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.