Fiduciary Duties in Sponsor-Owned Companies: COVID-19
March 26, 2020
The public health response to the COVID-19 virus has had broad and sweeping implications for many businesses. The impact of “lockdown” orders limiting movement and shuttering nonessential businesses has been staggering. Successful companies in certain sectors have seen revenues go to zero overnight while others grapple with new issues, such as remote operations and supply chain disruption.
Against that backdrop, many sponsors are dealing with multiple portfolio companies in various levels of distress and, in some cases, are being called upon to provide emergency financing or additional investments in order to carry their portfolio companies through the crisis. At the same time, sponsors often control the board of directors and/or provide financial and back office functions for their portfolio companies. All of that can make it difficult for sponsor representatives on boards of directors to navigate their fiduciary duties. Below are some practical tips for sponsor representatives on boards of directors.
- Understand the Context: Shareholders and creditors of a distressed company, whether or not in bankruptcy, may have very different interests. Shareholders often focus on higher return on their equity while creditors are focused on getting paid back. Directors of such companies must balance the different interests of these sometimes competing stakeholders.
- Know Your Duties: Directors generally have duties of care and duties of loyalty to the company. The duty of care means that directors must act in good faith and make decisions in a reasonably prudent manner. To do so, directors must be fully informed in making decisions. The duty of loyalty means that directors must act with loyalty and without conflict in making decisions for the company.
- Understand Whether Your Duties Have Been Disclaimed: Limited liability companies may have disclaimed or modified certain of the applicable fiduciary duties by contract in the LLC agreement. Understanding whether that is applicable to your company is important to exercising your duties.
- Identify to Whom Your Duties Run: Until the company is insolvent, your fiduciary duties run solely to shareholders. If the company is insolvent, then the duties expand to include creditors. Insolvency generally means any of (i) balance sheet insolvency, (ii) inability to pay debts as they come due, or (iii) operating with unreasonably small capital. The COVID-19 crisis has created at least temporary insolvency for companies in numerous industries that implicates fiduciary duties.
- Understand How Your Decisions Will Eventually Be Evaluated: In a consensual restructuring or a successful turnaround, the question of whether directors complied with the applicable fiduciary duties is rarely raised. On the other hand, where the restructuring is unsuccessful or nonconsensual, the issue of compliance with fiduciary duties can be used for leverage in negotiations by dissatisfied parties or result in full blown litigation. It is that context (and almost always with hindsight) that compliance with fiduciary duties will be raised. Directors who comply with their fiduciary duties are generally protected by the business judgment rule meaning their decisions do not have to be right but simply have to be reasonable business judgments. Courts may apply higher standards (i.e., heightened scrutiny) if directors are conflicted or the decision was not made by an independent board.
- Understand the Potential for Conflicts: Once the fiduciary duties have expanded to include creditors, decisions should be made to maximize enterprise value rather than focusing solely on equity value. Conflicts often arise in circumstances where equity holders might prefer a strategy that would have more equity reward or would be less punitive to equity while creditors would prefer a different approach. Sponsor representatives must be mindful that their duties run to the company (and not just to equity) where there is an insolvency.
- Rely on Independent Directors: To the extent you are on a board of directors that has independent directors, sponsor representatives may want to defer to the decisions of independent directors where the sponsors’ interests and their duties to the company have the potential to conflict. If a board of directors does not have any independent members, sponsors should consider adding them, particularly if part of the solution is sponsor financing or investment.
- Rely on Advisors: Directors are better protected when their judgment is informed by advice from outside counsel and advisors. In certain situations, the directors should consider retaining counsel separate from the company in order to assure that the different interests are protected.
- Establish an Organized Communications Process: Directors should establish regular board meetings and assure that clear and timely minutes are taken. To the extent possible, directors should avoid written communications about their duties or decisions outside of the organized channels of communications. Sponsor representatives should also be aware of the potential for conflict and evaluate and review all of their communications accordingly.
- Carefully Evaluate the Investment Structure from the Company Perspective: Sponsor representatives on portfolio company boards of directors should carefully evaluate any investment proposed by the sponsor from the company’s perspective. Sponsor investments should be approved by the independent directors, but sponsor affiliated directors should also assure that the investment is structured in a manner that is fair to the company. If the investment is structured as a loan, it is important to avoid costly litigation and that the investment have the features of a loan in order to avoid recharacterization challenges.
- Consider Shopping the Investment: Validation of the terms of the loan or preferred stock investment, as consistent with market, is beneficial in protecting the investment from a later challenge and avoiding fiduciary issues. Sponsor affiliated directors should consider encouraging the company to “shop” the investment to third-parties. If marketing ahead of closing with a sponsor is not feasible, consider a “go shop” provision that allows the borrower to seek better terms for a limited period of time.
- Understand Your D&O Policies: Directors should understand the scope of the D&O policies and make sure they are sufficient for these purposes. It is obviously critical that directors also understand the applicable exclusions and how their actions can impact the policies.
This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. Nancy Mitchell, an O’Melveny partner licensed to practice law in Illinois and New York, and John Rapisardi, an O’Melveny partner licensed to practice law in New York, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.
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