Directors and Officers Liability and Insurance : The D & O Diary : Kevin LaCroix : Securities Laws, Corporate Fraud, D & O Litigation

A November 18, 2007 New York Times article entitled "If Buyout Firms Are So Smart, Why Are They So Wrong?" (here) takes a critical look at many buyout firms' sudden haste to walk away from deals that were much ballyhooed only a short time ago. Clearly the bloom has gone off the buyout vine. As I discussed in an earlier post (here), litigation is an inevitable byproduct of the bursting of the buyout bubble. The battle lines in many of these lawsuits will the "material adverse effects" provision in the various buy-out agreements, which permit termination of the transaction where the target company's business conditions have deteriorated.

The right of a would-be buyer to invoke this provision is getting a close examination in the lawsuits arising our of the failed J.C. Flowers takeover of Sallie Mae. As discussed in a November 14, 2007 Law.com article entitled "Sallie Mae Litigation Raises Issue of Deal 'Adverse Effect'" (here), J.C. Flowers is arguing that the collapse of the securitization market and the disruption of asset-backed commercial paper have disproportionately affected Sallie Mae, and therefore have had a materially adverse effect on the company. Sallie Mae for its part contends that the credit crunch was excluded from the adverse effect clause. The court has set a July trial for the dispute.

The invocation of the materially adverse effect clause is one way for a would-be buyer to attempt to bail from a pending acquisition that no longer looks as attractive. An alternative approach, albeit one rarely followed, may be seen in the action of Cerberus Capital Management, which on November 14, 2007 advised United Rentals that it was not prepared to complete its planned acquisition of the company. (Refer here for the company's announcement.) Rather than arguing that there has been a materially adverse development, Cerberus has simply terminated the contract and tendered the specified termination fee of $100 million. As United Rentals put it,

Cerberus has specifically confirmed that there has not been a material adverse change at United Rentals. United Rentals views this repudiation by Cerberus as unwarranted and incompatible with the covenants of the merger agreement. Having fulfilled all the closing conditions under the merger agreement, United Rentals is prepared to complete the transaction promptly. The Company also pointed out that Cerberus has received binding commitment letters from its banks to provide financing for the transaction through required bridge facilities. The Company currently believes that Cerberus' banks stand ready to fulfill their contractual obligations.

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In prior posts, I have discussed how conflicts of interest in management-led buyouts can give rise to litigation (refer here), and I have examined the ways the recent credit market turmoil is not only undermining leveraged buyouts but also engendering lawsuits (refer here). I have also extensively reviewed options backdating litigation (most recently here). But I never expected to see all three of these woes afflict a single company at the same time, yet that is exactly what has happened to Affiliated Computer Services, which finds itself and several of its officers the target of an unusual lawsuit brought by give not-quite-former outside directors as part of a veritable conflagration of accusations between management, the company and its independent directors.

The starting point for this story is ACS's larger-than-life founder and Chairman, Darwin Deason, a four-times married former Arkansas farm boy who reportedly drinks the heinous combination of Diet Coke and Kahlua to self-treat an acknowledged drinking problem and who either did or did not threaten to kill his personal chef on his yacht in September 2001. These colorful personal details, and many more, are described at much greater length in a June 2003 D Magazine article entitled "Lifestyles of the Rich and Shameless" (here), as is this particularly interesting note about an unsuccessful MBO bid that Deason led in 1988, in connection with MTech, a company Deason previously founded:

In 1988, with banks failing all over Texas, MTech's majority owner MCorp...began to slide toward Chapter 11. Reading the tea leaves, Deason puts together a $360 million management buyout of his firm. As the last second, thought, Plano-based EDS raises its hand and shouts "Four hundred and sixty-five million!" MTech is sold to the highest bidder. Deason is furious. He resigns some 90 minutes into his employment with EDS, apparently walking out before anyone can get him to sign a noncompete agreement....Five months later, with 18 of his top 22 executives from MTech on board, he launches ACS.

Having formed ACS from the remnants of a failed MBO in which he was outbid by a competing bidder, it may well be supposed that Deason was determined not to permit himself to be similarly outbid in his attempted buyout of ACS itself.

In late 2006, options backdating allegations put Deason and ACS on the front page of the Wall Street Journal. In a December 30, 2006 article entitled "Living Large and Bouncing Back" (here), the Journal provided further interesting details about Deason's background, noting, among other things, that "although Mr. Deason, who retired as CEO in 1999 and is still ACS's Chairman, received two option grants on extremely favorable terms, two internal probes didn't find evidence that Mr. Deason knew about or took part in any backdating."

The Journal article details ACS's internal backdating investigations, the second of which resulted in the November 2006 resignation of Deason's successor as CEO, Mark King, as well as the company's CFO (the company's press release about which can be found here). The Company itself later announced in a January 5, 2007 filing on Form 8-K (here) that it was amending the exercise date of certain option grants, including one grant to Deason. The Company said it was taking the step to eliminate negative tax implications. According to the Journal, these option related issues created tensions between Deason and the independent directors that may have carried over to the circumstances surrounding the MBO.

An options backdating-related shareholders' derivative lawsuit against the company as nominal defendant and against certain current and former directors and officers remains pending (refer here).

In March 2007, Cerberus Capital Management, in conjunction with Deason (who owns 42% of the ACS voting rights, but less than 10% of its ownership by valuation) made a buyout offer that as adjusted was worth $6.2 billion. Cerberus withdrew its offer on October 30, 2007 (refer here), explaining that the withdrawal was "due to the continuation of poor conditions in the debt markets." But while debt market turmoil undoubtedly was the ultimate trigger of the demise, a full-throttle dispute between Deason and the independent Board committee set up to review the offer was a critical circumstance in which events unfolded, and which set the stage for the current public fracas between Deason and the directors.

The dispute between Deason and the Special Committee is dramatically revealed in a series of letters, all of which are now very publicly available. The first letter (here, Exhibit A), dated October 30, 2007, and written by the Kosowitz, Benson, Torres, & Freidman law firm on behalf of ACS's current CEO, Lynn Blodgett, demands the "immediate resignation" of the five Special Committee members, alleging that they had "totally failed to discharge [their] responsibilities, accusing them of delays that "squandered an immensely valuable opportunity" and having failed to elicit any alternative bids." The letter also accuses the directors of having disclosed "confidential trade secret information" to one of ACS's direct competitors. The letter concludes by accusing the five individuals of "gross breaches of their fiduciary duties," and states that the Special Committee must be terminated and they must each resign "forthwith."

Deason sent his own letter to the five individuals dated November 1, 2007 (here) in which he said he "most respectfully asks that you resign today from the Board." Deason's letter also accuses the five of delaying consideration of the Cerberus bid while failing to produce another bidder, as a result of which the Board has "lost shareholder trust." Deason asserts that "changing the membership of the Board is in the shareholders' best interest." The letter also proposes a slate of "replacement directors." Deason states that "the management of the Company has indicated it may also take action, including potential litigation, in the interests of the shareholders of the Company." Deason concludes by asking the individuals to make the "right choice" and "resign immediately."

The five directors responded in two letters dated November 1, 2007. First, their counsel, Weil Gotshal & Manges, responded to the October 30 letter, in a letter (here, Exhibit B) noting that the October 30 letter is "premised on the remarkable principle that it is management rather than the Board of Directors that is ultimately responsible for the business and affairs of the Company." The Weil Gotshal letter asserts that the delays in considering the Cerberus bid were due to the inclusion in the Cerberus deal of Deason's agreement to work exclusively with Cerberus, which provision the letter asserts was "designed to and did in fact chill the interest of competing bidders," a provision that Deason refused until June 10, 2007 to waive. The Weil.Gotshal letter asserts that the Special Committee process did in fact result in a higher bidder, but that "management and Mr. Deason worked hard to assure that no buyer would have a full and fair opportunity to obtain the information necessary to make a proposal."

The five ACS directors also sent their own November 1 letter (here) in response to Deason's letter, in which they assert that they have "acted appropriately and in a manner designed to safeguard the best interests of the company." The directors' letter recounts the delays occasioned by Deason's exclusivity agreement, and asserts that "you [Deason] and your management team worked hard to make it difficult for any other buyer to have access." Their letter states that "your interest only in a transaction in which you would participate on the buy side and management's interest in retaining their jobs" delayed the process.

The directors' letter goes on to state, with reference to the October 30 board meeting:

Your carefully choreographed power play Tuesday evening to coerce the independent directors of ACS into resiging on the spot is consistent with your continuing refusal to understand that the Board's fiduciary duties are to all shareholders - not just you. Your ultimatum: resign in one hour or I will go to the press and smear your reputations - was a remarkable piece of bullying and thuggery, and it almost worked.

The directors' remarkable letter goes to state that Deason's interference with the Special Committee "made it impossible for us to continue to effectively serve as directors." The letter notes Deason's extraordinary authority in his employment agreement (which apparently gives him the ability to recommend the approval or removal of directors) as well as Deason's conduct, rendered the individuals unable to "properly discharge" their fiduciary duties. The letter observes that "we could fire you and the entire management team, but that would not help our shareholders, customers or employees. Rather it would rip the Company apart and cause a lengthy fight and a period of uncertainty from which the Company would be unlikely to recover...we have decided ...that the best way for us to discharge our fiduciary duties is to resign in favor of a new majority of independent directors." The letter concludes by stating that upon completion of the process of vetting independent director candidates, the five would step down "with great relief."

Having offered their prospective resignations, the five individuals took one further extraordinary step: they filed a declaratory judgment action (here) in Delaware Chancery Court against the company, Deason, Blodgett, and ACS's current CFO. The not-yet-former directors' lawsuit, clearly filed as a preemptive strike against anticipated actions by Deason or company management, briefly repeats the assertions from the directors' November 1 letter, and asks the court to "declare that the Plaintiffs have not breached their fiduciary duties."

There is always a potential for a conflict of interest in a management-led buyout, as I have previously noted (here). The November 2, 2007 New York Times article entitled "A Bitter Rift When the Boss is the Buyer" (here) said that "the [ACS] drama highlights the potential conflicts that can occur when a founder or chief executive leads a deal to acquire a company, something that has become common in the recent wave of leveraged buyouts." One of the most challenging issues that can arise in an MBO is what the Wall Street Journal describes in its November 2, 2007 article "A Failed Deal at ACS Sets Off a Board Brawl" (here) as the "fraught dynamics created inside boardrooms when insiders try to take public companies under private ownership."

But even within the fraught dynamics that characterize these kinds of deals, the ACS tussle is extraordinary. It is pretty clear that the fraught dynamics gave way to open warfare as the two sides sought to establish who was to blame for the deal's failure. Clearly, Deason's determination to avoid losing out to a higher bidder, as he lost his 1988 attempt to buy out MTech, seems to be a critical part of many of the events. The topsy-turvy ouster of the independent Board members by company management may perhaps be explained, if not entirely understood, by the extraordinary provision in Deason's employment agreement that actually gives him the authority to recommend the approval or removal of directors.

The directors for their part were put in a position of struggling against the company's forceful Chairman while trying to determine whether an alterative to Deason's bid would be in the sharholders' best interests. The directors efforts took place under circumstances where shareholders had already initiated litigation (refer here) alleging that management-led buyout provided shareholders with inadequate value and that Deason had misappropriated inside information to secure Cerberus's participation in the transaction.

Ultimately, what doomed this deal was a perverse combination of timing and the changing marketplace conditions. Although Deason eventually waived the exclusivity agreement with Cerberus, that didn't happen until June, and the waiver only extended for two months. By August, changed conditions in the credit marketplace had greatly complicated ACS's effort to determine potential interest in alternative buyers, and the Board sought a further extension of Deason's waiver (about which refer here). But by then, Cerberus itself was having trouble securing financing, and the deal failed. With no prospects left, the finger-pointing began.

The five directors' declaratory judgment action, in which they sued the very company on whose Board they still serve (at least until their prospective resignations become effective), represents another extraordinary aspect of this unusual set of circumstances. Their attempt to defend themselves preemptively by initiating a declaratory judgment action effectively seeks to enlist the court on their side in their struggle to establish that they are not to blame for what happened.

While the intensity and the public nature of the ACS dispute may be unusual, there likely will be other similar recriminations as changed credit conditions cause other planned deals to fall apart. The "fraught dynamics" may give way to further lawsuits - yet another byproduct of the changed conditions in the credit marketplace. It is probably worth noting in that regard that every aspect of these circumstances -- the backdating allegations, the management-led buyout offer, and the managment dispute with the board -- led to litigation against directors and officers of the company. Just something that every board should keep in mind the next time the topic of D & O insurance comes up. When things go bad, a well-structured D & O program is absolutely indispensible.

The directors' declaratory judgment action poses some interesting issues from a D & O insurance perspective. The typical D & O policy has a so-called Insured vs. Insured exclusion, sometimes referred to as an infighting provision. While this provision usually has a coverage carveback for shareholders derivative suits, the typical wording contains nothing that would help understand where this lawsuit might fit. It would be hard to characterize these circumstances as anything other than "infighting."

Hat tip to the WSJ.com Law Blog (here) for the links to the letters and to the directors' complaint.

UCLA Professor Stephen Bainbridge has detailed analysis of the ACS "soap opera" on his Business Associations blog (here), including a discussion of relevant Delaware case law.

Bonfire of the Historical References: There was a real temptation in writing this post to refer to the title of Tom Wolfe's wickedly funny book, The Bonfire of the Vanities. Although Wolfe's title seemed perfectly apt for his book and, by extension, to this post, the book title is in fact a misplaced historical reference. The phrase "Bonfire of the Vanities" does not refer to a titanic conflagration of egos, but instead refers "the burning of objects that are deemed the occasion of sin" (according to Wikipedia, here), the most famous of which was the February 1497 burning of luxury objects by supporters of Savonarola (pictured above) in Florence, Italy. The phrase was undeniably a great title for Wolfe's book, but a perhaps overactive desire to avoid historical infidelity constrained me from using the phrase in this post, much as it seems to fit the circumstances at ACS.

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As credit market disruption has reached the leveraged buyout world, a number of deals announced earlier this year to great fanfare have been unceremoniously snuffed, while others are on life support. Not too surprisingly, one direct result from this deal derailment has been a spate of lawsuits, as jilted partners and disappointed investors cast blame and seek to recoup their lost expectancy.

Recent, widely discussed problems in the sub-prime mortgage market have led to greater uncertainty about the magnitude of the U.S. economic slowdown in 2007. Because more and more people with subprime mortgages are having trouble making payments, many lenders have declared bankruptcy. Falling house prices and rising mortgage rates have probably caused these problems. It is not inconceivable that the impact on house prices will thereby increase and detrimentally affect household consumption even more than anticipated by the base scenario of this forecast.

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If corporations domiciled in Delaware are going to be affected by the wave of "going private" transactions, then Delaware courts want to make sure that they set the ground rules. In a May 9, 2007 decision in the In re Topps Company Shareholders Litigation in the Delaware Chancery Court (opinion here), Chancellor Leo Strine held, in a case involving the $385 million takeover of the Topps Company, that Delaware's interests in maintaining its own laws were sufficiently important for the court to retain jurisdiction over the case even though a related case had been first-filed elsewhere.

As a recent post in Francis Pileggi's Delaware Corporate and Commercial Litigation blog (here) explains, the basis of the Court's ruling is the "internal affairs doctrine," which holds that courts will refuse to allow actions to proceed against corporations from other jurisdictions if the shareholders have sufficient avenues to address malfeasance under the laws of the corporation's domicile. By the same token, courts will retain jurisdiction under the doctrine if the corporation is domiciled in the court's own jurisdiction.

This principle was tested in the Topps case because of a separate principle by which Delaware courts generally will decline jurisdiction if the same or similar case was previously filed elsewhere. In the Topps case, a shareholder suit challenging the takeover of the Topps company had been filed in New York one day before a substantially similar challenge to the transaction was filed in Delaware. (A New York Sun article discussing the Topps takeover and the nature of the shareholder controversy can be found here.)

Chancellor Strine found that policy interests weighed in favor of keeping the case in Delaware. As he observed in declining to defer in favor of the first-filed case, "the paramount interest is ensuring that the interests of the stockholders in the fair and consistent enforcement of their rights under the law governing the corporation are protected." He went on to note that "when a corporation forms under the laws of a particular state, the rights of its stockholders are determined by that state's law and that the chartering state has a powerful interest in ensuring the uniform interpretation and enforcement of its corporation law, so as to facilitate economic growth and efficiency."

The Topps opinion observes that the policy considerations behind the internal affairs doctrine are particularly compelling in light of the wave of private equity takeovers of publicly traded companies, since over half of the Fortune 500 companies are domiciled in Delaware. Chancellor Strine wrote that "the reality is that the Topps Merger is part of a newly emerging wave of going private transactions involving private equity buyers who intend to retain current management." These transactions present interesting questions about how to address potential conflicts of interest "and how to balance deal certainty against obtaining price competition in a very different market dynamic." He further noted that "as with the phenomenon of stock options backdating, Delaware has an important policy interest in having its courts speak to these emerging issues in the first instance, creating a body of decisional authority that directors and stockholders may confidently rely upon."

The Topps opinion is the latest example where the Delaware Court of Chancery has evinced its willingness to use its authority to police "going private" transactions. In March 2007, Strine postponed a shareholder vote regarding the $115 million buyout of Netsmart Technologies Inc. until the company provided shareholders more information about future cash flow projections, and about why its board did not pursue strategic buyers. (The Netsmart opinion can be found here.) Netsmart's shareholders later approved the buyout (refer here).

In addition, Vice Chancellor Stephen Lamb refused last year to approve the settlement of a lawsuit involving a buyout of SS&C Technologies Inc. that was instigated by SS&C's CEO without prior authorization from its board. Lamb chastised the parties for failing to consult the court about a planned settlement based on supplemental proxy disclosures, and for failing to demonstrate that potential claims of shareholder plaintiffs had been adequately investigated. The opinion in the SS&C case can be found here.

The current buyout wave shows no signs of letting up, and litigation is an inevitable side effect of the wave. The Delaware court seem increasingly committed to making sure it is clear they are in charge.

A detailed discussion of the Topps decision can be found in this May 15, 2007 memorandum by the Potter Anderson & Corroon law firm, here.

A May 20, 2007 news article in the Wilmington News Journal discussing the Topps case can be found here. A May 17, 2007 post on the Harvard Law School Corporate Governance blog about the competition between states with respect to corporate law can be found here. Professor Larry Ribstein has an interesting commentary on the Topps decision in his Ideoblog (here).

In a recent post (here), I noted that the "internal affairs doctrine" may pose substantial hurdles for investors filing derivative actions in U.S. courts against foreign domiciled corporations.

You're the Topps, You're the Coliseum: According to Wikipedia (here), the recent takeover attempt is not the Topps company's first going private experience. The company first went public in 1972, but was acquired in a leveraged buyout in 1984 by Forstmann Little & Company. The company again went public in 1987. The latest takeover attempt is led by Michael Eisner. It will probably only be a matter of time before the company is once again taken public.

Topps of course makes the famous baseball trading cards (for details about which refer here). Bazooka bubble gum , which Topps also makes, originated the bubble gum comics, starring the iconic Bazooka Joe. It is no mystery, at least not to me, why grown-up little boys keep trying to buy the whole company. I would do it if I could.

In Two Hours, Blackstone Will Be Hungry Again: When Blackstone recently announced its plan to sell shares in an inital public offering (here), it seemed like the whole private equity thing had to have reached some kind of a peak. But now comes the announcement that China will invest $3 billion of its $1.2 trillion in reserves in an 9.9% equity position in Blackstone (here). Even though as part of the deal China agreed that it would not invest in a rival private equity firm for twelve months, it is hard to disagree with the Financial Times' assessment (here) that "the decision suggests China is testing the water for a much bigger investment in private equity. It could open the floodgates to a tide of money flowing into the sector at the precise moment regulators are becoming concerned it may be overheating." The private equity thing seems to have a lot further to run.

Updated Options Backdating Settlements: In a recent post (here), I took a look at a number of dismissal and settlements in options backdating-related lawsuits. In response to my post, readers brought additional settlements to my attention, which I have incorporated by updates into the original post. If any readers are aware of additional settlements, dismissals, or dismissal denials, please let me know and I will update the post as appropriate.

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As the number of securities fraud lawsuits has declined (refer here), an alternative means that plaintiffs lawyers are finding to amuse and enrich themselves are lawsuits filed in connection with "going private" transactions. An April 24, 2007 National Law Journal article entitled "New Legal Battles Over Going Private" (here) takes a look at the court fights that "challenge the terms of a merger that would transform a public company into a private one."

On the one hand, there is nothing new about litigation arising from M & A activity. There is a well-established tradition of plaintiffs' lawyers using the courts to force companies that are being acquired to re-open the bidding process or bump up the proposed acquisition price - and also to earn themselves some fees. But as The D & O Diary has previously noted (here), these lawsuits in the "going private" context sometimes have additional elements that represent a variation on the established M & A litigation theme.

As the National Law Journal article discusses, plaintiffs' lawyers frequently target certain aspects of going private transactions, including "deal sweeteners that enhance executives' compensation." Lawsuits also challenge deals because they "unfairly benefit specific corporate directors and executives" at shareholders' expense. The lawsuits can lead to a reopened bidding process, a higher acquisition price, and even in some circumstances "damages to shareholders after the deal closes."

The massive amounts of money involved in going private transactions create enormous opportunities for conflicts of interest to arise, particularly where incumbent management stands to benefit if a specific buyout group succeeds. These circumstances present a serious risk for claims against the directors and officers of the target companies. To see these factors at work within the context of a specific going private transaction, refer here to see my prior post regarding the Clear Channel Communications deal and lawsuit.

These kinds of lawsuits are expensive to defend because of the high stakes and time frames involved. The defense fees will usually be covered under the typical D & O policy, but in some instances settlements may not, in whole or in part. Some settlements or awards represent amounts (for example, for return of improper compensation) would be excluded under the typical amounts. Remedial steps, such as a reopened bidding process or a bumped up acquisition cost, would not in most instances represent covered loss. But to the extent awards or settlements are based on misrepresentations or other alleged malfeasance, the D & O policy could provide an important funding source for settlements and awards. Because of the complicated way that these kinds of claims intersect with the D & O policy, it could be particularly important for companies to enlist the assistance of a skilled D & O claims advocate in representing their interests in connection with the claim.

Another Subprime Lawsuit: One of the reasons I recently added a post (here) where I will maintain a running tally of subprime lending lawsuits is an intuition that as the consequences from deteriorating subprime mortgages ripple outwards, there will be more lawsuits against a broadening array of companies.

Along those lines, I updated the subprime lending lawsuit tally today to add a lawsuit that represents a new variant in the mix. According to news reports (here), Credit Suisse has been sued in connection with its bond securitization of subprime loans. Bankers Life Insurance Co. claims that it lost money on the investment grade bonds that Credit Suisse sold and that were backed by subprime mortgages. The lawsuit alleges, among other things, that the bank misled bond investors about how much protection they had against accelerated defaults. The lawsuit also accuses the bank of covering up delinquencies and attempting to maintain the illusion that the level of defaults were not serious.

We will undoubtedly be seeing more claims against a broader range of companies as the ripples from the subprime meltdown expand.

ABA Panel: On Friday May 4, 2007, I will be participating in an American Bar Association Tort Trial & Insurance Practice Section conference entitled "Beyond Legal: A Business Approach to Corporate Governance." A copy of the conference brochure can be found here. I will be appearing on a panel entitled "D & O Insurance: Placing a Premium on Good Corporate Governance." The panel will be moderated by my good friend Sean Fitzpatrick, and will include a number of distinguished speakers, including Professors Tom Baker of Connecticut Law School and Sean Griffith of Fordham Law School. If you will be attending the conference, I hope you will greet me and introduce yourself.

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The D & O Diary has previously noted (most recently here) the problems that can arise in connection with "going private" transactions in which management teams up with outside investors to buy out public shareholders' interests. The latest example may be Clear Channel Communications' November 16, 2006 announcement (here) that a group led by Thomas H. Lee Partners and Bain Capital Partners will acquire the company for $26.7 billion (including $8 billion of debt assumption).

Early press reports of the proposed transaction were critical of the deal; for example, the Wall Street Journal's November 14, 2006 article "Clear Channel Buyout Talks Fuel Concern of Management Conflicts" (here, subscription required) commented that the deal was the latest transaction raising concerns that "corporate executives may be pushing transactions that are ideal for themselves but might not be optimum for shareholders." Among other things, the Journal commented on the "lightning-fast auction" process that produced the two competing bids for the company, and on the close ties between the company's founders and managers, the Mays family, and the company's board. The article also raised the question whether the company adequately considered bids from groups less friendly to the Mays family or considered whether a break-up would raise more money than selling the company as one piece. According to other news reports (here), other shareholders have publicly questioned the transaction, including the benefits to the Mays family and the fact that the acquirors plan to sell off assets to finance the transaction.

The Company's November 16, 2006 8-K (here) describing the transaction reports some details of the deal that may also raise concerns. For example, the company has only until December 7, 2006 to consider any competing bids, and the company would, if it accepting a competing bid, it would have to pay the currently proposed acquirers a break up fee of $500 million. Past going private transactions have been criticized for similarly short "go shop" periods and for break up fees so large that potential competing bidders would be discouraged.

The 8-K also discloses that if following the completion of the transaction, either the company's CEO, Mark Mays, or its CFO, Randall Mays, have their employment terminated under change of control provisions, they would each receive cash payments equal to the sum of one year's base salary, bonus and accrued vacation pay, plus 2.99 times the sum of each executive's annual salary and bonus, as well as three years continued benefits. (The 8-K does note that the executives did at least give up the right to a state and federal tax "gross up" as well as the right to received 1 million options upon termination.) According to news reports (here), these provisions for payment to the Mays family member represent a "significant reduction" from the amounts originally under discussion -- but are still substantial, and are still the subject of sharholder objections, according to othere news reports (here). According to a shareholder quoted in these reports, "This is an extremely one sided deal."

Transactions involving these kinds of potential conflicts of interest create circumstances where accusations of wrongdoing can more easily arise. It is almost to be expected that the Clear Channel transaction is the subject of a purported shareholder class action. On November 16, 2006, the law firm of Wechsler Harwood filed a lawsuit (here) in Texas state court, accusing Clear Channel and its directors of breach of fiduciary duty. The lawsuit alleges that the "going private" transaction is for the benefit of insiders, particularly the Mays family, but to the detriment of the company's public shareholders. The lawsuit seeks an injunction against the transaction, or, should the transaction be completed, damages on behalf of Clear Channel's shareholders.

A cynical view of these kinds of lawsuits is that they represent no more than an attempt by plaintiffs' lawyers to extract a toll from the parties to the transaction. But at least in cases where the allegations of conflicts of interest are substantial, these kinds of claims may present a threat of more than just a cost of doing business.

The Clear Channel transaction is just the latest in a series of huge "going private" transactions. These mega-deals and the accompanying risk of D & O claims are likely to continue into the foreseeable future. As the Wall Street Journal noted in its October 26, 2006 article entitled "Growing Funds Fuel Buyout Boom" (here, registration required), private equity firms have raised buyout funds of as large as $20 billion. According to the article, fifteen of the top 20 buyouts ever have taken place in the last 18 months, and larger buyouts may lie ahead as private equity funds "eye takeover targets with stock market values of $50 billion or more." (The largest buyout ever is KKR's $25.1 billion takeover of RJR Nabisco.) The article quotes a leading M & A attorney as saying "We are seeing a significant privatization of corporate America."

The massive amounts of money involved in these "going private" transactions create enormous opportunities for conflicts of interest to arise, particularly where incumbent management has the potential to benefit if a particular party's proposed transaction succeeds. These circumstances present a serious potential risk of claims against directors and officers of the target companies.

As The D & O Diary has previously noted, private equity funds themselves are drawing scrutiny; according to media reports (here), the Department of Justice has begun an investigation whether private equity funds' "club deals" violate antitrust laws by artificially limiting the amount shareholders realize when companies are acquired.

The WSJ.com has an interesting "Who's Who in Private Equity," with a listing and description of the leading private equity firms here. Bain Capital, one of the successful bidders for Clear Channel, was founded by the current Republican Governor of Massachusetts, Mitt Romney.

A Rolling Stone magazine profile of Clear Channel and its influence on American radio and popular culture can be found here. Salon.com has an index of its articles about Clear Channel here.

Update: The private equity "buyout boom" continues. On November 20, 2006, the private equity firm the Blackstone Group announced (here) a $19 billion buyout of Equity Office Properties Trust.

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The D & O Diary has previously commented (most recently here) on the increasing risk of D & O claims arising from "going private" transactions in which incumbent management teams up with outside investors to buy out the interests of public shareholders. The most recent high-profile "going private" transaction to be announced - the Dolan family's $7.9 billion proposal to take Cablevision private - has already resulted in a claim against the company's board, according to this October 10, 2006 press release, here. Shareholders' objection to the proposed transaction is that it allegedly puts the Dolan family in an advantaged position, to the detriment of public shareholders. A colorful expression of this concern is reflected in the remarks of a T. Rowe Price portfolio manager, who was quoted in an October 10, 2006 Wall Street Journal article about the Cablevision transaction (here, subscription required), as saying that "I'm tired of management and private-equity firms trying to steal companies from underneath our noses, and I think this is another example of that."

An interesting commentary about the Cablevision transaction and the shareholder lawsuit appears on the Lies, Damn Lies blog, here.

Shareholders concerns about "going private" transactions also extend to the ability of management to pursue potential buy-out opportunities in which management might participate, without even the board of directors' knowledge, in a way that potentially discourages or disadvantages potential competing bidders. A recent SEC filing of Kinder Morgan, whose shareholders are now considering a $14.8 billion buyout deal, provides an interesting perspective into this process. (The filing may be found here.) Kinder Morgan's President entered discussions with investment banks in February 2006 about the possibility of pursuing alternative strategies. The discussion changed direction when the investment bank requested the opportunity to act as principal investor in a leveraged buyout. These discussions continued for months, yet the company's board was not made aware of the potential transaction until May 13, 2006.

According to the Wall Street Journal article (here, subscription required) describing the Kinder Morgan transaction,

The timing of events is notable because boards of directors often prefer to control the process of a management buyout as much as possible. The earlier they are aware of a potential buyout, the more they can shape the terms in ways that are favorable to the overall company....The tensions between management and board can become acute because the board is often interested in maximizing the number of bidders while management is eager for its own bid to succeed. For example, Mr. Kinder [Kinder Morgan's founder], at the request of Goldman's private-equity team, committed to not engage in talks with any third party in connection with any bid for 90 days. In an effort to keep the playing field more level, the board's special committee...requested that Mr. Kinder terminate that agreement.

The Kinder Morgan board' special committee later obtained more advantageous terms from the prospective acquirors and now the board supports the takeover proposal.

The Kinder Morgan transaction has also resulted in a claim against the company's management and its board of directors. (A copy of the complaint may be found here.)

The attributes of a management-led buyout are fraught with potential conflicts of interest. Management is highly motivated to ensure that their proposed transaction will succeed, which may cause them to agree to structures (such as not to talk to potential competing bidders) that may favor their proposal, but to which shareholders might otherwise object.

Nor are the potential conflicts of interest limited to management. The Kinder Morgan transaction reflects the unusual circumstance where the investment bank to who the company's management turned for strategic advice emerged as the principal investor, putting the investment bank in the unusual position of advising the company' management in connection with the bank's own proposal (in which management was participating) to buy the company.

In circumstances packed with so many potential conflicts of interest, it is all too easy for allegations of wrongdoing to arise. The high stakes involved exacerbate this risk. For that reason, these transactions almost inevitably generate shareholder claims alleging that management breached their duty of loyalty and that the board breached their duty of care. A cynical view is that these lawsuits are nothing more than plaintiffs' lawyers' attempts to extract a toll from the transaction participants. But where management's interests in a transaction potentially diverge from those of shareholders, the claims may present a more serious exposure.

As the Journal article (linked above) discussing the Kinder Morgan transaction put it, "As private-equity transactions continue to sweep through the financial markets, investors will begin putting extra scrutiny on how these transactions come together, and how fair they are to all shareholders."

Private Equity Conflicts: A different kind of conflict of interest may exist among the potential buyers in these "going private" transactions. According to an October 10, 2006 Wall Street Journal article entitled "Private-Equity Firms Face Anticompetitive Probe" (here, subscription required), the U.S. Department of Justice is looking into whether some of the top tier private equity firms have developed a tacit understanding that they would not undercut each other's takeover attempts with competing bids. Among other approaches under investigation is whether these firms form "clubs" drawing in potential competing bidders, which potentially could have the effect of depressing acquisition prices. The investigation apparently is in its early stages. A second article about the investigation appeared in the October 11, 2006 Journal (here, registration required)

Worse Than a Bad Hair Day: "Lightning Exits Woman's Bottom." (I am not making this up.) Read the story here.

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Hedge Fund Hardball Update: In an earlier post (here), The D & O Diary commented on the new game of "hedge fund hardball," drawing on a Wall Street Journal article (here, registration required) with that title. As discussed in the prior post, hedge funds are demanding, when the companies in which they invest miss filing their periodic report with the SEC, that the companies either pay the face amount of the debt or pay substantial penalties. A recent ruling by a New York trial court in an action that three hedge funds initiated against BearingPoint demonstrates the risk these actions present.

BearingPoint has failed to file a series of its periodic SEC filings as a result of previously disclosed issues with its internal controls and financial accounting. An indenture trustee, acting on behalf of hedge fund investors holding over 25% of a $200 million subordinated debenture issue, sued BearingPoint alleging that the company's failure to file the periodic reports breached covenants under the indenture agreement and represented a default. In a September 18 ruling (here), the NY trial court granted summary judgment on the trustee's behalf, ruling that the company's failure to file its periodic reports represented a default under the indenture agreement. The court reserved the question of damages for trial.

In its September 26, 2006 8-K (here), BearingPoint outlined the problems that the ruling presents for the company. The company noted that holders of other debt instruments could also try to establish a default and that "there could be material negative consequences on the Company's other outstanding debt obligations, indemnity agreements...and customer contracts" if the court's ruling should cause bondholders or parties on these other instruments to seek default or acceleration. The company also announced that due to the uncertainty surrounding the court's ruling the company was delaying filing its annual report with the SEC. Bearing Point's shares declined sharply on the news.

The hedge fund plaintiffs' motives in the action may be gleaned from the comment of one of the hedge fund principals quoted in the September 28, 2006 Washington Post article entitled "Bondholders Seek $21.5 million in Damages from BearingPoint Default" (here, registration required). The hedge fund principal is quoted as saying that "of course, it is just a technical default. But they breached the covenant. We wanted damages due to us as a result of the default." The principal also commented that "it was ludicrous" to suggest that the $21.5 million that the plaintiffs are demanding would hurt the company. (Keep in mind that the hedge fund plaintiffs supposedly own about 25% of the debt issue in dispute, so if that is true the face value of their investment is about $50 million -- their demand represents over 40% of the face value of their investment, all for what they concede is a technical default.)

It is pretty clear that the hedge funds are seizing upon technical default to wring money from the company. As noted in The D & O Diary's prior post, this tactic is of particular concern right now, because the number of companies who have had to delay their filings is at an all-time high, in part due to the number of companies that have had to hold up their filings because of options backdating issues. Even though the BearingPoint lawsuit is only against the company itself and not against any individual defendants, the threat of litigation surrounding these issues, as well as the larger threat of bankruptcy looming in the background, underscores the potential D & O risk these circumstances present. The conflicting interests between the company and its investors creates an environment where accusations of wrongdoing can more easily arise.

The CoporateCounsel.net Blog has a detailed post (here) discussing the legal issues in the BearingPoint case. Hat Tip to the CorporateCounsel.net Blog for the link to the NY trial court ruling.

More About MBOs, Going Private Transactions, and D & O Risk: In prior posts (here and here), The D & O Diary discussed the increased risk of D & O claims arising from the involvement of public company management in private investors' takeover transactions in the form of "management buy-outs" (MBOs) or "going private" deals. A purported class action lawsuit filed on September 26, 2006 in a Texas trial court (complaint here) against Freescale Semiconductor, its Chairman and CEO, and five other directors, presents an example of the kinds of claims that can arise.

The complaint alleges that the defendants sold the company for inadequate consideration in a transaction "tailored to meet the specific needs of a private equity consortium led by the Blackstone Group," and that the defendants rejected a more richly priced offer from a group led by KKR. The complaint alleges that the agreement with the Blackstone-led consortium imposes barriers to competing bidders, including a $300 million break-up fee if another bidder succeeds. The complaint further alleges that the individual defendants "will reap disproportionate benefits" from the transaction - although the complaint omits any specifics of these benefits. The complaint seeks to enjoin the consummation of the agreement with the Blackstone consortium and to compel the defendants to complete an auction to ensure that the shareholders receive the benefit of the highest acquisition price.

In addition, in a September 21, 2006 8-K (here), Metrologic Instruments announced that two derivative lawsuits have been filed against the company and its board alleging that the consideration shareholders will receive for the planned transaction to take Metrologic private is inadequate. Among the investor participants in the takeover is Metrologic's founder and CEO. The first of the two complaints alleges that the defendants timed and structured the transaction to allow themselves to capture the benefit of the company's future business potential without fair consideration to shareholders. The second complaint alleges that the defendants failed to maximize value and that the proposed takeover represents an attempt to engage in a self-dealing transaction.

As The D & O Diary has previously noted, the increasing involvement of private financing in public company ownership give rise to complicated D & O claims possibilities including allegations of conflicts of interest and of wrongdoing. These possibilities represent a growing area of D & O risk.

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The D & O Diary has written on several prior occasions (here, here and here) about the increasing D & O risk arising from the public company involvement of private fund investors, such as private equity funds, hedge funds and buy-out firms. In a prior post (here), The D & O Diary discussed the increased complexity arising from the involvement of public company management in private investors' take overs, in the form of "management buy outs"(MBOs). In a September 8, 2006 article entitled "In Some Deals, Executives Get a Double Payday," (here, subscription required) the Wall Street Journal focused on the conflicts of interests that can arise when management becomes involved in "going private" buy-outs of public companies; the article noted that private-equity firms will team up with management to improve their take-over bid, and that the private investors sweeten the deal by providing management with significant financial inducements:

In such cases, management with all its detailed knowledge of the company, goes from being a seller striving for a higher price to being a buyer looking for an attractive price. Usually the sale of a public company involves an auction or a competitive-bidding process. But when management joins private-equity buyers, there often isn't such an open procedure, and the process is especially fraught with potential conflicts of interest.

The Journal article emphasizes that the conflict is all the more abrupt when private investors offer management lucrative compensation packages that could permit management to benefit significantly if the buy-out is successful. The compensation can involve ownership participation and substantial performance bonuses.

While many boards actively review the takeover proposals, the take-over bidder will also attempt to skew the process in their favor, for example by telescoping the period where the bid remains open, forcing potential rival bidders to act on short notice. Potential bidders (who do not enjoy the support of management, but who may present a proposal that is more to shareholders' benefit) also may face a prohibitively high "break up" fee to try to get rid of the original bidder.

As may be expected, shareholders "sometimes revolt against such largess" as company management stands to gain in the buy-out transaction. The article cites the lawsuit Petco Animal Supplies shareholders filed in August 2006 against the company's directors based on the directors' "attempts to provide certain insiders and directors with preferential treatment in connection with their efforts to complete the sale of Petco" to private equity investors. A more detailed description of the Petco transaction, including the company's decision to go with the management led bid even though the rival bidder offered shareholders a 13.3% higher proposal, and including a more detailed description of the lawsuits (and the substantial benefits that management stands to gain if the original bidder successfully completes its buyout), can be found here.

As The D & O Diary previously has noted, the increasing involvement of private financing in public company ownership creates an environment where conflicts of interest -- and accusations of wrongdoing -- can more easily arise. These claims possibilities also present an enormously complicated D & O exposure environment. These considerations also make it more important than ever for companies to involve knowledgeable and experienced insurance professionals in their D & O insurance acquisition.

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The D & O Diary has previously written (here and here) about the problems and conflicts of interests that can arise from the involvement of private fund investors (private equity firms, hedge funds and buyout firms) in publicly traded companies. In a September 3, 2006 column in the New York Times (here, registration required) entitled "On Buyouts, There Ought to Be a Law," investment pundit and humorist Ben Stein explores yet another example of the risks arising from private financing. Stein decries the evils of management buyouts (MBOs), or "going private" deals. Stein's view is sharp and specific; he says that "these deals ought to be illegal on their face. That is, they should simply not be allowed as a matter of law."

Stein is concerned about leveraged buyouts of publicly traded companies involving senior members of the management team. His primary objection is that insiders will use their inside knowledge to buy the company from public shareholders on the cheap. He also is concerned that insiders may propose to buyout lenders or other investors business plans (and investment returns) that are undisclosed to public shareholders.

Stein's concerns are legitimate, and they vividly illustrate the conflicts of interest that can arise in an MBO. However, his draconian solution to prohibit management buyouts is not the best solution from the perspective of the shareholders. There may well be times when a company may operate more efficiently as a private company (indeed, in this post Sarbanes-Oxley era, an increasing number of companies may be reaching that conclusion); and there may be times when the management's buyout proposal is the best available alternative for shareholders. The problems arise not from the MBO itself, but when the information from which shareholders might make an informed decision about their best interest is withheld. The solution to Stein's concerns is not to outlaw transactions that may make economic sense in some situations; the solution is to make sure that these kinds of transactions only go forward with adequate disclosure and shareholder protections.

The D & O Diary (which is influenced by the comments of Professor Dale Oesterle of the Business Law Prof blog, here) believes the perferred approach would be to require the would-be MBO participants to disclose their reasons for taking the company private, and the reasons why a private company rather than a publicly traded company should carry out their plans. In addition, management should be required to disclose their calculations for profit from the transaction (an indispensable element in determine whether the buyout valuation is fair). Finally, no management led buyout should go forward without the opportunity for an auction process (following the previously identified disclosures), to ensure that shareholders are getting the best possible price.

In any event, MBO transactions represent yet another example where the increasing influence of private investors in public company finance has the potential to create conflicts of interest that could generate disputes and trigger D & O claims. The possibility of shareholder claims against senior management who are pursuing an MBO presents particularly complex D & O issues, since the acquirers would not be acting in their "insured capacity" as directors and officers of the company. But to the extent that the claims allege wrongdoing in their capacity as directors and officers, their D & O policies would be triggered. As the D & O Diary has previously noted, it takes a particularly skilled hand to craft D & O coverages in light of the complex challenges arising from the increasing involvement of private money in public company financing.

Professor Larry Ribstein has a post (here) on his Ideoblog that is highly critical of Stein's column.

Thanks to alert reader Marty Perry for the link to the Stein column.

Priceless: A perfect hangover cure, here.

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The Wall Street Journal's recent series on "Private Money" describes the "new financial order" arising from "the new rules of private equity game." According to the July 25, 2006 Journal article (subscription required) entitled "Cash Machine: In Today's Buyouts, Payday is Never Far Away," the new power players are private financiers - hedge funds, buyout firms and venture capital firms highly skilled at quickly extracting cash from the firms they acquire. The private financiers collect dividends, fees for advising, and fees for stock underwriting and management. The magnitude of the cash hauled out can be stunning; the article describes the $22 million in professional fees and $448 million in dividends that the private investors pulled out of Burger King prior to its May 2006 IPO.

The article describes the sequence of events involving Dade Behring, Inc, a medical diagnosis company that found itself saddled with enormous debt that was incurred to buy out private investors' equity stake. Eventually the debt burden drove the company to the brink of bankruptcy. Creditors formed a committee to examine the conduct of Dade Behring's "owners, directors and advisors." The creditors considered bringing claims relating to "illegal dividends, illegal stock redemptions and impairment of capital." (The company later recovered and subsequently went public.)

Although the Dade Behring creditors ultimately did not bring a claim, the example provides a cautionary tale for those who must assess the potential risk of D & O claims arising under the new rules of the private equity game. The presence on company boards of representatives of the new power players whose interests may conflict with the interests of the company, other investors, or creditors, creates an environment where accusations of wrongdoing may more easily arise. These same risks are present even if the private equity investors do not have company representation; the board's actions for the benefit of private equity investors could draw criticism of the board even if the investors do not have board representation. This risk could be particularly applicable where a debt-saddled company is driven into bankruptcy. Creditors may claim they are owed special duties while the company was in the "zone of insolvency." These claimants may assert that the private investors extraction of dividends, management fees, or equity buy-outs, represent a form of "looting" or "waste" or a violation of other legal duties, and that the other directors violated their duty of care for permitting these actions.

While the significance of private funding in the world of corporate finance has long been recognized, the Wall Street Journal series reflects a growing realization that the increasing influence of private funding has its consequences. Among those consequences is a potentially growing possibility of conflicting interests that could trigger D & O claims.

Crafting the appropriate insurance response when these risks are present requires a skilled hand. The presence of differing potential interests, and differing insurable interests, creates problems of program structure and of content. In terms of policy wordings, the formulation of the Insured versus Insured exclusion present particular potential concern. Policy definitions, particularly the definition of "Loss," as well as the conduct exclusions, also could be particularly important, as would common endorsements such as a Major Shareholder exclusion.

Zone of Insolvency: Stephen Bainbridge, UCLA Law Professor and author of the ProfessorBainbridge.com blog, has written an interesting paper examining (and questioning) the duties of directors of companies that are in the "zone of insolvency." The paper may be found here.

The One Sin Greater Than Plague or Death: In our time, we are comfortable thinking about issues such as debt or bankruptcy as strictly practical or legal concerns. But in an earlier times, debt was a moral issue. This is starkly illustrated in Henry Knighton's contemporaneous account of the Black Death in England; Knighton reports that "the Bishop of London sent word throughout his whole diocese giving general power to each and every priest...to hear confessions and to give absolution to all persons with full episcopal authority, except only in case of debt. In this case, the debtor was to pay the debt, if he was able while he lived, or others were to fulfill his obligations from his property after his death." Knighton's report appears in Eyewitness to History, a fascinating 1988 compilation of first-hand accounts of historical events, edited by John Carey.

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