On May 2, 2022, after a lengthy trial, Judge Christopher Sontchi of the Bankruptcy Court for the District of Delaware (the “Court”) ruled (the “2022 Opinion”) that a private equity sponsor (the “Sponsor”)1 breached its fiduciary duty to its distressed portfolio company, ASHINC Corporation (“Allied” or the “Company”), which ended up in bankruptcy.2 Specifically, the Court determined that the Sponsor wrongly controlled the negotiations with a potential suitor for the Company’s assets and sought a premium for its own debt holdings rather than ensuring all creditors were treated equally in a sale to the suitor. Ultimately, however, the Court held that the litigation trust set up under the Company’s chapter 11 plan (the “Trust”), which brought the litigation, failed to establish a reasonable basis for the Court to award damages.
The Court’s 2022 Opinion means that, despite having breached its fiduciary duty to the Company, the Sponsor will not be liable for the most significant damages sought by the Trust: the difference in value between an opportunity to have sold the Company’s assets outside of bankruptcy and the lesser value actually realized through a sale of the Company’s assets in bankruptcy.3 The 2022 Opinion followed the Court’s 2021 decision denying the Sponsor’s motion for summary judgment on the breach of fiduciary duty claim (the “2021 Opinion”).4 While the Sponsor may have dodged a significant liability hit for breaching its fiduciary duties—which turned on factual determinations based on, among other things, expert testimony—these opinions provide lessons for private equity sponsors on the fiduciary duty risks they face when their portfolio companies experience financial difficulties.
This is the Weil Restructuring Review’s second installment in a series of articles describing the Court’s 2021 Opinion and its takeaways for private equity sponsors. In Part I of our series, we discussed the Court’s holding that the Sponsor breached its obligations under the Company’s credit agreement by failing to make a capital contribution upon the Sponsor’s acquisition of the Company’s debt, as required by the Company’s credit agreement, which resulted in the Sponsor being liable for damages.5 Future articles will cover the Court’s summary judgment ruling on other claims against the Sponsor, including fraudulent transfer, equitable subordination, and recharacterization.
The 2021 Opinion serves as a reminder of legal doctrines that can be asserted against private equity sponsors when their portfolio companies end up in distress. In particular, when a sponsor is considering a potential transaction with or involving one of its financially troubled portfolio companies, it should remember that, in addition to protecting the value of its investment, it is obligated to consider the best interests of the portfolio company and its stockholders (or other stakeholders if the Company is insolvent).6 A sponsor, of course, is permitted to consider its own interests and it is not required to act altruistically toward its portfolio companies, but it cannot advantage itself over the other stakeholders, including the company’s creditors.7 Unfortunately, where to draw the line between legitimate self-interest and impermissible self-dealing may not always be easy to determine. If the company ends up in bankruptcy, disgruntled creditors will examine all the company’s transactions with or involving the sponsor and employ all possible theories to pursue the sponsor’s “deep pockets” to maximize their potential recovery.
One common theory discussed in this installment is that the sponsor (or the sponsor-appointed member of the company’s board of directors) breached its fiduciary duties to the portfolio company. Under the specific holding of this case, a sponsor seeking a greater recovery to itself, as compared to other creditors at the same level in the capital structure, when negotiating a sale of its debt in a company to a potential acquirer could violate its fiduciary duties. Both diligently adhering to corporate governance best practices and obtaining the advice of experienced counsel in considering options with respect to distressed portfolio companies are critical to mitigating the risk of fiduciary duty claims against the sponsor.
Background
A more extensive description of the background and facts giving rise to the Company’s chapter 11 filing can be found in Part I of this series, but a brief rundown of the relevant facts for the breach of fiduciary duty claim is set forth below.
During the 2008 financial crisis, Allied, like many other companies, experienced economic distress. In September 2008, Jack Cooper Transportation (“JCT”), a competitor car hauling company, approached the Sponsor to assess its interest in selling its equity stake in Allied. The CEO of JCT later stated that it was a “dream” of his to combine JCT and Allied, leading him to make a series of offers related to Allied over the coming years.8 The Sponsor did not inform the non-Sponsor members of Allied’s board (the “Board”) of JCT’s initial interest.9
Subsequently, in late 2008 and early 2009, JCT began reaching out to outside investors and Allied’s lenders, including ComVest Investment Partners (“ComVest”), then the Requisite Lender10 under Allied’s First Lien Credit Agreement (the “FLCA”), regarding a potential strategy to take ownership of Allied and install a new management team. In March 2009, ComVest met with the Sponsor and expressed its “intent to work with [JCT’s CEO] … on a solution to recapitalize Allied.”11 ComVest and the Sponsor discussed potential acquisition terms, but the Sponsor hindered ComVest from getting information about Allied, locked ComVest out of talking directly with Allied (and required ComVest to go through the Sponsor), and stated that ComVest would never run the Company.12 Later that year, the Sponsor and ComVest executed the Fourth Amendment to the FLCA (the “Fourth Amendment”) to permit the Sponsor to acquire ComVest’s first lien debt, which enabled the Sponsor to become the Requisite Lender.
In the summer of 2009, JCT again attempted to buy the Sponsor’s stake in Allied. During a meeting in June 2009, ostensibly to discuss JCT’s potential acquisition, the Sponsor tried to convince the CEO of JCT to sell JCT to the Sponsor. The Sponsor did not inform the Board of JCT’s ongoing interest in owning the Company at that time.13
In July 2010, JCT sent a letter of intent to the Company regarding a proposed acquisition. This time, the Board considered the letter of intent, but at the urging of a Sponsor-related member of the Board, decided to allow it to lapse without any response.14
Starting in the spring of 2011, JCT made a series of offers to purchase the Company’s debt from the Sponsor and certain other first lien lenders, including BDCM Opportunity Fund II, LP, Black Diamond CLO 2005-1 Ltd., and Spectrum Investment Partners, L.P. (collectively, “BD/S”), which JCT would then use to acquire the Company’s assets in bankruptcy through a sale under section 363 of the Bankruptcy Code. In December 2011, JCT offered to pay $244.2 million to acquire substantially all of Allied’s assets,15 or up to about 84 cents on the dollar (the “December 2011 Term Sheet”).16 Notably, the Sponsor demanded a premium price of $1.15 for each dollar of its first lien debt on the premise that it was the Requisite Lender. This demand meant that less money would be available for other first lien lenders, such as BD/S, forcing JCT to lower its offer to other first lien debtholders to 70 cents on the dollar.17 JCT and the various parties were unable to consummate a transaction.
In May 2012, BD/S filed an involuntary chapter 11 petition against Allied, which subsequently consented to the bankruptcy. In September 2013, the Company conducted an auction for the section 363 sale of substantially all of its assets, and JCT emerged as the successful bidder for a price of $135 million. The Court approved the sale, which closed in December 2013. A litigation trustee (the “Trustee”) was subsequently appointed under a confirmed chapter 11 plan to pursue claims against the Sponsor for the benefit of creditors. BD/S intervened in the lawsuit.18
2021 Opinion
The Trustee claimed that the Sponsor breached its fiduciary duty by engaging in self-dealing in connection with JCT’s attempted acquisition of the Company. Specifically, the Trustee alleged that the Sponsor “obstructed meaningful discussions about a combination of Allied and JCT in a brazen effort to enhance the value of its own investment at the expense of the Estate and all other Lenders,” which “culminated in late 2011 to 2012 with [the Sponsor] demanding a $20 million premium for its debt.”19 The Trustee also asserted that the Sponsor breached the duty of loyalty when it caused Allied to enter into the Fourth Amendment (permitting the purchase of first lien debt by the Sponsor), which “serve[d] no valid corporate purpose for Allied” but carried “significant benefits to [the Sponsor].”20 The Trustee added that during this period “the hopelessly conflicted Allied Board stood by doing nothing,” enabling the Sponsor to breach its “duty of loyalty to the Company and (derivatively) its creditors.”21
According to the Trustee, this breach led the Company to suffer damages: (i) $158.6 million, representing the difference between the offer the Company received from JCT in 2011-2012 and the amount for which the Company’s assets were ultimately sold22 and (ii) millions of dollars in unreasonable attorney’s fees and expenses Allied paid to the Sponsor.
Duty of Loyalty (Sponsors)
Under Delaware law, the duty of loyalty “mandates that the best interest of the corporation and its shareholders takes precedence over any interest possessed by a director, officer or controlling shareholder and not shared by the stockholders generally.”23 This means that a fiduciary must “refrain from doing anything that would work injury to the corporation.”24 As a result, the duty of loyalty “requires an undivided and unselfish loyalty to the corporation [and] demands that there be no conflict between duty and self-interest.”25 In other words, a fiduciary must act in the best interest of the company and not seek to advantage itself over other stakeholders.
The duty of loyalty extends to a shareholder that “owns a majority interest in or exercises control over the business affairs of the corporation,” a so-called “controlling shareholder.”26 As the duty of loyalty demands “true faithfulness and devotion to the interests of the corporation and its shareholders,” the possibility of a breach of fiduciary duty can be particularly worrisome in cases involving “an imperial … controlling shareholder with a supine or passive board.”27
Although Delaware law requires that “corporate fiduciaries observe high standards of fidelity and, when self-dealing is involved, places upon them the burden of demonstrating the intrinsic fairness of transactions they authorize, the law does not require more than fairness.”28 This means that “[c]ontrolling shareholders, while not allowed to use their control over corporate property or processes to exploit the minority, are not required to act altruistically towards them,”29 nor do they need to “sacrifice their own financial interest in the enterprise for the sake of the corporation or its minority shareholders.”30 Said simply, a sponsor is permitted to act in its own self-interest, but a sponsor cannot use its control to provide an advantage to itself over other stakeholders.31
Because the Sponsor owned a majority of Allied’s equity and controlled the majority of its Board,32 it was undisputed that the Sponsor owed a fiduciary duty to Allied; as such, the Sponsor had to satisfy the duty of loyalty in connection with any contemplated transactions involving Allied in which it was also involved.33
The Court rejected all of the Sponsor’s summary judgment arguments on the breach of fiduciary duty claim, allowing the claim to go to trial to determine if the Sponsor could prove its factual allegations.
The Sponsor May Have Obstructed Board Consideration to Benefit Itself to the Detriment of Allied
The Court found that the Trustee made sufficient allegations, supported by contested material facts, to support the argument that the Sponsor “used its control over Allied’s processes to exploit Allied and the other Lenders’ holdings.”34 The Court cited numerous alleged facts, including those described above, highlighting JCT’s consistent interest in Allied and multiple attempts to gain control of its assets, the failure of the Sponsor to bring some of those transactions to the Board’s attention, and various instances of the Sponsor standing in the way of consummating a transaction with JCT. The Court found that the Trustee had presented “ample evidence to show that in 2008-2009 there was a potential alternative transaction that [the Sponsor] did not present to Allied’s Board for consideration and such failure went beyond [the Sponsor’s] self-interest and had significant negative impact on Allied and its stakeholders.”35 The Court also pointed to the Sponsor’s demand, in connection with a potential sale of the Company, that JCT pay a substantial premium to the Sponsor due to its position as Requisite Lender. The Sponsor could act in its own interests to defend the debt it owned, but it could not try to favor its own debt ahead of other debt holders in violation of its fiduciary duty to the Company.
The Court also held that there were “material facts asserted by the Trustee (and supporting evidence) to allow the Court to determine that there are material facts in dispute” on the issue of whether there was a transaction “with JCT that could benefit Allied.”36 For example, the Sponsor argued that there was no evidence that JCT’s 2009 proposal to buy the Sponsor’s equity stake in Allied would have benefitted the Company.37 The Sponsor also argued that JCT’s discussions with first lien lenders regarding the potential acquisition of their debt in 2011-2012 were not relevant to the fiduciary duty claim, as those were not discussions with the Company regarding an acquisition of assets. To hold otherwise, according to the Sponsor, would require “somehow forcing the [the Sponsor’s] nominees on the [Board] to insert Allied into the JCT Negotiations” with the lenders.38
The Trustee responded that there was evidence of several potential transactions from 2008 to 2012 that would have been beneficial for Allied but that the Sponsor prevented. With regard to the 2011-2012 debt negotiations, citing testimony from numerous witnesses, the Trustee argued that the fact that JCT was discussing purchasing debt from lenders instead of purchasing assets from the Company was irrelevant, as JCT was pursuing a debt transaction as a means of acquiring the Company.39
The Court sided with the Trustee. It determined, among other things, that the Trustee brought forth evidence sufficient to demonstrate a dispute of material fact as to the Sponsor’s assertion that “there was ‘no transaction’ with JCT that could benefit Allied,” and, therefore, the allegation could go forward.40
The Legal Fees the Sponsor Incurred May Not Have Been Contractually Obligated
The parties also disputed the propriety of the Company’s payment of the Sponsor’s legal fees for certain transactions. In addition to arguing that the payment of these fees was a fraudulent transfer (which will be covered in a future article in this series), the Trustee contended that the Sponsor breached its fiduciary duty to Allied by causing it to pay “unnecessary and unreasonable” fees. The Sponsor responded that no breach could be established because Allied was contractually obligated to pay the fees. As described below, the Court denied the Sponsor’s summary judgment motion on this issue.
First, the Court rejected the Sponsor’s arguments regarding the payment of its fees for the Sponsor-ComVest transaction. Pursuant to the FLCA, Allied was contractually obligated to reimburse the costs and expenses for the lenders of legal fees incurred in connection with any refinancing or restructuring of the credit agreements following a default. For the fees to be covered by the FLCA, such fees must have been “(i) reasonable, (ii) after default, and (iii) in connection with any refinancing or restructuring of the credit arrangements provided under the FLCA in the nature of a work-out.”41
The Court stated that the Fourth Amendment and the Sponsor’s purchase of ComVest’s debt were not in the nature of a workout because “the Fourth Amendment did not ‘realign’ Allied’s financial structure (it only realigned the lenders’ claims and rights),” meaning that Allied may not have been contractually obligated to pay these fees.42
In addition, the Trustee alleged that the default occurred only because of the Sponsor’s actions. Specifically, a principal of the Sponsor advised the Board not to make a $4.8 million principal and interest payment in order to preserve liquidity for negotiations between the Sponsor and ComVest on a consensual deal that could benefit the Company. Yet within a few weeks, the Sponsor and ComVest agreed that the Sponsor would acquire ComVest’s debt. The Court determined that the Sponsor’s recommendation that Allied default in the weeks leading up to that transaction created, at the very least, a dispute of material fact as to whether the fees incurred were reasonable or warranted under the FLCA.43 Thus, summary judgment was not appropriate for these fees.
The Court next addressed the payment of the Sponsor’s fees related to litigation with CIT Group/Business Credit, Inc. regarding whether the Fourth Amendment was valid and the Sponsor was the Requisite Lender under the FLCA.44 The Sponsor argued that Allied was obligated under the Monitoring and Management Services Agreement (the “MMSA”) to pay such fees. The MMSA provided that Allied would indemnify the Sponsor for any losses, fees, and expenses arising out of any “action or failure to act” by Allied or by the Sponsor “at the Company’s request or with the Company’s consent.”45 The Trustee countered that this obligation would be inapplicable under the MMSA “if it is finally judicially determined by a court of competent jurisdiction” that the fees incurred “arose solely out of [the Sponsor’s] gross negligence or bad faith.”46
Delaware courts have held that “a failure to act in good faith may be shown where the fiduciary intentionally acts with a purpose other than that of advancing the best interests of the corporation, where the fiduciary acts with the intent to violate applicable positive law, or where the fiduciary intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties.”47 The Court pointed to previous decisions by the New York Supreme Court and the Third Circuit, as discussed in Part I of this series, which showed that the Sponsor had attempted to make an “inequitable end run” around the substance of the restrictions in the FLCA through taking actions that were “flatly prohibited” under the FLCA.48 As a result, the Court found that the fee provisions in the MMSA may be inapplicable, and denied the Sponsor’s motion for summary judgment on this ground as well.49
2022 Opinion
While a detailed discussion of the Court’s 2022 Opinion is beyond the scope of this article and series, which are primarily focused on the potential actions that can be brought against sponsors when their portfolio companies wind up in distress, as illustrated by the 2021 Opinion, it is worthwhile to consider briefly how such actions may ultimately be adjudicated and the inherent risks associated with litigating these issues to trial.
Breach of Fiduciary Duty
In the 2022 Opinion, the Court found that the Sponsor had breached its fiduciary duty to Allied by “exploit[ing] its control over Allied to demand a premium price for First Lien debt throughout the JCT Negotiations.”50 Allied’s Board (which was controlled by the Sponsor) also breached its fiduciary duties by deferring to the Sponsor instead of engaging in negotiations with JCT,51 failing to set up an independent restructuring committee, and neglecting to hire restructuring advisors to engage in such negotiations.52 Indeed, counsel for BD/S sent the Board several letters reminding the Board of its fiduciary duties to maximize value for all stakeholders, which the Sponsor, Board, and Company did not sufficiently address.53 The Court noted that because Allied was insolvent since 2008, its fiduciaries, including the Sponsor, owed duties to the Company for the benefit of all residual claimants, which included creditors.54
The Court stated that because the Sponsor controlled the entirety of the Company’s capital structure, the Sponsor “should have used its control to initiate a process to lock in a lucrative transaction on equal terms for Allied’s Lenders” rather than seek to “extract a premium for itself to the detriment of the other First Lien Lenders.”55 According to the Court, under Delaware law, a majority shareholder wielding control over a company as bargaining power for its own benefit is “the ‘essence’ of a breach of the duty of loyalty.”56 Moreover, a controlling shareholder that “intentionally subverts” a board of directors from exercising its independent business judgment – as the Sponsor did here – breaches its fiduciary duty.57
Although the Sponsor asserted that its fiduciary duty was not implicated because JCT sought to buy debt, rather than assets, and that the deferential business judgment standard applied, as opposed to the more burdensome entire fairness standard, the Court found both of these defenses unavailing. Instead, the Court determined that JCT’s efforts to purchase the Sponsor’s and others’ debt was really just a means to acquire Allied’s assets, rejecting the Sponsor’s “contention that this was a ‘simple’ debt trade enabling [the Sponsor] to somehow evade fiduciary responsibility to the Company.”58 This was further supported by the fact that Allied’s cooperation was necessary for the contemplated section 363 sale, yet the Sponsor never sought any meaningful input from the Company.59 In sum, because the Sponsor sought a premium price for its debt at a time when the Company was insolvent and the Sponsor owed a fiduciary duty to Allied’s creditors, instead of seeking fair and ratable treatment for all creditors in the JCT negotiations, the Court held that the Sponsor had breached its fiduciary duty of loyalty.60
Damages
Despite finding that the Sponsor breached its fiduciary duties, the Court also determined that the Trustee failed to meet her burden of establishing, by a preponderance of the evidence, a reasonable basis for her claimed damages. Delaware law requires plaintiffs to provide “a reasonable basis for assessing damages,”61 and courts will refuse to award damages that are “based on mere speculation or conjecture.”62 The Court found that the testimony provided by the Trustee’s expert witness related to the calculation of damages was unpersuasive.
Principally, the Court concluded that the expert’s reliance on the December 2011 Term Sheet in calculating damages was not reasonable because the December 2011 Term Sheet was “preliminary, non-binding, highly conditional, and superseded by multiple later term sheets in which JCT proposed to pay materially less.”63 As such, premising damage calculations on the December 2011 Term Sheet was “speculative, at best,” and “not evidence of actual harm.”64
The Court also disagreed with the expert’s decision to base damages on the face value of the first lien debt, rather than the actual market trading prices of that debt, and its unsupported assumption that JCT would credit bid the full amount of the debt in a hypothetical future bankruptcy sale. In addition, the Court pointed to several flawed conclusions in the damages calculation that “reflected a misunderstanding of the bankruptcy process,” which might have resulted from the expert having “only limited bankruptcy experience.”65 For example, the expert provided no evidence to support the notion that there would only be $5 million in restructuring expenses (which would be a deduction to damages) had the transaction described in the December 2011 Term Sheet been pursued when actual restructuring expenses totaled nearly sixteen times that amount.66 The Court also seemed concerned with the “strange conclusion” that the Sponsor would be liable for damages caused to itself, given that the majority of the consideration proposed in the December 2011 Term Sheet would have gone to the Sponsor.67 Cumulatively, the Court held that the calculation of damages was “materially flawed and unreliable.”68 Therefore, even though the Trustee successfully proved the merits of the fiduciary duty claim at trial, the Court was unable to award any damages in favor of the Trustee.
Takeaways
The Court’s decisions concerning the Sponsors’ fiduciary duties in the 2021 Opinion and 2022 Opinion serve as a useful reminder that, notwithstanding the centrality of maximizing returns for investors, sponsors have fiduciary duties to the portfolio companies they control. These competing interests will typically be aligned, particularly when the company is solvent. But there may be occasions, especially as companies begin to experience financial distress, in which sponsors may feel a pull to put the best interests of their funds first to the potential detriment of the portfolio companies they control. While sponsors need not be selfless in shaping their investment strategies, they should keep in mind that any self-interested transactions may be later scrutinized and challenged, especially if such transactions prove advantageous to sponsors relative to other stakeholders.
Relatedly, sponsors ought to be wary of overplaying their leverage. Although increasing a potential investment return may appear enticing, if a sponsor seeks to exploit its position by, for example, demanding a premium due to its control rights with respect to a portfolio company’s possible strategic actions, a court may determine that such a choice was detrimental to the portfolio company’s financial well-being, thereby enabling a court to find a sponsor liable for a breach of fiduciary duty.
Moreover, the principals of sponsors should be careful in making recommendations that portfolio companies default on their obligations. This is especially true when a sponsor may be simultaneously benefiting from such a default and disregarding the interests of the company and other stakeholders.
Furthermore, it is crucial for sponsors to engage in good corporate governance. When made aware of potential offers to buy a portfolio company, sponsors should consider promptly informing the board of such offers. Even if the proposal may not be attractive (or is a purchase of equity or debt instead of a purchase of assets), allowing the board the opportunity to evaluate the offer, and otherwise following corporate governance best practices, can reduce the likelihood of success on a breach of fiduciary duty claim.
Indeed, despite the Sponsor having avoided damages in this particular case, sponsors should still proceed with caution. Importantly, there is no guarantee that other courts would look at these same facts and come out the same way or that a different expert or less aggressive damages assertion would have led this Court to find that the Trust did prove damages. Further, while the Sponsor avoided the worst-case scenario of having to pay tens or hundreds of millions in damages, the Sponsor incurred substantial legal fees and time to litigate this case and may have suffered reputational damages.
Finally, because of the sticky issues that may arise when portfolio companies are in financial distress, sponsors should seek the advice of experienced counsel in their dealings with any portfolio company that is experiencing economic difficulties. Even if the company is not yet insolvent, self-interested transactions involving a sponsor may be subject to heightened, entire fairness review in any subsequent litigation by minority stockholders or creditors of the company (or a bankruptcy trustee) if the company becomes insolvent. Events and actions taken at a time when the company was merely distressed will likely be scrutinized in hindsight in light of allegations that the sponsor acted disloyally or exerted its influence in a manner that was detrimental to the company and all of its stakeholders. The Allied saga is a case in point.
Taking precautionary steps to avoid allegations of breaches of fiduciary duties can help prevent potential missteps and mitigate the possibility of an adverse and costly post-trial decision.
The authors would like to thank Glenn West (retired Weil private equity partner) and Evert Christensen (Weil securities litigation partner) for their valuable assistance in reviewing this article.
