novel feature that might helpbridge the gap when a PE firm wants aput right and the strategic investor is lessinclined to grant one. In that transaction,the PE firm had the right, after a specifiedperiod of time, to swap its stock in thecompany on tax free basis for the publicly-traded stock of its strategic partner during

a three-year period. While this approachmay help address the strategic partner’sconcern regarding liquidity demands, itdoes not resolve the pricing issue. Inaddition, depending on the size of theinvestment related to the strategicpartner’s equity float, the strategic partnermay require limitations on sales of itsstock in order to protect its stock price.

Generally, investors do not have anobligation to provide additional capital ormake additional investments in thecompany. However, they generally dohave the opportunity to participate prorata in any future equity issuances, oftenthrough pre-emptive rights.

Commercial RelationsCommercial contracts between thecompany and the strategic investor aresometimes a key part of the investmentthesis.

In some instances, the strategic investoris guaranteed a distribution channel whichwould not be available if the business weresold to another party and is thereforewilling to offer advantageous pricingand/or exclusivity arrangements in orderto achieve that goal. Favorabledistribution and other commercialarrangements can often provide theacquired business a guaranteed revenuestream for its products throughrequirements or even “take or pay”contracts. In other circumstances, astrategic partner may assume distributionresponsibilities for the acquired businessand may be compensated for doing sothrough the issuance of junior securities orother non-cash economics which may beparticularly attractive when debt financingis scarce.

Management EquityMany private equity transactions includeincentivizing management with significantequity participation. Since this model is

less customary in the corporateenvironment, agreements betweenstrategic and private partners about thedesign of management equityarrangements are essential. If the strategicpartner is contemplating acquiring theprivate equity investor’s share of thebusiness rather than exiting alongside theprivate equity investor via an IPO oreventual sale of business, it may be lessinclined to adopt the type of privateequity management ownership model towhich private equity investors—and themanagement teams that work withthem—have become accustomed. Privateequity investors, of course, may argue thatthe more traditional corporate approachto management incentivization is lesseffective in aligning the interests ofmanagement and its owners. While thisdebate may sound philosophical andcultural, it has important economicramifications for both types of investors aswell as the business’s management.

* * *Although strategic investors and privateequity firms are more typicallycompetitors than partners in acquisitions,it is expected that they will increasinglyjoin forces to acquire businesses in thecurrent economic climate. In doing so,they will need to face important decisionsrelating to governance, exit, commercialrelationships and incentivizingmanagement, where their perspectivesmay be different but where reasonableaccommodation can result in productivepartnerships.

Franci J. [email protected]

Michael W. [email protected]

Strange Bedfellows: Private Equity and Strategic Alliances (cont. from page 24)


Most LPs Approaching Target AllocationsThe tremendously strong fundraisingmarkets of 2004 to 2007 benefited fromthe rapid pace of distributions fromprevious vintages: LPs committed to newfunds in an attempt to reach their targetallocations, but because of the pace ofdistributions back to them from theirexisting funds, they were generally notgetting any closer to their targets. As aresult, many LPs increased their rate ofcommitments, fuelling the fundraisingboom.

This virtuous circle obviously couldnot last indefinitely, and in 2008 it hasclearly ground to a halt. Distributionshave slowed to a trickle, and many LPs arenow approaching or, in some cases, abovetheir targets. Fig. 5, below right, showshow LPs’ commitments vs. targetallocations have evolved over the past 12months to October 2008. In 2007, justover half of all LPs (53%) were undertheir target commitments to privateequity, while in 2008 that figure hasdeclined to only 36%. A year ago only29% of all LPs were at or above theirtarget commitments, now nearly half ofthem (48%) are.

This shift in actual vs. targetallocations will clearly have majorimplications for private equity fundraisingover the medium term, with the clearresult being a relative decline in themarket over the next couple of years.This was confirmed at the SuperInvestorconference in Paris – most LPs will still bemaking new fund commitments, butmore cautiously than before.

Sovereign Wealth FundsSWFs have historically been relativelymodest investors in private equity, withtypical allocations of 2-3% of AUM.However, SWF’s generally have long time

horizons, and do not need to match aspecific liability profile—in other words,they are ‘natural’ investors in privateequity. Combine this with the rapidgrowth of AUM, and it is clear that SWF’swill become the leading source of fundingfor the private equity industry:

� 2008: SWF’s have around $3.6 trillionAUM, so 2-3% gives a current privateequity investment of $70 -100 billion,or 3.5% to 5% of total funding for the$2 trillion global private equityindustry.

� 2013: SWF’s are projected to have$10-15 trillion AUM by 2013, andallocations to private equity shouldreach 5% to 6%—in other words, atotal private equity investment of$500-800 billion, or 20-25% of a $3trillion global private equity industry.

Most leading global private equity firmshave SWF LPs and anticipate increasingallocations from them—and few of themexpect that ‘burnt fingers’ from recentinvestments made in financial servicesfirms (e.g., ADIA’s 2007 investment inCitigroup) will halt this trend.

Growth AreasThe LP survey highlighted several marketsegments where LPs plan to increase theirallocations in future. Some of these arethe obvious beneficiaries of the changedmarket environment: distressed debt,mezzanine, and secondaries funds.Others were more of a surprise —e.g., LPsplan to continue investing in real estatefunds, despite the current marketdifficulties. Funds of funds continue toenjoy strong support.

There is widespread belief thatemerging markets private equity willcontinue to grow, focused primarily upongrowth capital.

Fundraising in 2008-2010Fundraising will be depressed in 2008 and2009, but we expect a good recoverythereafter. Total private equity funds raisedin 2007 reached $644 billion (all fundtypes, including fund of funds), while 2008looks like it will come in around $550billion. We forecast 2009 to be in the range$400 billion to $500 billion.

Unfortunately, none of this means that


Figure 5: More LPs now at or above target allocation

100%

90%

80%

70%

60%

50%

40%

30%

20%

10%

0%12 Months Ago

53%

Today

26%

3%

18%

36%

38%

10%

16%No defined targetallocation

Above targetallocation

At target allocation

Below targetallocation




fundraising will be easy for GPs: 2008and 2009 will clearly be difficult, andeven after that the record number of newfunds on the road will make thingsextremely competitive for GPs raisingtheir funds.

Changes in the LP/GPRelationshipInvesting in a private equity fund requiresa remarkable commitment from LPs—something akin to marriage. Our surveygave clear indications of what LPs look forin their relationships with their GPs: afterthe sine qua non of a good track record, itwas issues like trust and alignment ofinterest that scored highest.

Fund terms migrated in the GPs favorduring the heady fundraising markets of2004 to 2007. There is widespreadexpectation that the pendulum will nowswing the other way: the LPs who are stillinvesting have many funds to choosefrom, and fund terms will inevitably movein the LPs’ favor, with GPs seeking to gaina competitive advantage through favorablefund terms.

Fallout from 2005 and 2006Vintage FundsWhile private equity firms should seegood investment opportunities looking

forwards, there will clearly be majorproblems among portfolio companiesacquired during the height of the boom in2006 and 2007. How big is the problemlikely to be? Using our PerformanceAnalyst database, we calculated theproportion of buyout funds’ commitmentsthat were called up and invested during2006 and 2007 (Fig. 6, below.). With theobvious caveat that every investment isunique, and that some companiesacquired during 2006 and 2007 will bedoing very nicely, thank you, it is clearthat 2005 vintage funds look veryexposed, and the 2004 and 2006 vintageswill also have problems. (For furtherdetails, please see Preqin’s NovemberSpotlight newsletter availabe on Preqin'swebsite at www.prequin.com.)

The mood at the SuperInvestorconference was very pessimistic, withsome speakers saying that 25% of privateequity firms could disappear. Whilst therewill of course be a fallout, we do notexpect a figure anything like as high: thePE firms will work through many of theirportfolio problems, and default rates arelikely to be lower than for the economy atlarge. Furthermore, PE funds have a lotof dry powder available—currently inexcess of $450 billion—and so are well-

placed to take advantage of attractiveinvestment opportunities over themedium term.

What is the ‘medium term’? Thesimple—and uncomfortable—answer is“Not yet.” Most GPs at SuperInvestor aretaking a cautious approach, and do notfeel that the time to invest has come yet.

ConclusionsLPs fully understand the challenges facingmarkets generally, and private equity inparticular. Despite this, they are cautiouslyoptimistic on the prospects for private equity,and appear set to continue the longer-termtrend of making increased commitments tothe asset class. GPs see great investmentopportunities ahead, but are adopting acautious ‘wait and see’ approach.

We forecast 2008 fundraising to be15% down on the 2007 peak, with 2009a further 15-20% down. The longer-termgrowth trend will reassert itself in 2010.2005 vintage buyout funds could seenegative median IRRs, and the 2004 and2006 vintages will also struggle. Therewill inevitably be some spectaculardisasters, and some firms may not survive—but the vast majority will work throughthe problems and come out the other side.We’ll see strong growth in areas likedistressed private equity, mezzanine fundsand emerging markets.

2007, 2008, and 2009 vintages shouldperform well, delivering excellent returnsto the LPs that are able to invest in them.The winning firms will be those that stayclose to their LPs—and move towardsmore LP-friendly fund T&C’s.

Most importantly, private equity willcome through with its most valuable assetintact: the ability to deliver superior returnsthrough most market environments.

Mark O’HareManaging DirectorPreqin


Figure 6: % of commitment called during 2006-2007

60%

50%

40%

30%

20%

10%

0

17%

2003 2004 2005 2006 2007

% o

f co

mm

itm

ent

calle

dd

urin

g 2

006-

2007

38%

49%39%

31%

Vintage Years



decision is difficult to square with theother two recently decided Revlon cases.

McPadden and LearIn McPadden v. i2 Technologies, Inc., theplaintiff alleged that i2’s board acted in badfaith when it approved the sale of asubsidiary to its management team for $3million. Six months after the deal closed,that same team turned down an offer of$18.5 million for the business, and theteam eventually sold the business 18months later for over $25 million. In In reLear Corp. Shareholder Litig., the plaintiffsalleged that Lear’s board acted in bad faithwhen it approved an amendment to amerger agreement adding a termination fee,payable if Lear’s stockholders simply voted

down the merger, in exchange for a $1.25per share increase in the merger price.

Both i2 and Lear had exculpatorycharter provisions, eliminating personalliability of directors for breaches of the dutyof care as long as the directors acted in goodfaith. Therefore, in each case, the plaintiffscould recover only if they proved that thedirectors acted in bad faith.

The i2 court found that the directorshad been grossly negligent: they put theeventual management-buyer in charge ofthe sale process, even though they knew ofhis interest in buying the subsidiary; theyfailed to oversee the sale process, which didnot include contacting the most obviouspotential buyers; they knew their financialadviser was using projections prepared atthe direction of the eventual buyer; andthey agreed to a price at the lowest end ofthe valuation range determined using theleast favorable set of projections. All of thisseems to be extremely irresponsible behaviorand significantly more egregious than theactions or inactions of the Lyondell board.

Nevertheless, the court held that theplaintiffs failed to state a claim against thedirectors in light of the exculpatoryprovision in i2’s charter. ChancellorWilliam Chandler stated that grossnegligence “cannot be an example … of badfaith conduct.” While the intentionaldereliction of duty or the consciousdisregard for one’s responsibilities mayconstitute “bath faith,” the court found thatthe plaintiffs failed sufficiently to allege thatthe directors acted in this way. Instead, theplaintiff ’s pleadings indicated that thedirectors acted with gross negligence orreckless indifference—both of which wereexculpated by the charter provision.

In Lear, the court rejected an argumentthat the defendant directors acted in badfaith by agreeing to a $1.25 per share priceincrease in exchange for a no-votetermination fee representing 0.9% of the

total deal value, knowing that it wasimprobable that shareholders wouldapprove the sweetened deal. ViceChancellor Leo Strine concluded thatdirectors “cannot be faulted for beingdisloyal simply because the stockholdersultimately did not agree with theirrecommendation.”

Even if the directors’ decision wasunreasonable or grossly unreasonable, Lear’sexculpation provision required plaintiffs toallege “facts that support a fair inferencethat the directors consciously acted in amanner contrary to the interests of Lear andits stockholders.” The plaintiffs alleged thatLear’s Board took “no care” and approved in“bad faith” a merger agreement almostcertain not to be approved, but they failedto plead particularized facts supportingthese “inflammatory and conclusory chargesof wrongdoing.”

Vice Chancellor Strine went further. Incontrast to the Lyondell decision, ViceChancellor Strine acknowledged that boards“may have to choose between acting rapidlyto seize a valuable opportunity without theluxury of months, or even weeks, ofdeliberation—such as a large premiumoffer—or losing it altogether.” Accordingto the Vice Chancellor, it takes a veryextreme set of facts to sustain a disloyaltyclaim premised on the notion thatdisinterested directors intentionallydisregarded their duties. He concluded thatsince the Lear board and special committeemet frequently, and since the specialcommittee hired reputable advisors, theplaintiff could not sustain the disloyaltyclaim.

LessonsWhile no director wants to be caught up inlitigation, the risk of significant personalliability is likely more persuasive in shapinga director’s actions and giving rise to skittishand overcautious behavior. For the


…[B]oards are permitted

to act quickly in

appropriate circumstances

to avoid losing a good

deal; grossly negligent

behavior (which may be

exculpated) is not the

same as bad faith (which

may not); and only a very

extreme set of facts

demonstrating a conscious

disregard of one’s

responsibilities or the

dereliction of duty will

allow a plaintiff to sustain

a claim of bad faith

against a target’s directors. CONTINUED ON PAGE 29


acquiring sponsor, this could mean facingtarget boards that will insist on moreextensive pre-signing market checks,particularly in light of the Lyondell court’sinsistence on the importance of the pre-signing market check in satisfying a board’sRevlon duties. It could mean that the targetboard will take more time before signing adeal to make sure it has done everythingpossible to ensure that it has obtained thebest price for the target—the “reasonablyavailable” qualification will likely beoverlooked. And to cover themselvesfurther, target boards may well insist onbroader post-signing marketingopportunities.

This increased risk of personal liabilitymay also affect the willingness of the bestqualified people to serve as directors on theboard of both public companies and

sponsors’ portfolio companies. And noneof this will come as welcome news to thepartners in private equity firms who serveon a portfolio company’s board, particularlyif the firm is looking to sell.

On the other hand, the McPadden andLear cases provide some welcome comfortfor sponsors and directors alike: boards arepermitted to act quickly in appropriatecircumstances to avoid losing a good deal;grossly negligent behavior (which may beexculpated) is not the same as bad faith(which may not); and only a very extremeset of facts demonstrating a consciousdisregard of one’s responsibilities or thedereliction of duty will allow a plaintiff tosustain a claim of bad faith against a target’sdirectors.

These cases are difficult to harmonizewith Lyondell, and so long as Lyondell is

good law, there will continue to beuncertainty as to what conduct mayconstitute “bad faith” in the context of asale of control of a target. If, however, theDelaware Supreme Court reverses Lyondell,many will let out a sigh of relief, and thecourts’ understanding of the realities ofmodern deal practice as evidenced byMcPadden and Lear will let everyonebreathe a little easier.

Andrew L. [email protected]


ImplicationsThe Halliburton Opinion certainlyreinforces the concept that thoroughFCPA due diligence is best conducted pre-acquisition. Where practicable, privateequity firms and funds should fullyinvestigate and resolve any potential issuesdiscovered during pre-acquisition duediligence prior to closing and, in certainsituations, consider making disclosuresand seeking an opinion from the DOJ inthe event that the acquiror thinks it mayinherit FCPA liability upon closing.Acquiring firms looking to availthemselves of the DOJ opinion procedurereview will be wise to note the DOJ’sstatement in the Halliburton Opiniondiscouraging companies from enteringinto agreements that limit the informationthat can be provided to the DOJ. TheDOJ’s request may be entirely unworkable

in a transactional world that oftenoperates narrowly within confidentialityagreements, but it bears noting that theability to receive a DOJ opinion may beadversely impacted by an acquiror’sinability to disclose. In the appropriatecircumstance, we would expect that theDOJ might exercise some flexibility wherethe impracticality of obtaining such aconfidentiality agreement is demonstrated.On the positive side, the HalliburtonOpinion shows that the DOJ recognizessome of the realities of the bidding processand acknowledges that situations existwhere it is impossible, or impracticable,for an acquiror to complete FCPA duediligence before closing. The DOJexhibited flexibility in acceptingHalliburton’s proposed remedy in such asituation and its opinion offers a roadmapfor a successful due diligence and post-

closing planning. Private equity firmsfaced with similar circumstances, wherethe completion of FCPA-related duediligence prior to closing is not possible,can minimize their legal risks byconducting intense post-closing FCPAdue diligence, disclosing and remediatingany issues, and imposing their compliancepolicies and procedures upon the targetimmediately upon closing.

Paul R. [email protected]

Christopher J. [email protected]

Erin W. [email protected]

Avoiding FCPA Anxiety (cont. from page 18)


Bankruptcy Court Authorityto Make PaymentsRegardless of whether a policy providesSide A, B and/or C coverage, insurersregularly require authority from thebankruptcy court before making anypayments under any insurance policywhich may be deemed to be an asset ofthe bankrupt’s estate, including policiesheld at the level of the portfolio companyand the PE shareholder. As a result, well-advised portfolio companies and sponsorsshould ensure that specific bankruptcyclauses are added to their policies in orderto facilitate their ability to get thisauthority from the bankruptcy court. Thenext few sections describe some of thesebankruptcy clauses.

Does the Insured v. Insured ExclusionExclude Claims by the BankruptcyTrustee and Other Parties? D&O insurance policies generally includean exclusion—called the “insured v.insured” exclusion—to coverage for claimsbrought by other insured parties. Thepurpose is to prevent collusion betweenthe insured entities to the detriment of theinsurer. In a bankruptcy, the “insured v.insured” exclusion is problematic becauseif a trustee or other party is representingthe interest of the company (an insured)when it brings a claim against thedirectors and officers (insureds), theexclusion may be triggered.

Therefore, most insureds insist on anexception to the insured vs. insuredexclusion to allow coverage for claimsbrought by a bankruptcy trustee, anexaminer or their respective assignees.Careful attention to the wording of thisexception is necessary to make sure allpossible claimants are excepted out of theexclusion. If a portfolio company hasoperations in various foreign jurisdictions,

the type of parties that may bring claimsin all jurisdictions should be specificallyexcepted.

Does the Portfolio Company PolicyHave a Financial Insolvency Exception?In general, Side A coverage for non-indemnifiable loss usually has no retention(deductible), thereby allowing thedirectors and officers to access thecoverage for their first dollar of loss. SideB coverage for indemnifiable loss usuallyhas a retention, frequently a significantone, e.g., $1,000,000+. Absent a properlyworded financial insolvency clause, in theevent a claim is ‘indemnifiable,’ i.e., fallsunder Side B coverage, the insurer willpresume that the directors and officershave been indemnified by the companywhere it is required or permitted by law,regardless of whether the directors andofficers have actually been indemnified.

This ‘presumption’ can be very costlyfor a director or officer when the companyis financially unable to provideindemnification and the director or officermust immediately look to the insurancepolicy for protection. As a result of thepresumption, the director must first pay asignificant retention because the claim istreated by the insurer as an ‘indemnifiableloss,’ even though no actualindemnification has occurred. To makematters worse, some policies haveadditional conditions that could requirethat the portfolio company (i.e., thetrustee) make a ‘good faith’ application tothe court on behalf of the director,formally seeking a determination onindemnification, before the director canaccess the insurance policy.

It is very unlikely that a director orofficer could personally fund such a largeretention, or that a trustee could becompelled to go to court to seek

indemnification on behalf of the director.(Indemnification rights become morecomplicated once a portfolio company isin bankruptcy, which is something thatshould be discussed further withbankruptcy counsel.) This leaves theindividual director in a very precariousposition since the director may not be ableto meet the conditions under the policy toaccess coverage. Unfortunately, this leavesthe individual director or officer exposed.

A properly worded financial insolvencyprovision should effectively eliminate thepresumption. This would then make anyclaim by a director or officer a Side Aclaim in the event that the portfoliocompany enters into a court-supervisedreorganization or bankruptcy proceeding.Again, Side A gives the directors andofficers direct access to coverage under thepolicy for their first dollar of loss.

Does the Portfolio Company PolicyContinue to Cover Claims After aPortfolio Company Files forBankruptcy?It comes as a surprise to most privateequity sponsors that insurance policiesgenerally do not cover acts committedafter a change of control. What’s worse,in many policies, sometimes buried deepwithin a series of definitions, a bankruptcyis included as an event meeting thedefinition of “change of control.” Thismeans that once a bankruptcy is filed,coverage under the terms of the policyautomatically ceases. While claims couldbe covered for a short period of time, e.g.,until the end of the policy period, theboard may be immediately exposedinasmuch as their insurance protectionceases for any wrongful acts, once abankruptcy filing is made. Obviously, theinsured should seek to have this wording




changed, or else at the very momentcoverage may be needed the most, it maywell be unavailable.

ConclusionThis article highlights just a few of theissues that may arise in the context of abankruptcy of a portfolio company whichmay result in a principal of a sponsor,sitting on the board of a portfoliocompany in financial distress, finding out

that he or she can’t access the portfoliocompany policy or the private equitysponsor policy. Of course, coveragealways depends upon the policy wordingin light of the applicable facts andcircumstances. As a result, it is hard topredict, with certainty, whether or notthere will be coverage in advance of anevent. With that said, a careful review ofpolicy wording now, at both the portfolio

company level and private equity sponsorlevel, could make a difference amountingto millions of dollars.

Heidi A. [email protected]


October 10, 2008Heidi A. LawsonA Comparative Review of D&O Liability andCoverage Issues in the United Kingdom,Brazil, China, India and Russia C5Third Annual European D&O LiabilityInsurance ConferenceLondon

October 15, 2008Andrew N. BergTax Strategies for Corporate Acquisitions,Dispositions, Spin-Offs, Joint Ventures,Financings, Reorganizations, andRestructuring 2008Tax Strategies for Private EquityPracticing Law InstituteCrown Plaza Hotel, New York

October 23-24, 2008Franci J. Blassberg, Program Co-ChairTwenty Fourth Annual Advanced ALI-ABACourse of Study on Corporate Mergers andAcquisitionsOctober 23rdSpecial Problems When Acquiring Divisionsand SubsidiariesOctober 24thNegotiating the Acquisition of the PrivateCompanyALI-ABA Committee on ContinuingProfessional EducationNew York

November 5, 2008Katherine AshtonRecent UK and US Legal Developments inInternational Corporate RestructuringsCorporate Restructuring ConferenceRedcliffe TrainingLondon

November 11, 2008Thomas M. Britt IIISuccessful Investment Strategies in EmergingMarkets (Focusing on China, India andVietnam)2008 KVIC Partners ForumSeoul

November 17, 2008Elisha Raman Bet-Mansour Opportunities and Challenges for PrivateEquity Bidders in the Current Deal Market

Franci J. Blassberg, Program Co-ChairCorporate Governance for Private EquityIBA Conference on International Leveraged Buyouts London

December 3, 2008David H. SchnabelTax Strategies for Corporate Acquisitions,Dispositions, Spin-Offs, Joint Ventures,Financings, Reorganizations, andRestructuring 2008Tax Strategies for Private EquityPracticing Law InstituteLos Angeles

December 9, 2008Rebecca F. Silberstein, Panel ChairPrivate Equity in 2009: What You Need toKnow Now—Major Trends in Large andMid-sized FundsWest Legalworks (Thomson Reuters)New York

December 10, 2008Dr. Thomas SchürrleInternational Aspects of CorporateCompliance: Importance of the U.S. FCPAfor German CompaniesEuroforumBerlin, Germany

December 10, 2008Mark P. Goodman Massive Redemptions, Poor Performance andFund Closures: The Key Issues Surroundingthe Global Financial Crisis and yourDirectors’ and Officers’ LiabilityMaloy Risk Services and Debevoise &Plimpton LLPCCO University Outreach Program/Webex

Recent and Upcoming Speaking Engagements


In light of current economic conditions, privateequity professionals serving as directors ofportfolio companies may want to re-familiarize themselves with the law concerningthe impact of a corporation’s financial distresson their fiduciary duties. Decisions inDelaware since the last economic downturnhave changed some of the rules of the game.

Refresher on Fiduciary Duties As all corporate directors are repeatedlyreminded, directors of corporations havetwo primary fiduciary duties, the duty ofcare and the duty of loyalty. The duty ofcare requires that each director exercise thedegree of care that an ordinary and prudentperson would use in similar circumstances.The duty of loyalty requires that a directoract in good faith in the best interests of thecorporation and its shareholders andprohibits self-dealing.

The decisions of directors are generallyprotected by the “business judgment rule,”which presumes that in making a businessdecision, the directors acted on an informedbasis, in good faith and in the honest beliefthat the decision was in the best interest ofthe corporation. Decisions of “interested”directors, however, are subject to the moreonerous “intrinsic fairness” test, whichexamines whether the action of the boardwas both substantively and procedurally fair.

Fiduciary Duties When aCompany Is in DistressIn a solvent corporation, the board ofdirectors owes its fiduciary duties to thecorporation’s shareholders. Creditors areonly entitled to the benefit of theircontractual rights only as set forth in thefinancing or other agreements to which theyare party. When a corporation is in distress,the focus of the board’s obligations expandsto include not only the interests ofshareholders, but also those of creditors.

With respect to many board decisions, thischange in focus will not be significant anddirectors should think in terms of the bestinterests of the “community of interests”constituting the corporation. But in someinstances, the interests of creditors andshareholders will diverge. When this occurs,the corporation’s directors need not slavishlyfollow the demands of its creditors. However,the directors should not subject thecorporation and its creditors to undue riskin pursuit of a recovery for shareholders.

The “Zone of Insolvency”—Is It Irrelevant?Until recently, restructuring professionalsgenerally advised clients in distress that theconstituency to which a board of directorsowes fiduciary duties expands to includecreditors when the corporation is in thevicinity or “zone of insolvency.” In recentdecisions, however, the Delaware courtshave moved toward a bright-line test,suggesting a duty to creditors does not ariseuntil the corporation is actually insolvent.Courts in many jurisdictions, such as NewYork, have not yet spoken clearly on thisissue. But the Delaware courts are highlyinfluential in the field of corporategovernance, and other jurisdictions arelikely to follow Delaware’s lead.

This change in Delaware law may meanless in practice than in theory. It is oftenimpossible or, at least, impractical todetermine when a corporation actuallybecomes insolvent. The two traditionaltests of solvency – the balance sheet test(i.e., whether the liabilities of thecorporation exceed its assets at fairvaluation) and the equity test (i.e., whetherthe corporation can pay its debts as theycome due)—can be difficult to apply.Consequently, in most instances, a boardshould start thinking in terms of

maximizing value for everyone rather thanjust shareholders once the company is infinancial distress.

Good News for DirectorsIt is important to remember that in manyrespects a director’s fiduciary duties do notchange when a corporation is insolvent. Asbefore, the director’s principal obligationsare the duties of care and loyalty and mostdecisions of the board are still protected bythe business judgment rule.

Further, since the last economicdownturn, the Delaware courts haveconfirmed that the rules applicable todirectors of solvent corporations apply inother important respect when a corporationis insolvent. In recent decisions, theDelaware courts have held that creditors(like shareholders) have no direct right ofaction against a corporation’s directors forbreach of fiduciary duty and are subject toprovisions in a corporation’s charter thatlimit the liability of directors for breaches ofthe duty of care. (As all directors shouldknow, however, a director’s liability forbreaches of the duty of loyalty cannot belimited by the corporation’s charter.)

Directors of distressed portfoliocompanies, however, may face specialchallenges if they are “interested” (whetheras a result of the sponsor’s shareholdings,purchases of debt or otherwise), as theintrinsic fairness test may then be applicableto the directors’ actions. We will examinethis subject in more detail in the next issueof the The Private Equity Report.

Richard F. [email protected]

Hilary [email protected]

Jasmine Powers [email protected]

A L E R T

Duties of Directors of Distressed Companies: An Update and Refresher

Documents

Debevoise & Plimpton Private Equity Report · Geoffrey P. Burgess – London Marc Castagnède – Paris Margaret A. Davenport E. Drew Dutton – Paris Michael J. Gillespie Gregory