debevoise & plimpton private equity report

W H AT ’ S I N S I D E

3 To Change or Not to Change:Should Sponsors ModifyManagement Equity Due to the Economic Downturn?

5 GUEST COLUMN

State of the Private EquitySecondary Market

7 “Blind Pools”—Another Vision of Investing inFailed Banks

9 Mind the (Funding) Gap:Trouble Ahead forMultiemployer Plans

11 Dealing With Mr. Big: Recent Developments inTransactions InvolvingControlling Shareholders

13 UPDATE

How Green Is Your Portfolio?

15 Caution Ahead: Rules of the Road for Buying Assets fromDistressed Companies

17 ALERT

What Really Changed? — The Market Impact of the 2008 Changes to Rule 144

19 ALERT

Developments in EU AntitrustLaws — Private Equity FundsMay Be Liable for Violations of Portfolio Companies

Fall 2009 Volume 10 Number 1

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

© 2

009

Mar

c Ty

ler

Nob

lem

an /

ww

w.m

tnca

rtoo

ns.c

om

IntroductionThe SEC is poised to adopt a rule thatwhile not advanced by the private equitycommunity might nonetheless save somePE professionals some money.

How so? Private equity professionals,like other citizens, are often besieged byrequests for political contributions.Under a new rule proposed by the SEC onAugust 3, 2009 as part of its efforts toaddress perceived pay to play practices byinvestment advisors (the “ProposedRule”), however, private equity sponsorsmay soon have a new, pithy and disarmingresponse to those irksome dinnertimephone calls seeking political donations:“Sorry, I’d like to help, but the new SECantifraud rule governing political

contributions by investment advisers is socomplicated and expansive that I can’tafford the legal work to determine if I canmake the contribution in the first place.”

The Proposed Rule is designed to endperceived “pay to play” practices in theselection process of investment advisers bystate and local governments. TheProposed Rule relates to state and localgovernment clients only. It does notapply to federal or non-U.S. governmentalclients.

A private fund sponsor will have tocomply with the Proposed Rule even if itis not a registered investment adviser: theProposed Rule applies to both registeredinvestment advisers and advisers that are

The End of Pay to Play? The Proposed SEC Rule BanningCertain Political Contributions

CONTINUED ON PAGE 21

“I would love to, but I have to check with my corporate counsel first.”

It is hard to believe that this is the tenth anniversary issue of theDebevoise & Plimpton Private Equity Report. In many ways, it seems likejust a few short years ago that the dearth of attention and analysisafforded to the private equity community by legal commentators andthe financial press prompted us in 1999 to start a quarterly report toadvise our clients and friends of topics we thought might be of interestto them. In many other ways, that seems like several generations orbusiness cycles ago. Today the private equity community may besuffering in a number of ways, but hardly from a failure to attract morethan its fair share of attention from the popular press, financial press,politicians, regulators, labor, and even the academic community. In thelate '90s, private equity was just becoming an accepted asset class; today,while not perhaps at its most popular or profitable moment, it has shownitself to be a formidable factor in the business and investment landscapeand to be positioned to accept and help shape the regulatory andstructural changes that will undoubtedly emerge in the coming decade.

We still believe we have something unique to offer to our readers:thoughtful and practical guidance on the legal and business issues thatimpact the way private equity funds are, and will be, raised, committedand turned into successful exits.

In the coming months, one of the themes on everyone's mind is theanticipated regulatory changes expected to impact the industry. On ourcover, we report on a proposed SEC rule designed to end perceived payto play practices in the industry by banning certain politicalcontributions to state and local officials charged with selecting investmentadvisers. The broad sweep of the proposed rule may warrant a proactiveapproach by fund managers in reviewing in-house policies with respect topolitical contributions by employees and may result in some significantconsequences, including a ban on routine contributions.

We had hoped to provide an update on the state of proposedregulations from the European Union on Alternative Investment FundManagers, but have decided that the pace of the competing revised

proposals is better suited at this time to a daily rather than a quarterlypublication. We expect that the various proposals will emerge into acompromise approach on which we can report in our next issue. It goeswithout saying, however, that U.S. managers will not welcome theapproach the EU will take with respect to non-EU managers.

We report from Europe that U.S. managers would be well-advisedto track especially closely antitrust compliance by their portfoliocompanies in light of a recent decision imposing liability on a parentfor the antitrust violations of its wholly-owned subsidiary.

In our Guest Column, Michael Pugatch from HarbourVest, reports onthe state of the secondary market for private equity fund interests and putsthe notion that 2009 is the “golden age” for secondaries into perspective.

In an article designed for those of you interested in distressedinvesting, we remind you of the risks involved in purchasing assetsfrom distressed companies, many of which can be avoided throughcareful structuring and negotiation. We also provide some cautionaryadvice for those considering investing in businesses with underfundedmultiemployer plans, which are often present in distressed businesseswith a unionized workforce.

Incentivizing mangers of private equity portfolio companies whentheir compensation is heavily equity related can create difficult issues ina depressed economy. We analyze the ways modifications tomanagement equity programs can be designed and discuss whetherthose modifications are in fact appropriate.

As we enter our second decade with the Debevoise and PlimptonPrivate Equity Report, we would like to thank you for your alwaysthoughtful comments on our articles and would like to encourage youto keep us posted on the ways we can best provide practical guidance toyou in the coming years.

The Debevoise & PlimptonPrivate Equity Report is apublication of

Debevoise & Plimpton LLP919 Third AvenueNew York, New York 100221 212 909 6000

www.debevoise.com

Washington, D.C.1 202 383 8000

London44 20 7786 9000

Paris33 1 40 73 12 12

Frankfurt49 69 2097 5000

Moscow7 495 956 3858

Hong Kong852 2160 9800

Shanghai86 21 5047 1800

Private Equity Partner /Counsel Practice Group MembersFranci J. Blassberg Editor-in-Chief

Stephen R. Hertz Andrew L. Sommer Associate Editors

Ann Heilman MurphyManaging Editor

David H. Schnabel Cartoon Editor

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

All contents ©2009 Debevoise& Plimpton LLP. All rightsreserved.

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

Private Equity FundsMarwan Al-Turki – LondonKenneth J. Berman– Washington, D.C.Erica BerthouJennifer J. BurleighWoodrow W. Campbell, Jr.Sherri G. CaplanJane EngelhardtMichael P. HarrellGeoffrey Kittredge – London Anthony McWhirter – LondonMarcia L. MacHarg – Frankfurt Jordan C. Murray Andrew M. Ostrognai – Hong Kong David J. SchwartzRebecca F. Silberstein

Hedge FundsByungkwon LimGary E. Murphy

Mergers & AcquisitionsAndrew L. BabE. Raman Bet-Mansour – ParisPaul S. BirdFranci J. BlassbergRichard D. BohmThomas M. Britt III – Hong KongGeoffrey P. Burgess – LondonMarc Castagnède – ParisNeil I. Chang – Hong KongMargaret A. DavenportE. Drew Dutton – Paris Michael J. GillespieGregory V. GoodingFelicia A. Henderson – ParisStephen R. HertzDavid F. Hickok – LondonJames A. Kiernan III – LondonAntoine F. Kirry – ParisJonathan E. Levitsky

Guy Lewin-Smith – LondonLi Li – ShanghaiChristopher Mullen – LondonDmitri V. Nikiforov – MoscowRobert F. Quaintance, Jr.William D. RegnerKevin A. RinkerJeffrey J. RosenJeffrey E. RossKevin M. SchmidtThomas Schürrle – FrankfurtWendy A. Semel – LondonAndrew L. SommerStefan P. Stauder James C. Swank – ParisJohn M. Vasily Peter Wand – Frankfurt

Leveraged FinanceKatherine Ashton – LondonWilliam B. BeekmanDavid A. BrittenhamPaul D. BrusiloffPierre Clermontel – Paris Alan J. Davies – London

Letter from the Editor

Franci J. Blassberg

Editor-in-Chief

IntroductionManagement equity is always at the front andcenter of any private equity acquisition sinceit aligns the economic interests of the privateequity sponsor and management after closingand rewards management for theircommitment to the success of the portfoliocompany. The effect of the economicdownturn on management’s expectationswith respect to their equity has ranged frommodest disruption of this traditionalincentive alignment structure at someportfolio companies to complete devastationat others. This article explores how privateequity sponsors are dealing with (or notdealing with) the changed financial returnexpectations of the management of certainportfolio companies.

BackgroundNearly all private equity sponsors favormanagement equity programs consisting of acombination of some form of purchasedequity and some form of “free” equity. Thepurchased equity, often funded from proceedsto management in the transaction or effectedthrough the rollover of existing target equity,

is intended to ensure that management’seconomic fortune is tied to the private equitysponsor’s success through the risk of losingcapital actually invested. “Free” equityaccompanies the purchased equity and isessentially a form of carried interest,providing management with the opportunityto earn a return disproportionate to their cashinvestment as a reward for providing servicesto the portfolio company during a successfulinvestment period.

Although this framework is generallyconsistent across private equity sponsors,there is significant variation from sponsor tosponsor and, sometimes, from deal to deal.For example, the purchased equity may ormay not be the same class of equitypurchased by the private equity sponsor, orloans to management to purchase equity maybe permitted or disfavored. Free equity mayconsist of appreciation rights (such asoptions, stock appreciation rights orpartnership profits interests) or full-valueawards (such as restricted stock or restrictedstock units), and may be subject to vestingbased on performance or continued service

(or both). For performance-vestingawards, goals may be keyed solely toan exit, or to ongoing financialmetrics such as EBITDA, or otherperformance criteria. The effect of atermination of a holder’semployment may differ fromsponsor to sponsor, and calls on themanagement holder’s equity (and,less often, puts) may or may not betriggered by a termination ofemployment. Transfer restrictionsmay lapse on an initial publicoffering or may continue after theoffering until the private equitysponsor has largely exited theinvestment. The economic downturn hasdisrupted the return models with

respect to management equity in many deals,in some cases significantly. In particular,some deals that closed at the height of theprivate equity boom from 2005-2007 arenow facing the prospect of, potentially,sharply lower returns than were anticipated atthe time of closing. In addition, it is possibleto likely that private equity sponsors will beforced to stay invested in certain of their dealsfor much longer than the normal 5-7 yearinvestment period. The question that followsfrom this changed landscape—sometimesraised independently by a private equitysponsor and sometimes forced on a sponsorby management—is whether any changesshould be made to the management equityprogram as a result.

Doing Nothing in the DownturnOf the two alternatives to dealing withmanagement equity in the current economicdownturn—doing nothing and doingsomething—doing nothing has been themost common course to date. The followingreasons are typically offered for maintainingthe status quo:

l When considering whether to grant newawards, a private equity sponsor may beunwilling to increase the dilution of itsinterest caused by additional managementequity.

l When considering whether to repriceoptions or otherwise adjust outstandingawards, the private equity sponsor may beconcerned with the reaction of limitedpartners of the fund or, if the portfoliocompany is public, of the publicshareholders.

l The private equity sponsor may not wishto treat management of a portfoliocompany uniformly with respect to any of

Debevoise & Plimpton Private Equity Report l Fall 2009 l page 3

Peter Hockless – LondonAlan V. Kartashkin – Moscow Pierre Maugüé Margaret M. O’NeillNathan Parker – LondonA. David ReynoldsPhilipp von Holst – Frankfurt

TaxJohn Forbes Anderson – LondonEric Bérengier – ParisAndrew N. BergPierre-Pascal Bruneau – ParisGary M. FriedmanPeter A. FurciFriedrich Hey – FrankfurtAdele M. KarigRafael KariyevVadim MahmoudovMatthew D. Saronson – LondonDavid H. SchnabelPeter F. G. SchuurMarcus H. StrockRichard Ward – London

Trust & Estate PlanningJonathan J. RikoonCristine M. Sapers

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

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

CONTINUED ON PAGE 4

To Change or Not to Change: Should Sponsors Modify Management Equity Due to the Economic Downturn?

l Debevoise & Plimpton Private Equity Report l Fall 2009

the possible adjustments, and theprospect of making changes to some, butnot all, employees’ equity may besufficiently disruptive that no changesare made. Similarly, some sponsors maybe concerned about a domino effectfrom treating one portfolio companydifferently from another similarly situatedportfolio company, although this has beenseen as a lesser concern to date.

l As we have seen over the past year,markets do eventually recover, at least inpart, and a private equity sponsor maybe unable or unwilling to predict arecovery and may be wary that changeswill result in a windfall if the recoveryhappens sooner, or more robustly, thanexpected.

l More generally, the private equitysponsor may view management equitychanges as fundamentally inconsistentwith the message that the private equityfund and management shouldparticipate together in both good andbad times.

Doing SomethingSometimes, however, a private equitysponsor views doing nothing as the wronganswer. This view is most often the resultof the sponsor having concluded thatexisting equity held by a management teamdoes not provide a sufficient incentive forthe management team to remain focused onincreasing the value of the portfoliocompany and to continue moving (nomatter how slowly) toward an exit. Inparticular, where a sponsor views amanagement team as fundamentally solidbut as having been swept up in thedownturn by general market forces, changesto a management equity program may bemore readily embraced. Other reasons,such as the costs of replacing a managementteam, the desire to avoid furtherdeterioration in the portfolio company’sbusiness or the need to deal with amanagement team or individual managers

with particular leverage, are also offered asreasons to make changes.

Changes to management equityprograms considered by private equitysponsors range from tweaks to radicalsurgery. Although the following changes aremost often considered, the diversity ofportfolio companies, sponsors andmanagement teams makes it unlikely thatidentifiable trends will develop.

l New Grants of Free Equity. Newawards are most common, probablybecause of their simplicity. Althoughnew awards increase the dilution causedby management equity, the privateequity sponsor may feel reasonablycomfortable after modeling the dilutionand expected return from the old awardsand the new awards. Full value awards,such as restricted stock and restrictedstock units, are often perceived as a moredesirable form of free equity for thesenew grants—from the sponsor’sperspective, because a lower number offull value awards are granted (whencompared with stock options), and, frommanagement’s perspective, because fullvalue awards continue to have anintrinsic value even if the value of theunderlying stock falls after the grantdate. Vesting in these new awards neednot follow the same vesting principles asthe prior awards, and applyingperformance vesting to a full value awardis not uncommon. Requiring anadditional cash investment as considerationfor these new awards is uncommon.

l Repricing of Options. Stock optionscontinue to be the most prevalent formof free equity, and sponsors may considerwhether to reprice underwater options.For private portfolio companies, a“straight” repricing—that is, thereduction of the exercise price to thenew, lower fair market value—is areasonably straightforward exercise.More complicated repricings, such as a

reduction in the number of optionshares in addition to a change in theexercise price, may require participantconsent and, for a public portfoliocompany, may require compliance withthe SEC’s tender offer rules. Publicportfolio companies may also needshareholder approval of a repricing underNYSE or Nasdaq corporate governancerules, and institutional shareholderreaction should be considered (even ifthe private equity sponsor ultimatelycontrols the shareholder vote). In thepast, repricings presented significantaccounting risk if done incorrectly(which resulted in having to wait sixmonths and one day to effect arepricing); under the current accountingrules, only the incremental cost of arepricing must be reflected in theportfolio company’s financial statements,and as a result a repricing can typicallybe effected without significantaccounting complexity or risk.

l Resets of Performance Vesting andRelated Adjustments. For awardssubject to performance vesting, sponsorsmay consider resetting the performancegoals to match the new expectations ofthe portfolio company’s performance.For example, if existing EBITDA or cashflow metrics are hopelessly obsolete, therealignment of incentives through newEBITDA or cash flow metrics may makesense. Alternatively, a private equitysponsor may consider adoptingcompletely new performance metrics tomatch a portfolio company’s newoutlook—for example, preservation ofcash or compliance with debt covenantsmay, in the near term, be a morecompelling performance metric than exitvalue. The quid pro quo for these changesmay include re-setting requirements forcontinued employment, so that thesponsor can be reasonably assured that

To Change or Not to Change (cont. from page 3)

CONTINUED ON PAGE 8


State of the Private Equity Secondary Market G U E S T C O L U M N

The private equity secondary market hasreceived much attention over the pastyear. In its simplest form, the secondarymarket allows institutional or individualinvestors with existing private equityinvestments to sell their assets tosecondary buyers. A buyer purchasesthese assets at an agreed upon price,typically representing a discount tocurrent reported net asset value (“NAV”),and then assumes any remainingunfunded obligation associated with theseller’s investment.

There are a variety of reasons forselling assets in the secondary market.Recently, these have included a need forliquidity, a desire to reduce futureunfunded obligations, or a decision topare back overall exposure to the privateequity asset class. As the global financialcrisis took hold in September 2008, manyinvestors who were over-allocated toprivate equity or who needed immediateliquidity turned to the secondary market.

Over the past year, endowments andpublicly-traded private equity funds wereamong the more active secondary sellers.In a market where financial institutionsand corporations had historically been themost active, this represented a dramaticshift in the profile of institutions sellingassets. In late 2008, market activity wasdominated by endowments that sufferedlarge losses across their public equity andfixed income portfolios. This led to theoften-discussed “denominator effect,”where an endowment’s private equityholdings eclipsed its target allocationbecause of a shrinking overall asset base,resulting in over-exposure to privateequity and forcing some of theseinstitutions to reduce their holdings.Nearly half of the available commitmentsfor sale that HarbourVest evaluated during

the fourth quarter of 2008 were held byendowments, which had historically madeup only a small fraction of the overallmarket.

Similarly, during the first half of 2009,nearly one-third of HarbourVest’s dealflow came from publicly-traded privateequity funds. In the years leading up tothe credit crisis, many of these funds hademployed an over-commitment strategy,relying on the expectation that a privateequity portfolio could “self-fund” byutilizing the recurring distributions fromone or more PE sponsors to meet thecapital call requirements of othersponsors, which are typically funded overan average of ten years. As a result, thesepublic vehicles would often over-committheir equity base in order to maximize theamount of NAV that was directly exposedto private equity versus cash or othersecurities reserved for future unfundedobligations. This strategy, like otherforms of leverage, can succeed in a risingmarket with available liquidity. However,as the exit environment deteriorated, thepace of distributions slowed, and access tocredit dried up, many public vehicles wereforced to sell assets on the secondarymarket quickly and often at deepdiscounts to raise cash and meet fundingobligations.

The financial crisis also had a markedimpact on the behavior of secondarybuyers. Secondary firms that had activelyacquired assets prior to the crisis beganscaling back amid market uncertainty anda view that trailing NAVs were (in manycases) well in excess of declining fairmarket values. As a consequence,secondary bids for private equity assets felldramatically and rapidly over the secondhalf of 2008 and first half of 2009.According to secondary market

intermediary Cogent Partners, the averagemedian bid as a percentage of NAV fellfrom over 90% in 2006 and 2007 toapproximately 55% in the second half of2008. Prices dropped even further in thefirst half of 2009, declining toapproximately 36% of NAV.

This dramatic decrease in pricing ledto a sharp decline in the number ofcompleted transactions in 2009. Whilethe dollar amount of deals evaluated byHarbourVest through the third quarterwas up 15% over the same period in2008, HarbourVest estimates that thevolume of completed deals is down byover 50% from last year. This reflects thematerial bid-ask spread between buyersand sellers that has persisted through mostof the year. Many forced sellers didcomplete transactions at steep discounts.However, many more potential sellersdeclined to sell at such distressed prices,electing to hold with a hope that pricinglevels would improve.

Another key market theme over thepast year has been an increase in theavailability of partnership interests that

CONTINUED ON PAGE 6

While 2009 has been

referred to by some

observers as a “golden

age” for secondaries, the

level of recent activity for

completed deals in the

market suggests

otherwise.

have called little to no capital. Sellingthese lightly-funded interests, which aretypically 0-20% called, can help investorsreduce exposure to private equity andalleviate concerns about their ability tofund future commitments. Given the lackof new deal activity over the last year,many of the underlying investmentswithin these lightly-funded portfolioswere made prior to the financial crisis andat relatively high valuations. Accordingly,pricing for these interests has typicallybeen below the average discounts seen inthe broader secondary market. In somecases, buyers were offering to assume theremaining unfunded commitments whileacquiring the existing NAV for nopurchase price. While these opportunitiescan appear attractive, many traditionalsecondary investors have avoided themgiven that largely unfunded positionsmore closely resemble primarycommitments and are often not a corepart of their strategies. The buyers have

instead been non-traditional, such asinsurance companies, pension funds, andeven some endowments. These lightly-funded secondaries often provide buyersthe opportunity to increase exposure to aparticular general partner in theirportfolio while decreasing their averagecost basis in that partnership.

While 2009 has been referred to bysome observers as a “golden age” forsecondaries, the level of recent activity forcompleted deals in the market suggestsotherwise. HarbourVest believes that themarket will experience an increase incompleted transactions within the nextseveral quarters as the bid-ask spreadbetween buyers and sellers begins tonarrow. This will be partly driven byrenewed buyer confidence as the marketscontinue to stabilize and visibility onunderlying company operatingperformance improves. A gradualacceptance of market pricing on the partof sellers should also help narrow the gap.

Ultimately, HarbourVest expects thatan increase in deal activity by generalpartners, which in turn leads to morefrequent capital calls, could serve as acatalyst for increased secondary marketactivity. While some investors with largerliquidity issues have sold assets over thepast year, many others have held back, asthe lack of funding activity has notcreated immediate liquidity concerns.However, many secondary buyers believethat the inevitable increase in the rate ofcapital calls from general partners will bethe key to unlocking a flood of secondarytransactions.

Michael J. PugatchHarbourVest Partners, LLC

Guest Column (cont. from page 5)

If you would like to take advantage ofthis service, indicate the delivery methodyou prefer and your email address. Pleasealso take this opportunity to update yourcontact information or to add additionalrecipients by copying and filling out thefollowing form and returning it to us.

I would like to receive my reports:

q via email

q via email and regular mail

q via regular mail

Name of Contact ________________________________________________________________________

Title __________________________________________________________________________________

Company Name ________________________________________________________________________

Address _______________________________________________________________________________

City ____________________________________ State or Province ___________ Postal Code __________

Country _________________________ E-mail Address _________________________________________

Telephone _________________________________ Direct Dial __________________________________

Fax ______________________________________ Direct Dial Fax _______________________________

Did you know you can receive the Debevoise & Plimpton Private Equity Report by email?

To reply, please send information by fax to 1 212 521 7978 or by email [email protected]

By mail: Carmen Garcia, Marketing DepartmentDebevoise & Plimpton LLP919 Third Avenue, New York, NY 10022

page 6 l Debevoise & Plimpton Private Equity Report l Fall 2009

Notwithstanding the attractive loss-sharingarrangements that the FDIC has offered toinvestors in failed banks, private equityinvestors have continued to struggle with theregulatory hurdles presented in bankacquisition transactions. The latest marketinnovation to circumvent some of these issuesare so-called “blind pools.” Blind pools aredesigned to avoid the principal regulatoryhurdles presented by the FDIC PolicyStatement on Qualifications for Failed BankAcquisitions (“FDIC Policy”) and the FederalReserve’s “controlling influence” standardunder the Bank Holding Company Act(“BHCA”).

The “blind pool” phenomenon isrelatively new, and, at press time, notransactions had actually been effected usinga blind pool structure. However, a numberof firms, including Friedman Billings &Ramsey and Goldman Sachs have raisedblind pools of approximately $1 billion eachto fund the acquisition of failed banks; othersreportedly are working on similar fundswhich would acquire a platform bank to bethe vehicle through which failed banks wouldbe “rolled up.” The pools themselves aregenerally structured to limit the participationby institutional investors to 9.9% of thevoting common stock issued by the poolsand by individuals to 4.9% of such stock.The pools also permit investors to acquirenonvoting stock. Unlike special acquisitioncompanies (“SPACs”), which also have beenformed to make failed bank acquisitions, theinvestors in blind pools do not retain a rightto approve any bank acquisitions undertakenby the pool; rather, such decisions are leftexclusively to pool management. In addition,unlike many other private equity structures,an investor in a blind pool has no knowledgeof the identity of the pool’s other investors sothere is no risk that they could be acting “inconcert.”

As described in detail in the Summer2009 issue of the Debevoise & Plimpton

Private Equity Report, the FDIC Policyimposes significant regulatory requirementson banking transactions and arguably createsan unequal playing field between privateinvestors, on the one hand, and so-called“strategic investors” (that is, other bankingorganizations), on the other. Many in theprivate equity community believe that,notwithstanding the FDIC Policy, whichgives lip service to accepting private equity-backed investments in failed banks, theFDIC will approve a private equity bid for afailed bank only when there is no otherreasonable alternative. The blind poolstructure is designed to avoid directapplication of the FDIC Policy and theperceived negative imprimatur of privateequity investments in banks through thevoting stock ownership limitations on thepool’s investors, the use of non-voting stockand the non-disclosure of investors’ identitiesto each other.

The Federal Reserve traditionally hastaken a conservative stance as to whatconstitutes a “controlling influence” underthe BHCA and, thus, triggers registration as abank holding company (“BHC”) under thatAct. A little more than a year ago, theFederal Reserve published a Policy Statementon Equity Investments in Banks and BankHolding Companies (the “FRB Policy”) thatmany hoped signalled some relaxation in theagency’s traditionally strict approach. Indeed,approximately two weeks after publishing theFRB Policy, the Federal Reserve allowedMitsubishi UFJ to make a 24.9% investmentin Morgan Stanley without requiringMitsubishi to register as a BHC; this approvalcreated expectations that the Federal Reservemight apply the FRB Policy to allow two ormore private equity firms to each acquire upto 24.9% of the voting stock of a fund toacquire one or more banks without thosefirms having to register as BHCs. To date,however, the Federal Reserve has beenreluctant to allow such private equity club-

like structures, generally because of concernsthat private equity firms with significantvoting stakes (that is, above 9.9%) may beacting “in concert” in making bankacquisitions and, thus, should have theirinterests aggregated for purposes of BHCdeterminations. In addition to suchaggregation issues, the lengthy process (oftenseveral months or more) the Federal Reserveoften undergoes to make a determinationabout the permissibility of a structure hasproven to be a significant obstacle to privateequity involvement in bank deals. The blindpools are designed to avoid the FederalReserve issues that have dogged privateequity focused investment in this area by (1) limiting voting stock by investors in thepool to below 9.9% (which is below thelevel for virtually all bank regulatory filings),(2) avoiding “acting in concert” concerns byleaving decision-making principally in the

“Blind Pools”—Another Vision of Investing in Failed Banks

CONTINUED ON PAGE 8

Although blind pools

represent the latest

market innovation to

pursue the attractive

economics that failed

bank acquisitions offer

by virtue of the FDIC’s

loss sharing arrangements,

it is not clear whether

they create a new

investment paradigm or

are merely a stop-gap

approach....



hands of pool management and(3) generally not permitting pool investorsto know the identity of other investors inthe pool.

These regulatory benefits of blind poolscome with tradeoffs since this structurelimits the ongoing involvement of investorsin pool management and in themanagement of the banks acquired by apool. Investors seeking greater participatoryrights may find blind pools less desirablethan other structures, such as SPACs, whichat least allow shareholders to vote onparticular deals. For this reason, ifadditional regulatory clarity from theFederal Reserve and additional easing ofregulatory requirements from the FDIC isforthcoming, blind pools may be attractive

only to truly passive investors.Although blind pools represent the latest

market innovation to pursue the attractiveeconomics that failed bank acquisitionsoffer by virtue of the FDIC’s loss sharingarrangements, it is not clear whether theycreate a new investment paradigm or aremerely a stop-gap approach until theFederal Reserve and the FDIC permitmore private equity-focused structures topursue acquisitions in a reasonable, timelymanner. Of course, as the policy of theFederal Reserve and the FDIC in this area continues to take shape, the recent re-awakening of the public markets in bankstocks, and the associated impact onvaluations, may reduce the attractiveness ofsome bank deals to PE funds. Still, given

the ample supply of failed banks, privateinvestment pools — whether via privateequity-focused acquisitions, SPACs, blindpools, or some other market innovation —will likely continue to play a significant rolein helping to resolve the banking crisis forthe foreseeable future.

Satish M. [email protected]

Gregory J. [email protected]

“Blind Pools” (cont. from page 7)

the portfolio company’s managementteam will remain in place.

l Cash Awards. Some private equitysponsors may wish to provide relief tomanagement but also decide that theyare unwilling to tinker with theircustomary methods of providingmanagement equity. For these sponsors,it may make sense to consider a long-term cash incentive program. Ifstructured correctly, such a program canbe self-funding by predicating the awardsto management on the direct or indirectgeneration of cash to pay those awards.Cash awards in the current downturnmay also (rightly or wrongly) beperceived by a management team asmore valuable than additional equity.These awards would normally be subjectto medium-term performance-vestinggoals rather than vesting on an exit.With respect to annual bonuses, someprivate equity sponsors are providing forshorter (e.g., quarterly or semiannual)performance periods so that performance

goals can be reexamined and refined overthe course of the year in light of ongoingbusiness volatility.

What About Liquidity?Although the economic downturn hasextended the investment horizon for someprivate equity sponsors in some portfoliocompanies, discussions about changes tomanagement equity have to date generallynot gone so far as to cover the possibility ofproviding a management team with theopportunity to exit its investment morequickly than the private equity sponsor.Exceptions to this general rule are, andshould be, rare—a manager exiting before asponsor exits (other than in the obviouscases of termination of employment orfollowing an initial public offering) shouldbe viewed as a fundamental change in theprivate equity model of management equity.In addition, the sponsor runs the potentialrisk in this situation of appearing to rewardfailure with liquidity. One example forwhich an exception may be appropriate is aselling founder nearing retirement age who

was never intended to remain with theportfolio company past a normalinvestment horizon. It is also conceivablethat some sponsors could offer partialliquidity outside of a public offering as areward for satisfying performance goals,although probably not for a portfoliocompany that is a reasonable candidate foran IPO.

What Next?It remains to be seen whether an economicrecovery reduces the pressure on privateequity sponsors to make changes tomanagement equity programs at theirportfolio companies. That may be the case,but an economic recovery will also likelylead to a more robust hiring market, whichin turn may give members of managementmore leverage to demand improvements intheir position. Additional pressure may alsobe placed on management equity if therecovery is delayed or in the event ofanother downturn.

Jonathan F. [email protected]

To Change or Not to Change? (cont. from page 4)

Introduction Private equity sponsors investing inindustries with union employees covered bymultiemployer plans — i.e., pension planssponsored by unions to which manydifferent employers contribute — shouldpay special attention over the next severalyears to the potential liabilities under thoseplans. A recent report issued by Moody’shighlights the financial turmoil surroundingmulti-employer plans caused by theeconomic downturn and other factors.While these plans are generally prevalentonly in a narrow slice of industries of theold economy, private equity sponsorsinvesting in these industries should bediligent in ascertaining the full range ofeffects that these plans could have uponpotential targets. These effects, described inthis article, include cash costs not fullyreflected as liabilities or contingencies in atarget’s balance sheet (or related foot-notes),credit downgrades and labor unrest.

Brief Overview ofMultiemployer PlansMultiemployer plans (sometimes alsoreferred to as Taft-Hartley plans) are plansformed and sponsored by unions andtypically cover employees within aparticular industry (such as theconstruction, trucking and hotel/casinoindustries). As part of the collectivebargaining process, a group of employersagree to make contributions to these plans— a typical contribution formula would bea fixed dollar amount for each hour workedby a union employee covered by the plan.For technical reasons, even before thecurrent economic downturn, these planswere often underfunded because the levelsof plan benefits would be increased as thevalue of the plans’ assets increased.

Still, notwithstanding the potential for a

contributing employer to bear liability inconnection with plan underfunding, theseexposures are generally not required underGAAP to be reflected in any way on acontributing employer’s financial statementsunless and to the extent actually paid, inwhich case they are run through theemployer’s statement of cash flows. In thatsense, from the perspective of acontributing employer’s financialstatements, a multiemployer plan is like a401(k) plan because the cash liability runsthrough the statement of cash flows, but noliability for underfunding appears on thebalance sheet or in the footnotes to thefinancial statements.

The principal exception to thataccounting treatment is if the contributingemployer negotiates an exit to its futureobligations to contribute to the plan (eitherin whole or in part). The liabilityrecognized by the employer in thiscircumstance, known as “withdrawalliability,” is assessed by the plan basedon a statutory formula and is typicallypayable in installments over a number ofyears. When a withdrawal liability istriggered, the liability would beincludible both in the statement of cashflows and on the balance sheet.

Prior to the current economicdownturn, the economic and non-economic costs of contributing to amultiemployer plan were often relativelystable and not disruptive of the normaloperations of a contributing employer(except in the event of the employer’swithdrawal, which was rare and usuallywithin the employer’s control). Butdespite the continuing accountingtreatment of these exposures underGAAP described above, acquirers andratings agencies are now focusing moreclosely on the potential liabilities under

these plans in light of the economicdownturn, demographic changes andlegislative initiatives. In September 2009,Moody’s issued a report in which it catalogsthe current funded status of multiemployerplans and the expected future pressuresunder these plans over the next severalyears. The Moody’s report says that,although widespread downgrades ofcontributing employers are not expected, itis possible that a contributing employer’sincreased cash obligations under such plans(which Moody’s, unlike GAAP, treats as adebt-like adjustment to the employer’sfinancial statements) may increase theemployer’s risk profile and be a factor inconsidering a downgrade of it.

Effect of the EconomicDownturn and Other EventsMultiemployer plan risk is by no meansnew, but a number of events over the past


Mind the (Funding) Gap: Trouble Ahead for Multiemployer Plans


While these plans are

generally prevalent only

in a narrow slice of

industries of the old

economy, private equity

sponsors investing in

these industries should

be diligent in

ascertaining the full

range of effects that these

plans could have upon

potential targets.


few years have converged to increase thisrisk.

l Economic Downturn. The mostimportant of these events is theeconomic downturn, which hasexacerbated the already significantunderfunding of many multiemployerplans. Data collected by Moody’sestimates that multiemployer planswere collectively 77% funded in 2007and are likely to be 56% funded in2008. (The precise underfunding willnot be known until the plans’ 2008annual informational returns becomepublic.) In addition, bankruptcies haveoperated to reduce the number ofcontributing employers in industriescovered by multiemployer plans. Theresult of these factors is a decliningnumber of employers having theobligation to fund an increasingliability.

l Change in Union Demographics.There have also been important

changes in union demographics. Newentrants in traditionally unionizedfields are less likely to have unionizedworkforces. The Moody’s report citesas examples FedEx in transportationand WalMart in supermarkets. As aresult, and in combination withpopulation demographics generally,there are a fewer number of activeemployees in the plan supporting thebenefit obligations to a greater numberof retired workers in the plan who areliving longer. Added to this mix is thepotential withdrawal from plans bylarge, stable contributing employers(UPS being a prominent recent example).

l Legislative Initiatives. The PensionProtection Act of 2006 (PPA)categorized troubled multiemployerplans into “yellow zone” (badlyunderfunded) and “red zone” (verybadly underfunded) plans. PPArequires that both yellow zone and redzone plans achieve specified fundingtargets within a 10-15 year period, achange from prior law. Red zone plansmust also consider reducing benefits.The likely effect of these rules in mostcases is an increase in plancontributions and a freeze or decreasein plan benefits. Subsequent legislationhas softened the impact of these rulesbecause of the economic downturn butnot eliminated them entirely, andfurther legislation is possible.Interestingly, this legislation, which isintended to preserve the status quo for aplan until a market recovery, may havethe effect of masking a plan’s truehealth to potential acquirors.

The combination of these factors seemsto spell trouble for employers thatcontribute to multiemployer plans in theform of the direct cost of increased cashcontributions and the indirect costs of

decreased benefits, or both. Decreasedbenefits may create indirect costs as aresult, for example, of increased unrestamong the union population or byeffectively requiring the employer to makeup the lost benefits in some other way.

The Moody’s report offers as anexample the Central States multiemployerplan, which covers the trucking industry.In December 2007, UPS, one of thelargest contributors to the Central Statesplan, successfully negotiated to withdrawfrom the plan. This withdrawal requiredUPS to contribute roughly $6 billion tothe plan, but, even after the contribution,the plan was estimated to be only 67%funded. Moody’s also estimates that,because of the drop in asset values in2008, the plan’s current underfundingmay be as much as $25 billion(corresponding to a 44% funding level).In mid-2009, another large contributingemployer, YRC Worldwide, negotiated an18 month funding holiday from theCentral States plan because of financialdistress. The Moody’s report points outthat if YRC were to cease contributing tothe plan altogether, the remainingcontributing employers would be afraction of the size of UPS and YRC andwould be collectively responsible for fundingthe estimated $25 billion referred to above.

No (Easy) Way OutThere is no easy way for an employer tocontrol these obligations, for threereasons. First, withdrawal requiresnegotiating with the union. For example,UPS, which withdrew from the CentralStates plan in 2007, had been trying to doso for years, which reportedly contributedto a 15-day strike in 1997. Second, evenwhere the union approves the withdrawal,the withdrawing employer must pay itsallocable share of unfunded benefits in

Mind the (Funding) Gap (cont. from page 9)


In any private equity

deal in which the target

contributes to a

multiemployer plan, the

potential plan liabilities

should be a particular

focus of diligence,

despite the absence of

any liability or

contingency for these

exposures on the target’s

GAAP balance sheet.


Controlling shareholders of publiccompanies contemplating a sale of thecompany to a third party sometimes favorprivate equity bidders over their strategiccompetitors. This is because privateequity sponsors typically can be moreflexible than strategic buyers instructuring transactions that allow thecontrolling shareholder to retain an equitystake in the surviving entity or to receiveother financial benefits that are not sharedwith the minority shareholders, such ascontinuing employment with thesurviving entity, stock options and otherarrangements.

The Delaware Chancery Court’s recentdecision in In re John Q. Hammons HotelsInc. Shareholder Litigation (Oct. 2, 2009)provides a road map for parties tostructure controlling shareholder saletransactions so that they will be subject tothe protections of the business judgmentrule, rather than the more rigorous “entirefairness” standard of review. However, theChancery Court held in Hammons that amerger between a controlled company anda third party unaffiliated with thecontrolling shareholder was subject to theentire fairness test because the controllingshareholder received considerationdifferent from that received by theminority shareholders and because thetransaction did not include sufficientprocedural protections to protect theminority: namely, in addition to thespecial committee process typically usedin going private transactions, there be acondition to the merger that it beapproved by holders of a majority of theoutstanding shares held by the minorityshareholders.

The Hammons Hotels SaleHammons arose out of the 2005 buyout of

John Q. Hammons Hotels, Inc. byJonathan Eilian, an unaffiliated privateinvestor. Under the merger agreement, allholders of the publicly traded Class Acommon stock received $24 per share incash (which constituted a substantialpremium), and Mr. Hammons, who helda small portion of the Class A commonstock and all of the high-voting Class Bcommon stock and controlledapproximately 76% of the company’svoting power, received in exchange for hisClass B shares a small equity interest inthe acquiring entity, a preferred interestwith a large liquidation preference, a $300million credit line and certain other assets.The merger agreement was negotiatedby an independent and disinterestedspecial committee and included aclosing condition requiring that themerger be approved by holders of amajority of the shares held by minorityshareholders voting on the merger(which condition was waivable by thespecial committee).

Plaintiffs, holders of Class Acommon stock, alleged that Mr.Hammons breached his fiduciary dutiesas a controlling shareholder by usinghis controlling position to negotiatebenefits for himself that were notshared with the minority shareholders.Plaintiffs also argued that the target’sdirectors breached their fiduciary dutiesby conducting a deficient process innegotiating and approving the merger.

The Standard of Review:Entire Fairness or BusinessJudgmentDelaware courts traditionally reviewmergers in which minority shareholdersare cashed out by the controllingshareholder under the entire fairness

standard established by the SupremeCourt of Delaware in Kahn v. LynchCommunication Systems, Inc. (1994). Theentire fairness standard is designed toprotect minority shareholders from the“inherent coercion” existing where thecontrolling shareholder stands on bothsides of the transaction and negotiateswith the target board to buy out theminority. In such a case, the use of aproperly functioning and independentspecial committee, or subjecting thetransaction to an informed majority-of-minority vote, will shift the burden ofproof to the plaintiff to show that the

Dealing With Mr. Big: Recent Developments in Transactions Involving Controlling Shareholders


The Delaware Chancery

Court’s recent decision

in ... Hammons ...

provides a road map for

parties to structure

controlling shareholder

sale transactions so that

they will be subject to

the protections of the

business judgment rule,

rather than the more

rigorous “entire

fairness” standard of

review.


transaction was not entirely fair.In Hammons, plaintiffs argued that

the merger should be reviewed under theentire fairness standard, regardless of anyprocedural protections that may havebeen used, because Mr. Hammonseffectively stood on both sides of thetransaction. The Delaware ChanceryCourt disagreed. The court pointed outthat the fact that Mr. Hammons retaineda small equity interest in the survivingentity and received other considerationnot shared with the minorityshareholders did not change the fact thatthe offer to the minority shareholderswas made by an unrelated third party,and that Eilian negotiated separatelywith Mr. Hammons and the specialcommittee representing the minorityshareholders. Accordingly, the courtconcluded that Lynch did not mandatethat entire fairness automatically applyto the merger.

However, the Delaware ChanceryCourt declined to review the merger

under the business judgment rule. Thecourt reasoned that, even though Mr.Hammons did not stand on both sidesof the merger, Mr. Hammons and theminority shareholders were “competing”for portions of the consideration thatEilian was willing to pay to acquire thetarget, and Mr. Hammons’ controllingposition enabled him to veto anytransaction he did not like. In such acase, the business judgment rule wouldbe the appropriate standard of review ifthere were “robust proceduralprotections” in place to ensure that theminority shareholders had sufficientbargaining power and adequateinformation to decide whether to acceptEilian’s offer.

According to the court, adequateprocedural protections exist if the mergeragreement (1) is recommended by anindependent and disinterested specialcommittee and (2) includes a non-waivable condition that the merger beapproved by a majority of alloutstanding shares held by the minorityshareholders — including those who donot actually vote.

Applying this standard to theprocedural protections used in theHammons Hotels merger agreement, theDelaware Chancery Court found thatthey were deficient. The fact that themerger agreement gave the specialcommittee the power to waive theminority vote, and required only thevote of a majority of the minorityshareholders actually voting on themerger, rather than a majority of theoutstanding minority shares, renderedthe protections inadequate, even thoughthe merger was in fact approved byholders of a majority of the outstanding

minority shares. Accordingly, the courtheld that the merger should be reviewedunder the entire fairness standard.

Implications of HammonsIn light of Hammons, controlled targetsmay push hard to include a majority-of-the-minority approval condition insituations where the controlling andminority shareholders are in competitionfor merger consideration, in order toavoid the application of the entirefairness standard. This could result inlesser deal certainty, especially where themajority stake is concentrated amongrelatively few shareholders, who may usetheir potentially blocking position toseek to negotiate improved terms.However, Hammons could provide abright-line rule for structuring a sale of acompany with a controlling shareholderto a third party in a manner that wouldnot subject the transaction to the entirefairness test, if the target follows theproper special committee process and thetransaction is conditioned on approvalby holders of a majority of theoutstanding shares held by the minority.

* * *The Delaware Chancery Court’s decisionin Hammons has been appealed to theSupreme Court of Delaware. We willcontinue to monitor the situation andwill update you on any importantdevelopments.

William D. [email protected]

Dmitriy A. Tartakovskiy [email protected]

Dealing With Mr. Big (cont. from page 11)

In light of Hammons,

controlled targets may

push hard to include a

majority-of-the-minority

approval condition in

situations where the

controlling and minority

shareholders are in

competition for merger

consideration, in order

to avoid the application

of the entire fairness

standard.


How Green Is Your Portfolio? U P D AT E

Private equity funds may be able to breatha small sigh of relief. On October 7,2009, the UK government published itsresponse to the third and finalconsultation on the Carbon ReductionCommitment (“CRC”) legislation and theoutlook for the private equity industrydoes not look as bleak as first feared.Coming into effect on April 1, 2010, theCRC legislation will regulate large non-energy intensive business and public sectororganizations. The October 7th responsesets out the UK government’s final policyposition on the CRC Energy EfficiencyScheme (as it has now been renamed), andexplains some significant changes to thescheme to be formally implemented inrevised draft legislation before the end ofthis year.

The prior proposed CRC legislationpresented difficulties for private equityfunds because UK organizations,controlled by a common parent, were tobe grouped together with their parententities and treated as a singleorganization. The ultimate parent of thecombined organization, including thoseparent entities based outside of the UK,would bear responsibility for compliancewith the legislation by their qualifying UKportfolio companies. Although this is stilllikely to be the default position, theresponse indicates that the revised CRClegislation will provide a mechanism bywhich corporate groups may be split intoseparate participants for reporting andcompliance purposes, which could inmany cases allow private equity funds tolimit their exposure to the scheme andwhich should reduce the problems of jointand several liability across a fund’sportfolio.

As mentioned in our previous article,all UK organizations (with groups of

companies being treated as oneorganization) that consume more than6,000 megawatt (“MWh”) hours ofelectricity in a given time period will berequired to participate in the scheme.The revised legislation will allow theultimate parent of an organization tovoluntarily select any “Significant GroupUndertaking” (“SGU”) within its group tobe disaggregated from the group andparticipate separately in the scheme. AnSGU (which was referred to as a“principal subsidiary” under the priorproposed legislation) is any UKorganization that, in its own right, wouldqualify for the scheme. As long as theSGU consents to such disaggregation, itwill be obliged to participate in thescheme as an entirely separate participant,and, most importantly, its parentcompany will not be jointly and severallyliable for that SGU’s compliance with thescheme.

The election to disaggregate one ormore SGUs from a corporate group willneed to be made at the beginning of theregistration process (this period is fromApril 1, 2010 through September 30,2010 for the introductory phase of thescheme), at the start of each subsequentphase of the scheme, or when an SGU ispurchased by an existing participant. Themost important condition fordisaggregation appears from the responseto be that an SGU cannot bedisaggregated if it would result in theremaining group falling below the6,000MWh participation threshold afterdisaggregation of the relevant SGU. Even if the proposed changes areimplemented in the most private equityfriendly manner, the legislation may stillbe challenging for funds, as each fund willneed to identify the participant group for

registration purposes and assess where bestto disaggregate its portfolio companies.

The response contains only a summaryof the main changes to the scheme, andthere are, therefore, several uncertaintiesthat will not be resolved until the revisedlegislation is published. Most importantlythe response does not state:

l whether group companies with noemissions can effectively be absolved ofjoint and several liability by using thedisaggregation process; and

l what will happen if a parent companydecides to sell part of a disaggregatedSGU, where such sale would result inthe remaining disaggregated groupfalling below the 6,000MWhthreshold. Will the remaining groupbe permitted to continue to participateas a separate grouping (even though itno longer meets the threshold for beingan SGU), or will it be “re-aggregated”with the ultimate parent entity?

The response also details a number ofother important changes to the scheme,including removal of the requirement topurchase allowances for the firstcompliance year from April 2010 to May2011. In the first year of the schemeparticipants will therefore only be obligedto register, report and monitor their CO2emissions.

We will provide a full update on theseand other changes to the scheme once therevised draft legislation is issued.

Geoffrey P. [email protected]

Russell D. [email protected]


Recent and Upcoming Speaking Engagements October 1, 2009Satish Kini Gregory Lyons“Private Equity Investments in Banks -Hurdles and Opportunities”Practising Law InstituteNew York

October 29, 2009Andrew Berg“Tax Strategies for Financially TroubledBusinesses and Other Loss Companies”Tax Strategies for Corporate Acquisitions,Dispositions, Spin-Offs, Joint Ventures,Financings, Reorganizations andRestructurings 2009Practising Law InstituteNew York

October 29-30, 2009Franci J. Blassberg, Program Co-Chair“Negotiating the Acquisition of the PrivateCompany”“Special Problems when Acquiring Divisionsand Subsidiaries”Twenty-Fifth Annual Advanced ALI-ABACourse of Study on Corporate Mergers andAcquisitionsALI-ABA Committee on ContinuingProfessional EducationBoston

November 3, 2009Geoffrey Kittredge“Fund Terms and Conditions in the NewWorld Order PEI and EMPEA”

Geoff Burgess“Panel Session: Ask the Audience”

The Emerging Markets Private EquityForumLondon

November 8, 2009Li Li“Development and Inter-Relation BetweenRMB and Foreign Currency Funds EMPEAand BPEA”Second Annual Beijing Global PrivateEquity ForumBeijing

November 12, 2009Sherri CaplanRichard HahnMichael Wiles Bryan Kaplan“Private Equity Limited Partners inBankruptcy: Preparations, Rights andRemedies” Bankruptcy and Private EquityThomson ReutersWebcast

November 12, 2009Ken Berman“Board Considerations in a New Era” 2009 Independent Company DirectorsConferenceInvestment Company Institute andIndependent Directors CouncilAmelia Island, FL

November 12, 2009Heidi Lawson“Risk Management for PRC CompaniesGoing Global”Asian Business Dialogue on CorporateGovernance 2009Asian Corporate Governance AssociationBeijing

November 16-17, 2009Franci J. Blassberg, Session Chair,Moderator“Assessing the Current State of the PrivateEquity Marketplace”

E. Raman Bet-Mansour“Public Relations, Labour Relations andLobbying: Managing External RelationshipsInternational Bar Association”

Geoffrey Kittredge“Sponsorless Funds, Purchase and Sale ofFunds or Portfolios, and Other OrganicChanges at the Fund Level: What Are theSpecial Issues Presented by a Failed Portfolio?”

Matthew D. Saronson, Session Co-Chair,Co-Moderator“Developments in Taxation of Private Equity”

International Private Equity Transactions2009: A Symposium for Leading PrivateEquity LawyersInternational Bar AssociationLondon

November 19, 2009David Schnabel“Tax Strategies for Financially TroubledBusinesses and Other Loss Companies”Tax Strategies for Corporate Acquisitions,Dispositions, Spin-Offs, Joint Ventures,Financings, Reorganizations andRestructurings 2009Practising Law InstituteChicago

For more information about upcoming events visit www.debevoise.com/newseventspubs/events


The high profile section 363 sales of GM,Chrysler, and other distressed businessesduring the current recession have debunkedthe myth that the formal bankruptcyprocess cannot support quick, complexasset sales and convinced the businesscommunity that a bankruptcy filing doesnot necessarily destroy consumerconfidence or capsize a carefully deployedsales process.

But even as the section 363 sale takes itsstar turn, its counterpart, the more familiarout-of-court sale, remains the preferredmethod (and sometimes the only method)for many distressed asset acquisitions,especially those by private equity funds.Indeed, from the perspective of a privateequity sponsor attracted to a particularsegment of a business, section 363 sales willnot be an option. Those assets will beavailable only out of court either becausetheir owners do not legally have access tosection 363 sales or because the sellers areunwilling to endure bankruptcy for the sakeof the sale — particularly if the asset sale ispart of an overall out-of-court restructuringin which a consensus to avoid bankruptcyhas already been reached or the business tobe acquired is a healthy operation within atroubled company. And, many acquisitionsgo to the courageous: those who wait forthe relative safety of a section 363 sale mayconcede many attractive opportunities.

Out-of-court distressed asset salessometimes offer advantages over section363 sales. Out-of-court transactions avoidthe considerable — sometimes prohibitive— costs, delays and publicity of abankruptcy process. The seller’smanagement and the buyer can maintainthe type of control of the sales process that

in bankruptcy must be shared withcreditors and ultimately belongs to thecourt. Once in a bankruptcy proceeding,two-party negotiations between the buyerand seller may give way to multi-partynegotiations, unless the creditors happen tosupport the transaction or are otherwisedisinterested. Finally, out of court, theparties are not bound to section 363’snotice and auction requirements. Buyers ofdistressed assets will thus continue to seekout of court bargains and will need to keepin mind, among others, two risks facingout-of-court buyers of assets of distressedcompanies: (1) fraudulent conveyance riskand (2) successor liability risk. Fortunately,these risks can often, though not always, bemitigated through careful due diligence andcareful deal-making, each of which alsocontributes to ensuring the economicsuccess of the acquisition.

Fraudulent ConveyanceBuyers may find themselves the unwelcometargets of fraudulent conveyance actionsbrought by creditors or shareholders of thedistressed seller, even years after the dealcloses. In particular, buyers need tounderstand (and factor into their purchaseprice) the possibility that, if the sellersubsequently files for bankruptcyprotection, the sale could be attacked —ultimately voided — as a fraudulentconveyance. Fraudulent conveyance claimscan be brought under the Bankruptcy Codeor state law. Under the Bankruptcy Code,a buyer is exposed to potential fraudulentconveyance claims if the seller files forbankruptcy protection within two years ofthe transaction. If the claim is broughtunder state fraudulent conveyance statutes,the look-back period is usually longer.

Under New York law, for example, theperiod is six years.

But what is a fraudulent conveyance?There are two kinds. The first is a saleentered into with the actual intent tohinder, delay or defraud the seller’screditors. While a buyer must take carethat no such intentional wrong is beingperpetrated by the seller, it is the second,unintentional and subtler form that causesthe greater worry for buyers, preciselybecause it may exist and require remedyeven if nothing inappropriate is done. Thissecond kind is the constructive fraudulentconveyance, and it is principally the focusof a buyer’s concern in most distressedtransactions. A transaction may be foundto be a constructive fraudulent conveyanceif the seller (1) did not receive “reasonable

Caution Ahead: Rules of the Road for Buying Assets from Distressed Companies

... [E]ven as the section

363 sale takes its star

turn, its counterpart, the

more familiar out-of-

court sale, remains the

preferred method (and

sometimes the only

method) for many

distressed asset

acquisitions, especially

those by private equity

funds.


equivalent value” and (2) was insolvent atthe time (or rendered insolvent as a result)of the transaction, had unreasonably smallcapital to conduct its business, orintended to incur debts beyond its abilityto pay as such debts matured.

If a court finds that an insolvent sellerreceived less than fair consideration, theremedy is to unwind the transaction —which is generally impracticable — or torecover the judicially-determined value ofthe asset from the buyer, less amountsalready paid, which is, to put it mildly,highly undesirable. It is important toremember that the analysis is always donewith the benefit of hindsight, whencreditors of a now bankrupt seller arelooking for additional sources of recovery.Therefore, although fraudulentconveyance claims are rarely litigated (andmay often have little merit), they willnonetheless often be asserted againstbuyers viewed as potential deep-pocketsand may have substantial settlement value.

There is no way to eliminate thefraudulent conveyance risk completely.There are steps that can be taken tominimize the risks, and the time for a

buyer to start preparing a defense againstsuch risks is during the transaction itself.For example, were the particular assetsbeing purchased aggressively marketed byan independent third-party investmentfirm? Has there been active bidding in anauction process? Has an independentthird-party provided a fairness opinionwith respect to the transaction? Will theseller remain solvent after the transaction?In some instances, the buyer may also beable to take comfort from the consent of athird party — a secured lender or aregulator — to the transaction where theconsenting party is focused on theadequacy of the consideration paid by thebuyer. Of course, some of theseapproaches are more difficult toimplement (but not impossible) when abuyer is purchasing a limited group ofassets and assuming a limited group ofliabilities from a group of sellers — as thebuyer would prefer that the marketing,auction, fairness opinion and lenderconsent be focused solely on the particularassets the buyer is purchasing (and theparticular subsidiaries from which theassets are being purchased).

Successor LiabilityIn the U.S. and in other common lawjurisdictions, buyers of assets from a sellercannot be forced to take on the liabilitiesof that seller. The exceptions to this rule,however, are significant, and togetheramount to the second major risk facingbuyers of assets out of court fromdistressed sellers.

First, when buying an unincorporateddivision of a distressed company, theparties themselves may divvy up liabilitiescontractually: some assumed by the buyer,others retained by the seller. The buyerwill generally choose to assume some, butnot all, supplier and service contractsassociated with the acquired assets. The

seller, in turn, will desire to retain somecontracts to support and operate theunsold portion of its business. Othercontracts may need to be partitioned, andstill others will be desired by neither party,but assumed or retained as a burden withtransaction consideration negotiatedaccordingly. This division of liabilitiesshould be clear not only on its face butalso scrutinized for any possible surprisesto the buyer. By assuming contracts, abuyer accepts certain pendant liabilities aswell; some are obvious, but others may bedragged in unnoticed unless the buyercarefully examines contract language,preexisting or transaction-triggeredbreaches, and other statutory andconventional aspects of contracts takenaboard.

Even the most careful due diligenceand drafting cannot insulate the buyerfrom some liabilities, which may flowthrough the acquisition regardless ofcontract. For example, federal statutescreate exceptions for certainenvironmental, labor and employmentliabilities. Environmental liabilities maybe obscure to the buyer, or even unknownto the seller, yet follow the assets and bebinding to the buyer. Labor andemployment obligations may also followthe asset, notwithstanding contractuallanguage to the contrary. For example, abuyer must take care that it is notacquiring goods produced in violation ofthe Fair Labor Standards Act. Thetransaction itself may trigger the“WARN” Act if reductions in workforceare involved. Statutory and judicialexceptions, which vary by state, also existfor products liabilities, which do not fittraditional doctrines of successor liability:for example, under certain circumstancesand in some states, an acquirer may be

Buying Assets from Distressed Companies (cont. from page 15)


In the U.S. and in other

common law

jurisdictions, buyers of

assets from a seller

cannot be forced to take

on the liabilities of that

seller. The exceptions

to this rule, however,

are significant....


What Really Changed? — The Market Impact of the 2008 Changes to Rule 144

A L E R T

As we predicted in our Winter 2008edition of the PER, the changes to Rule144 adopted almost two years ago were,among other things, likely to changemarket practices in deals involving theissuance of restricted securities, includingofferings of high-yield debt to finance PEtransactions. While the freeze in thecapital markets in late 2008 and early2009 inevitably stalled the development ofnew practices, the impact of the changesto Rule 144 on market practice is nowbeginning to take shape.

As discussed further below, the changesto Rule 144 have not yet moved theneedle for market practices involvingissuers of high yield notes who are notalready filing periodic reports with theSEC. But they have begun to have animpact on market practices involvingissuers who were filing periodic reportswith the SEC prior to the offering of therestricted securities.

As a quick refresher, the principalchanges to Rule 144 were to:

l reduce to six months from one year theRule 144(d) holding period for resaleof restricted securities of companiessubject to the reporting requirementsunder the Securities Exchange Act of1934 (note that this does not includeso-called “voluntary filers”);

l provide that non-affiliates ofcompanies not subject to the abovereporting requirements may resellrestricted securities of such companieswithout limitation after a one-yearholding period;

l reduce substantially the restrictionsunder Rule 144 on resales of restricted

securities by non-affiliates such that,once the applicable holding period haspassed, resales of restricted securities bynon-affiliates are generally not subjectto other limitations under Rule 144.One important exception applies toresales of restricted securities ofreporting issuers, where the issuer mustcomply with a continuing informationrequirement for six more months afterthe initial six-month holding periodhas passed; and

l permit issuers to remove restrictedlegends on privately placed securities,as clarified by the SEC in a footnote tothe Rule 144 amendment adoptingrelease.

As noted above, almost two years afteradoption of the rule changes, there appearsto have been little evolution in marketpractice for registration rights for securitiesof companies not already filing periodicreports with the SEC, including mostissuers of new high-yield notes issued inleveraged acquisition transactions. In thesedeals, investors are continuing to value SECregistration of the notes in an A/B exchangeand the required SEC periodic reports andapplicable Sarbanes Oxley complianceresulting from SEC registration. Thesecompanies typically continue to be“voluntary filers” after the high-yield notesare registered.

In contrast, investors in privatelyplaced notes issued by companies that arerequired to file periodic reports with theSEC prior to the offering appearincreasingly willing to forego a registrationrights agreement. This is presumablybecause not only are reporting covenantscontained in most indentures, but also

because the new shorter Rule 144 holdingperiod is about the same duration as theperiod of time before an A/B exchangeoffer historically must have beencompleted under a customary registrationrights agreement.

The market is slowly adjusting to thenew shorter holding period. For example,in one recent deal, investors in high-yieldnotes of a reporting issuer insisted on aregistration rights agreement, but requiredthe issuer to conduct the A/B exchangeoffer only if, one year after the issue date,the notes were not freely transferable bynon-affiliates or the restricted legend hadnot been removed from the notes.

In several other recent deals for debtsecurities of reporting companies,investors did not require a registrationrights agreement and instead relied onhard-wiring a legend removal mechanic onthe notes to enhance their marketability.In those cases, the issuer implementedprocedures proposed in October 2008 bythe Securities Industry and FinancialMarkets Association (SIFMA) andreviewed by The Depository TrustCompany for “deemed removal” ofrestricted legends on securities and changeto unrestricted CUSIP numbers. Byincluding the SIFMA proposed languageon the face of the notes and appropriateprovisions in the related indenture, therestricted legend on the notes is “deemedremoved” upon delivery to the indenturetrustee of a “certificate of freetransferability,” a form of which isattached to the indenture. The notesthemselves also include a footnote to theCUSIP numbers specifying that thesenumbers are deemed to change to



unrestricted CUSIP numbers upondelivery of the same certificate. Practicallyspeaking, this means that the issuer needsto obtain an unrestricted CUSIP numberat the same time that it obtains the Rule144A and Reg S numbers prior toissuance of the securities. The issuer’sfailure to comply with these procedurestriggers penalty interest that, similar to theregistration rights agreement model,accrues as long as the issuer continues tofail to remove the restricted legend fromthe securities by the agreed date (usually,one year from the initial settlement date).Penalty interest rates vary and can includefeatures such as a step-up or a cap, muchas they did under traditional registrationrights agreements.

We also understand that the use ofregistration rights agreements is decliningin PIPEs transactions for reasons similarto those that apply to debt securities ofreporting companies. One twist in Rule144, however, applies to former shellcompanies and has sparked significantdiscussion. Under Rule 144(i) and severalrelated SEC Compliance & DisclosureInterpretations, restricted securities of acompany that at any time previously hadbeen a shell company may be resold underRule 144 only if the issuer fulfills all ofthe requirements of Rule 144(i)(2),including that the issuer has filed allExchange Act reports (other than Form 8-K reports) and other required materialsduring the preceding 12 months. It is

unclear how restricted legends onsecurities of former shell companies canever be removed since compliance withreporting requirements is determined atthe time of resale.

We will provide appropriate updates onevolving market practices in this area infuture editions of the Private EquityReport. It remains to be seen if the rulechanges will ultimately result in a shift inpractice for “quasi-public” issuers who arevoluntarily filers and make once routineA/B exchanges a part of history.

Peter J. [email protected]

Paul M. [email protected]

The Market Impact of the 2008 Changes to Rule 144 (cont. from page 17)


connection with the withdrawal upfrontwhich, in the case of many of these plans,could be a substantial amount. For UPS,this amount was $6 billion. Finally, inorder to prevent a race to the exits,Federal law also creates an additional typeof withdrawal liability when substantiallyall employers withdraw from the plan atroughly the same time (whether or not inconcert with each other). This liability— called “mass withdrawal liability” —essentially allocates the entireunderfunding of the multiemployer planto all employers who withdraw during aroughly two year period. Again, usingUPS as an example, if a mass withdrawalwere to occur under the Central Statesplan before 2010, UPS would be deemedto be part of the mass withdrawal andwould be allocated its proportionate shareof what Moody’s believes is likely a $25billion underfunding — and thiscontribution would be in addition to the$6 billion UPS already has paid.

Effect on Private EquityIn any private equity deal in which thetarget contributes to a multiemployerplan, the potential plan liabilities shouldbe a particular focus of diligence, despitethe absence of any liability or contingencyfor these exposures on the target’s GAAPbalance sheet. For the foreseeable future,it should be assumed that all multi-employer plans are at least “yellow zone”plans; this assumption is not likely to betoo far off. More than a few will be “redzone” plans. These liabilities cannot easilybe left behind with a seller or otherwisehedged against, and, while it may bepossible to self insure these costs bymodeling the possible cash contributionsto the plan into one’s purchase price undera range of “normal” scenarios over theinvestment period, other risks associatedwith continuing plan contributions (e.g.,the chances of successfully negotiatingbenefit changes, of labor unrest or of masswithdrawal) are industry risks and will not

easily be quantifiable. In all events, to be clear, (1) owning a

strong player in an industry may not beenough to avoid these problems to theextent the strong player’s contributionsincrease due to the missed contributionsof competitors who have withdrawn orgone bankrupt, and (2) private equitybuyers should be modeling the possibleeffect of these contingent liabilities on atarget’s credit ratings despite their absencefrom a target’s financial statement since,unlike under GAAP, these contributionsobligation are treated as debt-likeobligations by Moody’s, and they thuscould, in the wrong circumstances, dragdown the target’s credit rating.

Jonathan F. [email protected]

Alicia C. [email protected]

Mind the (Funding) Gap (cont. from page 10)

A L E R T

Recent decisions by the European courtsraise the concern that private equity firmsmay face liability for violations of EUantitrust laws by their portfolio companies.Those decisions hold that parent companiesare subject to a rebuttable presumption ofliability for violations committed by theirwholly-owned (or nearly wholly-owned)subsidiaries. Although these decisionsconcerned industrial groups, the same rulesmay be applied to investment entities.

Importance of the IssueThe attribution of liability may have severalconsequences. First, the parent companyand the subsidiary will be held jointly andseverally liable. Second, the EuropeanCommission’s mandatory cap on fines(10% of revenues) will not be based on therevenues of the subsidiary whichcommitted the infringement, but on thegroup’s worldwide revenues. Third,although the Commission’s guidelines forcalculation of a fine for an antitrustinfringement are based on the value of salesto which the infringement relates, theCommission may increase the fine based ona group’s overall economic strength in orderto ensure a sufficiently deterrent effect.

The Akzo and the Elf Aquitaine CaseIn the Akzo decision of September 10,2009, the European Court of Justice(“ECJ“) confirmed that a parent companyis presumed liable for its wholly-ownedsubsidiary’s involvement in a cartel, even ifit did not itself take part in the cartel’sactivities. Just a few weeks later, onSeptember 30, 2009, the European Courtof First Instance (“CFI”) decided that this

presumption also applies to parentcompanies of almost wholly-ownedsubsidiaries. The CFI attributed liability toElf Aquitaine for the conduct of its 98percent-owned subsidiary.

Basic Principles on Attribution of LiabilityA parent company may be held jointly andseverally liable with its subsidiary, if thelatter does not determine its own course ofconduct on the market fully independently.The conduct is not independent if (1) theparent has the possibility to exercise decisiveinfluence on the commercial decisions of itssubsidiary, and (2) effectively exercises thispossibility. The rationale for imposingliability on the parent is that EU antitrustlaw addresses “undertakings,” a term thatthe EU courts and the Commissioninterpret as economic units rather than legalentities. An undertaking may therefore be acombination of several individual legalentities, namely parent and subsidiaries.This is different from the U.S. approach,under which a parent is generally not liablefor its subsidiary’s actions, except where theparent treats the subsidiary as “a mereagency or instrumentality.”

For the same reason, although thegeneral rule is that an acquirer is liable forthe conduct of a target only from themoment of the aquisition, an acquirer may,in some cases, be attributed full liability fora target’s infringement committed before itsacquisition of the target. For example, ifthe target loses its legal personality becauseits assets have been absorbed, the acquirermay be fully liable under the doctrine ofeconomic continuity.

The burden of proof to establish that asubsidiary did not act autonomously restswith the Commission. However, in thecase of 100% (or close-to 100%)ownership, there is a rebuttablepresumption that the subsidiary does notact autonomously, and the parent companyhas to prove the contrary.

The threshold to rebut this presumptionis high: To prove “autonomy,” i.e., that thesubsidiary determines its own course ofconduct on the market independently, theparent company needs to showindependence not just in the aspects ofcommercial policy which are directlyrelevant to the specific case (e.g.,distribution strategy and pricing), but moregenerally as well. According to the ECJ, theCommission may consider also the generalrelationship between parent and subsidiary,i.e., their economic, organizational and legallinks. For example, if the parent andsubsidiary share directors or executives, arebuttal will likely fail. Consequently, caseswhere the presumption has been rebuttedare so far extremely rare.

Investment Entities and FundsThe Commission has applied this conceptof parent liability also to investmententities. It has attributed liability to aninvestment holding company, a turnaroundfund and even an investment vehicle heldby a private equity consortium. It isimportant to note that the Commissionseems to draw a line between passivefinancial investors and investors that followa more hands-on approach, although theECJ has not yet decided this issue. The

Developments in EU Antitrust Laws —Private Equity Funds May Be Liable for Violations of Portfolio Companies




held liable for injuries caused by priormanufactured products in a line which theacquirer continues to manufacture.Avoiding such liability is not alwayspossible and requires careful structuringeven when it is possible.

Certain additional creditors’ claims alsomay follow the business operation,sometimes without the awareness of thebuyer (or even the seller): materialmen’sand mechanics’ liens, and oil, gas andagricultural liens each have special ruleswhich make their disclaimer by the buyer,if possible at all, a matter requiringdiscovery, express treatment and otherspecial provisions, usually including noticeto the potential claimant. Also, a fewstates have not yet eliminated their bulktransfer laws. In such states, an asset salemay constitute a bulk transfer if itinvolves the sale of a substantial portion ofthe seller’s inventory outside the ordinarycourse of business, in which case notice ofthe asset sale must be given to the seller’screditors. Finally, most states imposesuccessor liability on the buyer if thetransaction is deemed to create a “mere

continuation” of the acquired business orif the transaction is considered a “de factomerger.” A forewarned buyer shouldcarefully consider a distressed asset salewith these attributes, and should explorealternatives.

These risks can be ameliorated throughcontractual covenants, closing conditions,indemnification, escrow or holdbackprovisions. For example, a generalindemnity together with particularindemnities for pending or threatenedlitigation and environmental conditions orviolations may be appropriate. However,the value of such contractual protectionmust be weighed carefully, as these typesof provisions may not have much teethagainst a distressed seller on the verge of abankruptcy filing. Distressed acquisitionsface a higher risk of judicial attention andlater attack, and the seller’s representationshave less weight against such risks than ina transaction between two healthycorporations. A distressed seller’sindemnifications for buyer liabilitiesarising from the seller’s pre-sale acts willalso represent limited assurance. Buyers

may want to carefully analyze theirstructuring options — weighing in favorof escrows and holdbacks — in light ofwhat may be, for all practical purposes, an“as is” sale.

Buyers of a distressed business or oneheld by a distressed parent in out of courttransactions should take care to enter intosuch transactions only with goodplanning, adequate preparation and awell-thought-out process, in order tomitigate the fraudulent conveyance andsuccessor liability risks that may bepresent when extracting assets from adistressed seller.

Jasmine [email protected]

Derek [email protected]

Buying Assets from Distressed Companies (cont. from page 16)

Commission’s Akzo decision observes thatAkzo “is not simply an investment vehiclethat merely serves to invest capital incompanies whose commercial operation itthen leaves to those companies,” thusimplying that such investment vehicleswould not be subject to the presumptionof liability. Conversely, attribution ofliability may occur if an investor exercisesa decisive influence over a portfoliocompany.

As a consequence, private equityinvestors that exercise “hands-on”management of portfolio companies activein the EU should scrutinize closely their

portfolio companies‘ activities, consideringin particular that:

l Preventing antitrust problems bymeans of an effective and testedcompliance program is always lessexpensive than managing problemsafter they arise (and paying fines).

l Exposure to fines may be avoided orreduced by applying for leniency.However, full immunity is onlyavailable for the first company involvedin an alleged cartel to providecomprehensive information to theantitrust authorities. Again,compliance control is key.

l Internal investigations may shed lighton potential antitrust exposure and alsohelp to create a basis for effectivecooperation with the antitrustauthorities, as is required in order tobenefit from leniency programs.

Dr. Thomas Schü[email protected]

Daniel [email protected]

Developments in EU Antitrust Laws (cont. from page 19)


exempt from registration under Section203(b)(3) of the Investment Advisers Actof 1940 (the “Advisers Act”). Section203(b)(3) is the exemption relied uponby private fund sponsors that have fewerthan 15 clients.

The Proposed Rule has created quitea bit of controversy in the private equitycommunity — particularly over aproposal to prohibit fund sponsors andother investment advisers fromcompensating placement agents andsolicitors in connection with thesolicitation of governmental entities.However, the main focus of theProposed Rule — political contributionsby investment advisers that might bedesigned to induce state pension planinvestments — could also have asignificant impact on the activities ofprivate fund sponsors and theiremployees. This article focuses on thepolitical contribution component of theProposed Rule.

Some BackgroundThe proposal is modeled on MunicipalSecurities Rulemaking Board Rule G-37,adopted in 1994, which addressed pay toplay practices in the municipal securitiesmarkets. Rule G-37 prohibits a broker-dealer from engaging in municipalsecurities business with a municipalissuer for two years after the broker orcertain of its employees make a politicalcontribution to an elected official of themunicipality who can influence theselection of the broker-dealer. AnotherMSRB rule prohibits broker-dealersfrom using consultants to solicitgovernment clients.

In 1999, the SEC turned its attentionto pay to play practices in theinvestment advisory business, but theproposal was met with stiff resistance

and was never adopted. The SEC’s interest in pay to play was

renewed recently following allegations ofpay to play practices in New York, NewMexico, Illinois, Ohio, Connecticut andFlorida. In addition to enforcementactions by the states and the SEC,several states have moved forward withnew regulations to combat pay to playpractices including, among others, anexecutive order issued by the New YorkState Comptroller mirroring theproposed SEC rule, a pension reform billbanning the use of placement agents inIllinois and increased disclosurerequirements for placement agents inConnecticut and California.

The SEC’s Rationale for Action on Pay to PlayThe regulation of state and localcampaign contributions would notnecessarily seem to be within theexpertise of the SEC, the federalagency charged with overseeing thesecurities markets and securitiesprofessionals. Nevertheless, inproposing the Rule, the SEC statedthat pay to play practices implicate thefiduciary duties that are at the core ofthe Advisers Act. According to theSEC, obtaining business orinvestments through pay to play “candistort the process by whichinvestment advisers are selected andcan harm advisers’ public pension planclients, and the pension planbeneficiaries, which may receiveinferior advisory services and payhigher fees.”

The Scope of the RuleThe Proposed Rule would prohibitinvestment advisers from acceptingcompensation for providing advisoryservices to a state or local government

client for two years after the adviser orone of its “covered associates” makes acontribution to certain elected officialsor candidates (the “Two-Year Bar”). Inaddition to the Two-Year Bar, an adviserand its “covered associates” would alsobe prohibited from coordinating orsoliciting any contribution or paymentto an official of a government entity towhich the investment adviser isproviding or seeking to provideinvestment advisory services (as well asto a political party of a state or localitywhere such government entity exists).

The manager of a private fund inwhich a government entity invests wouldbe treated as though the manager wasproviding investment advisory servicesdirectly to the government entity. Thus,the manager could not accept

The End of Pay to Play? (cont. from page 1)

... [T]he SEC is

considering the over 200

comments that have been

submitted in response to

the Proposed Rule.

While most of the

comments have been

critical, given that pay to

play stories continue to

appear in the press, it

should not surprise

anyone if the SEC adopts

the Proposed Rule, or

something very similar

to it, this time around.


compensation (management fees, carriedinterest and other compensation)attributable to the investment of thegovernment client.

As noted below, the broad anduncertain scope of the proposed rulemay well result in a severe cutback inroutine political contributions by privateequity professionals to candidates forstate and local office.

Contributions, Officials and Covered AssociatesAs is the case with any SEC rule, thedevil is not so much in the details but inthe definitions. The scope of thedefinitions are particularly importantand sensitive in the case of the ProposedRule due to the possible effects onconstitutionally protected politicalspeech. In this case, there are threedefinitions that deserve particularscrutiny: “contribution,” “official” and“covered associate.”

What Is a Contribution?The term “contribution,” while broad, isfairly straightforward. A contribution isany gift, subscription, loan, advance, ordeposit of money or anything of valuemade for: (1) the purpose of influencingany election for federal, state or local office;

(2) payment of debt incurred in connectionwith any such election; or (3) transition or

inaugural expenses of the successfulcandidate for state or local office.

The Proposed Rule includes twoexceptions for contributions of $250 orless. First, there is an exception forcontributions of $250 or less made tothe official for whom the contributor isentitled to vote. Second, the ProposedRule also provides a less helpfulexception with respect to contributionsmade by a covered associate to officialsother than those for whom the coveredassociate was entitled to vote. There areseveral conditions to this exception,including: (1) the contributions by thecovered associate must be $250 or less inthe aggregate; (2) the adviser must havediscovered the contribution by thecovered associate within four months ofthe date of the contribution; and (3) theadviser must cause the contribution tobe returned to the covered associatewithin 60 days of learning of thecontribution.

Who Is an Official?In order to trigger the rule’s prohibition,the contribution must be made to an“official” who is (or who has theauthority to appoint any person who is)directly or indirectly responsible for theselection of an adviser or who caninfluence the outcome of the selectionprocess.

The definition of which officials ofthe state or local governments arecovered presents a number of challenges.First, the term is not limited toincumbents, nor is it limited tocandidates for the office that make theinvestment adviser selection. Acandidate for the U.S. House ofRepresentatives who will not, if he orshe wins, be in a position to select theinvestment adviser, would nonetheless bean official if he or she is currently in a

position to influence the selection ofinvestment advisers. Furthermore, acontribution to a candidate who doesnot get elected would still trigger theTwo-Year Bar. Interestingly, agovernment employee who does nothold elective office, but may be in aposition to select or influence theselection of an investment adviser, wouldnot be an official unless he or she isseeking an elective office that would puthim or her in a position to influence theselection process.

The subjective judgments inherent inthe definition of an “official” furtherexpand the potential application of theProposed Rule. In particular, it isdifficult to see how an adviser canidentify with confidence each personwho is “indirectly” responsible for, orwho “can influence the outcome of ” theselection of an investment adviser.

Who Is a Covered Associate?The expansive definition of “coveredassociates” also contains traps for theunwary. A political contribution by anyof the following persons (or a PACcontrolled by them) will trigger the Two-Year Bar:

l the adviser’s general partners or

managing members, the president andany vice president in charge of aprincipal business unit, division orfunction;

l any executive officer who inconnection with his or her regularduties performs, or supervises anyperson who performs, investmentadvisory services;

l any executive officer who inconnection with his or her regularduties solicits, or supervises any



As is the case with any

SEC rule, the devil is not

so much in the details but

in the definitions. ... In

this case ... “contribution,”

“official” and “covered

associate.”



person who solicits, investmentadvisory business; and

l any employee who solicits a state orlocal government.

While the SEC stated in theproposing release that this definitionwould not include a comptroller, head ofhuman resources or director ofinformation services, it would include,for example, an executive officer whoperforms advisory services for one fundand contributes to an official of agovernment entity invested in anotherfund managed by the investment adviser.Donations by third parties includingattorneys, family members, friends orcompanies affiliated with the adviser arenot specifically included in thedefinition of “covered associate” butwould also trigger the Two-Year Bar ifthey are really indirect donations by a“covered associate.”

Further traps are created by temporalvagaries associated with one’s status as a“covered associate.” Suppose anemployee makes a contribution and issubsequently promoted to a position inwhich he or she is a covered associate —does the political contribution triggerthe Two-Year Bar? The Proposed Rule isclear that it would. Furthermore, theTwo-Year Bar would continue even if acovered associate who made a donationleaves the firm or moves to anotherposition where he or she is not a coveredassociate.

The Two-Year Bar would also apply ifthe advisory firm hires a person into acovered associate position who made acontribution prior to being hired. Thus,potential outside hires may be effectivelydisqualified from consideration due totheir prior political contributions, eventhough those contributions wereperfectly legal when made. This could

lead to awkward politically-orientedquestions during the hiring process of anew covered associate. It may also makebusiness school students interested inpositions in private equity and otherinvestment advisory firms think thricebefore making political contributions tocandidates.

GrandfatheringIt should be noted, however, thatcontributions made prior to the effectivedate of the Proposed Rule are“grandfathered” and thus will not triggerthe Two-Year Bar. Contributions madeafter the effective date of the rule toofficials of existing governmental clients,however, would not be “grandfathered.”

The Two-Year Bar and Its ConsequencesIf the adviser or its employees make aninappropriate contribution, the adviser isnot prohibited from providing advice,only from receiving compensation forsuch advice. In fact, the SEC assumesthat the adviser would be required toprovide uncompensated advisory servicesfor a reasonable period of time until theclient retains a new adviser. Due to theexpansive definition of “compensation”under the Advisers Act, the types ofbanned compensation would includemanagement fees, carry and any form ofeconomic or other benefits receiveddirectly or indirectly by the adviser forproviding investment advice with respectto the government entity in question.Reimbursement for overhead and othercosts would also be consideredcompensation.

The Two-Year Ban could causeparticular issues for private equity fundsbecause investor withdrawals are oftennot permitted or impracticable. Thereare simple fairness issues, of course, thatmay also have fiduciary implications.

For example, why should a governmententity get services free that otherinvestors have to pay for? Also, whoultimately pays for the uncompensatedadvice, the adviser or the other investors?The impact of providing uncompensatedadvice could also trigger “most favorednation” agreements. One suggestionthat has been made to the SEC incomment letters is that a fund adviser, ifit is faced with the Two-Year Bar, shouldbe permitted to return to the fund thefees that are attributable to thegovernment entity. This seems like anunsatisfactory result, at best.

The Two-Year Bar will be the sameregardless of the severity of theinfraction. In addition to the possibility

The Two-Year Bar would

also apply if the advisory

firm hires a person into a

covered associate position

who made a contribution

prior to being hired.

Thus, potential outside

hires may be effectively

disqualified from

consideration due to their

prior political

contributions, even

though those

contributions were

perfectly legal when

made.




of returning certain contributions asdiscussed above, the Proposed Ruleprovides that the SEC may grant theadviser an exemption if it concludes theimposition of the prohibitions isunnecessary to achieve the rule’spurpose. Each exemption would beexamined based on a facts andcircumstances approach. Along with thenature of the contribution itself(including the timing, amount, thecontributor’s status at that time, and thecontributor’s intent), the SEC will alsoconsider whether the adviser (1) hasadopted and implemented policies andprocedures reasonably designed toprevent violations of the Proposed Rule;(2) had no actual prior knowledge of thecontribution; and (3) after learning ofthe contribution, has taken all availableremedial or preventive measures as maybe appropriate under the circumstancesincluding the return of the contribution.

ConclusionAt this writing, the SEC is consideringthe over 200 comments that have beensubmitted in response to the Proposed

Rule. While most of the comments havebeen critical, given that pay to playstories continue to appear in the press, itshould not surprise anyone if the SECadopts the Proposed Rule, or somethingvery similar to it, this time around.

Given the complexities of the ProposedRule, as well as the state rules governingpay to play, there may be a naturalinclination for a firm simply to prohibitemployees from making politicalcontributions to candidates for state andlocal office altogether. Unfortunately,such a policy may not be sufficient, since,for example, a contribution to a candidatefor federal office may trigger the Two-YearBar if the candidate is currently a state orlocal “official.” For these reasons,developing a sufficiently comprehensiveand up-to-date list of candidates andofficials to whom contributions areprohibited may be the most cumbersome,and potentially costly, task for sponsors,even in circumstances where a sponsorimposes an outright ban on contributionsto candidates for state and local office.

In all events, we believe private fund

managers should resist the temptation towait until after the Proposed Rule isfinalized to adopt or revisit their existingpolicies relating to political contributions.Some states and localities are ahead ofthe SEC in adopting anti-pay to playrules that mirror the SEC approach. Ata minimum, a private fund manager thatis soliciting an investment by state orlocal entity should determine whetherthat jurisdiction has anti-pay to playrules and assure that its employees havenot made any political contributionsthat may be problematic under thoserules.

We will update this article to reflectthe definitive SEC rule in this area onceand if it is adopted.

Kenneth J. [email protected]

Gregory T. Larkin [email protected]

Lookingfor a past

article?

A complete article index, along with

all past issues of the Debevoise & Plimpton

Private Equity Report, is available in the

“publications” section of the firm’s website,

www.debevoise.com.

debevoise & plimpton private equity report

Documents