debevoise & plimpton private equity report/media/files/insights... · 3 rewinding the clock:...

W H AT ’ S I N S I D E

3 Rewinding the Clock: The Impact of Changes to GAAP on Leveraged Loan Covenants

5 How Green Is Your Portfolio? –Implications of the UK CarbonReduction Commitment forPrivate Equity

7 GUEST COLUMN

Shelter from the Storm: A Discussion with Calvin Renoof Arthur J. Gallagher & Co.About Management LiabilityInsurance

9 Unlocking the Purchase PriceAdjustment Puzzle

11 Convergence, Part 2: Have Strategic Buyers Begun to Replicate PE-StyleManagement EquityArrangements?

13 Recent Developments in the English RestructuringMarket May Leave MezzanineLenders Out in the Cold

15 Whipsaw Claims and Wage and Hour Suits: PotentiallyExpensive EmploymentLiabilities to Watch for in Litigation Diligence

17 Good News for SellingShareholders Worried AboutFraudulent Conveyance Risk

32 ALERT

Institutional Limited PartnersAssociation Releases PrivateEquity Principles Report ListingPrivate Equity Preferred Terms

Summer 2009 Volume 9 Number 4

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IntroductionIt should be a match made in heaven. Thebanking sector and private equity wouldseem, in at least one important respect, tobe perfect partners: the former an industrydesperate for new capital and the latterflush with capital and short of opportunitiesto deploy it. And the Federal DepositInsurance Corp. (“FDIC”), in extending toprivate equity investors in a small handfulof deals the benefit of relatively generousloss-sharing arrangements (pursuant towhich the FDIC assumes losses on aspecified level of a failed financialinstitution’s loan portfolio), has shownsome willingness to encourage this incipientromance. As a result, after the FDIC’s Julyproposed policy statement regarding privateequity investment in failed banks was

widely criticized as effectively precludingsuch investment, private equity firms waitedto see if the mounting problems in thebanking sector and their numerouscomments to the July proposal would havean effect.

The FDIC’s Final Statement of Policy onQualifications for Failed Bank Acquisitions(the “Policy Statement”), released on August26th, contained some good news for privateequity firms. The Policy Statement retreatsfrom several of the most problematicaspects of the July proposal, although itcontinues to have potentially expansivereach. The Policy Statement’s modest goodnews is coupled with the FDIC’s continuedwillingness to improve the economics for allacquirers of failed banks. In many recent

Reluctant Matchmaker: The FDIC's Policy on Failed Bank Acquisitions— Friendly Enough for Private Equity?

CONTINUED ON PAGE 27

“Which would you bank on?”

Is it just our imagination, or is the pulse of the private equitycommunity resuscitating? We certainly don’t mean to suggestthat deal activity is booming or that fundraising is back ontrack, but we (like many others in the private equity world ) seea glimmer of revival. The combination of the number of sell-side assignments, the inflows of capital to high-yield funds,limited partners’ lessened concern about potential capital callsand the private equity community’s interest in pursuingtransactions suggests that the summer doldrums may haveended early this year.

But, the environment has clearly changed. Given the pace ofregulatory action, the continued reluctance of banks to provideleverage and the constant uncertainty about valuations,understanding the legal developments and risks of privateequity investing and fundraising has never been more important.

In this issue, we highlight a number of areas where the rulesof the road have changed. On the cover, we discuss the FDIC’srecently released Final Statement of Policy on Failed BankAcquisitions and focus on both the good and bad news forprivate investors interested in investing in troubled banks orthrifts. We also tackle one of the most mind-bogglingregulations we’ve seen in a long time in our article entitled“How Green is your Portfolio — Implications of the UKCarbon Reduction Commitment for Private Equity.” In thatarticle, we caution private equity investors whose portfoliocompanies have UK operations that the UK government isserious about carbon reduction and is willing to publicize the

energy utilization of private equity organizations and theirportfolio companies on its own sort of league table.

If the recent report from the Institutional Limited PartnersAssociation is any indication, governments are not the onlyones interested in being agents for change in the private equityenvironment. In our Alert, Michael Harrell suggests that ILPA’sproposed “prefered terms” for private equity go beyond a mereLP “wishlist,” and appear to be an attempt to move the marketwith respect to key economic terms — including carriedinterest distributions, clawback reserves and calculations and feesharing — to be more LP friendly.

In our Guest Column, Calvin Reno of Arthur J. Gallagher& Co. shares his thoughts on the current market formanagement liability insurance and the issues to keep in mindwhen renewing or structuring comprehensive managementliability coverage.

Elsewhere, we highlight some issues that will impact theability to finance deals in the future, including the way inwhich changes in GAAP will impact leveraged loan covenants.We also explain that the treatment of mezzanine lenders inrecent UK restructurings may impact the future availability andterms of mezzanine financing. The UK restructuringenvironment is also the topic of one of our Alerts, and weprovide a short primer on ways in which the UK restructuringenvironment is coming to resemble the approach to U.S.bankruptcy.

The Debevoise & PlimptonPrivate Equity Report is apublication of

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

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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 KongDavid 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

If a well-drafted set of leveraged loanfinancial covenants possess the intricatelogic and precision of a Swiss timepiece,their internal mechanism is driven not by ahandcrafted or quartz movement, but bygenerally accepted accounting principles.We are sure it comes as no surprise that thegnomes responsible for crafting theseprovisions are focused on recent changes inGAAP and their impact on covenantpackages. In this credit environment,however, even the most benign tinkeringwith well-established designs for covenantpackages to adjust for reductions inheadroom brought about by changes inGAAP are apt to attract more than their fairshare of attention.

This article focuses on a number ofrecent changes in GAAP and theirimplications for leverage loan covenants,

including the application of fair valueaccounting to outstanding debtinstruments, accounting for minorityinterests, and changes in acquisition-relatedaccounting principles. The thoughtfulborrower will soon recognize that dustingoff covenants from before the credit crunchfor new transactions will not work becausenot only have the markets changed but sohas GAAP. These changes also highlight thebenefits of measuring financial covenants ina loan agreement under GAAP as in effecton the date a credit agreement was enteredinto (affectionately known as “frozenGAAP”) as opposed to GAAP as in effectfrom time to time even though this requiresa borrower to keep a separate set of bookswhich can be costly and cumbersome.

FAS 159Under FAS 159 (effective for yearsbeginning after November 15, 2007), aborrower may, when it enters into a CreditAgreement, choose to apply the fair valueoption as to that debt.2 As a result, the

value of its liability would bewritten down from time to time tothe extent the debt trades at adiscount (and subsequently writtenup if and when the debt tradesback up). This has twoconsequences. First, the write-down would create non-cashincome and the subsequent write-up would create a non-cash loss.Such income (or loss) may or maynot impact the Consolidated

EBITDA calculation depending on whetheror not Consolidated EBITDA excludesnon-cash gains or losses (in any event itmay be useful to specifically identify suchincome or loss as a Consolidated EBITDAadd-back). Second, the borrower’soutstanding debt (i.e. the denominator ofthe leverage ratio) would be reduced to theextent debt trades at a discount, whichwould result in a boost to its leverage ratio.This would provide a benefit for borrowerswhose debt trades at a discount. That beingsaid, the FAS 159 option is irrevocable, andsubsequent adjustments to the value of thedebt if and when it trades back up wouldimpact both the financial covenants and theearnings per share of the borrower in therelevant periods.3 Borrowers may not likethe resulting volatility.

Lenders who do not want theirborrowers to take advantage of this optionwould need to provide in the relevantCredit Agreement that financial covenantswill be calculated in accordance with GAAPwithout giving effect to any election underFAS 159. It remains to be seen whether ornot such a provision will become marketpractice.

FAS 160 FAS 160 (effective for fiscal years, andinterim periods within those fiscal years,beginning on or after December 15, 2008)changes the method for reporting the shareof the net income (or loss) of a borrower’s

Debevoise & Plimpton Private Equity Report l Summer 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

Rewinding the Clock:The Impact of Changes to GAAP on Leveraged Loan Covenants1

In our last issue, the Guest Column focused on the new M&A accounting standards and their impact on private equity transactions. In thisarticle, we focus on how recent changes to generally accepted accounting principles affect acquisition loan agreements.

1 The author would like to thank Jillian Griffithsand Jason Waldie from PricewaterhouseCoopers fortheir helpful comments and suggestions on earlierdrafts of this article.

2 Credit Agreements existing at the timeFAS 159 came into effect were subject totransition rules that permitted borrowers aone-time option to apply fair valueaccounting to such agreements.

3 FAS 159 also requires that debt issuance costs beexpensed immediately as opposed to being recorded asa deferred charge and amortized over time. Becausethis would be an interest expense, it does not impactConsolidated EBITDA but it impacts reportedearnings.

l Debevoise & Plimpton Private Equity Report l Summer 2009

less than wholly owned but consolidatedsubsidiaries that is attributable to third-party interests in such subsidiaries (i.e.“minority interests”).

Prior to the entry into effect of FAS160, the “consolidated net income” of aborrower was a number determined afterdeducting the net income (or adding thenet loss) attributable to minority interests.Credit Agreements often added backminority interest expenses for the purposeof calculating the borrower’s ConsolidatedEBITDA on the theory that income fromconsolidated but less than wholly-ownedsubsidiaries was available to service thedebt of the borrower.

Under FAS 160, the share ofconsolidated income (or loss) attributableto minority interests will now be reportedas “net income (or loss) attributable to

non-controlling interests in less-than-wholly owned subsidiaries” on theconsolidated income statement of aborrower. More importantly, borrowerswill now report two measures of theirconsolidated net income. The firstconsolidated net income numberrepresents the entire net income of theconsolidated group including the portionof such income attributable to minorityinterests in controlled but less than whollyowned subsidiaries. The financialstatements are then required to separatelyidentify the net income (or loss)attributable to the parent company andthe net income (or loss) attributable tonon-controlling interests in less-than-wholly owned subsidiaries.

Because borrowers will now report twomeasures of their consolidated net income,borrowers and their lenders may want tobe specific as to whether the term“consolidated net income” used in thefinancial covenants refers to a number that(1) includes net income or lossattributable to non-controlling interests inless-than-wholly owned subsidiaries or (2)only includes the net income or lossattributable to the parent company (as wasthe case before FAS 160). If a CreditAgreement follows the first approach, it isno longer necessary (or appropriate) toadd back “net income attributable to non-controlling interests in less-than-whollyowned subsidiaries” for purposes ofcalculating Consolidated EBITDA.

FAS 141RLike FAS 160, FAS 141R is effective forfiscal years, and interim periods withinthose fiscal years, beginning on or afterDecember 15, 2008. It applies to alltransactions or other events in which anentity obtains control of one or morebusinesses. Below is an overview of someof the new FAS 141R accounting rulesthat are relevant to the calculation of

financial covenants.

Acquisition-Related Costs and Deal Expenses Under FAS 141R, most M&A deal-relatedcosts and expenses, including legal,banking, accounting due diligence andother advisory fees (such as the deal feepaid to a private equity sponsor at theclosing of a transaction) will be expensedas incurred. This is a change from theprevious rules which permitted many ofthose costs and expenses to be capitalized.The fact that more costs are required to beexpensed will reduce the Borrower’s“consolidated net income” and hence itsConsolidated EBITDA, unless M&Adeal-related costs and expenses arespecifically added back to “consolidatednet income” for purposes of calculatingConsolidated EBITDA. While such anadd-back was not uncommon under theprevious rule for those costs and expensesthat borrowers were not permitted tocapitalize, FAS 141R creates additionalpressure to make sure the add-back iscomplete, especially if it is subject to acap. In addition, in Credit Agreementsentered into to finance a specificacquisition, the parties will need todetermine whether the add-back is limitedto the costs and expenses of theacquisition so financed or also applies tothe costs and expenses of any futurepermitted acquisition.

Restructuring CostsUnder FAS 141R, subject to variouslimitations, restructuring costs generallywill be expensed when and as incurred,i.e., potentially over several reportingperiods. This is a change from theprevious rules which permitted anacquirer to capitalize certain restructuringcosts and accrue a liability on the closingdate for other anticipated restructuring

Rewinding the Clock (cont. from page 3)


Under FAS 141R, most

M&A deal-related costs

and expenses, including

legal, banking, accounting

due diligence and other

advisory fees (such as the

deal fee paid to a private

equity sponsor at the

closing of a transaction)

will be expensed as

incurred. This is a change

from the previous rules

which permitted many of

those costs and expenses

to be capitalized.


How Green Is Your Portfolio? —Implications of the UK Carbon Reduction Commitment for Private EquityAs the U.S. Congress considers whether topass legislation curbing emissions of carbondioxide and other greenhouse gases linkedto global climate change, the UK’s Labourgovernment has already made its positionclear with proposed emissions legislationthat, if adopted in its current form, willhave broad and potentially costlyconsequences for private equity funds andtheir general partners and investmentmanagers.

Two of the most controversial features ofthe legislation – its imposition of group-level liability and its extra-territorial reach— will be of particular concern to privateequity sponsors, as will its price tag,estimated at £830 million for the privateequity industry in its initial year. First, oneor more UK companies controlled by acommon parent, will be grouped togetherunder the scheme with their parententity(ies) and treated as a singleorganization with primary responsibility forcompliance by each member of theorganization resting with the ultimateparent. Second, the ultimate parent willbear such responsibility even when it is notlocated in the UK. The result: privateequity funds organized outside of the UKand potentially their general partners andmanagers will have direct responsibility –and potential civil and criminal liability –for compliance with the legislation by theirUK portfolio companies.

The legislative scheme, known as the“Carbon Reduction Commitment” or“CRC,” regulates large non-energy intensivebusinesses and public sector organizationsand is scheduled to come into effect onApril 1, 2010. The third round of publicconsultation on the CRC Order wascompleted in June of this year, with

comments and responses on the draftlegislation received on or before June 4.These responses will be considered by thegovernment, which intends to publish aresponse to the consultation and publish anupdated version of the CRC Order. Therevised CRC Order will then be sent toParliament for approval, and will bedebated and if necessary amended beforebecoming law.

While private equity and other affectedindustry trade associations have beenlobbying hard to give the legislation a moreindustry friendly caste – in the case ofprivate equity, to cut off its applicationabove the portfolio company level – so farthere has been little indication of receptivityto these efforts.

How Will It Work? The CRC will apply to indirect CO2emissions attributable to the generation ofgrid electricity and direct CO2 emissionsfrom supplied gas and fuels used byparticipants in the UK There are two keyelements of the CRC Order – arequirement to obtain CO2 emission“allowances” and an end-of-year rankingand bonus/penalty scheme.

First, the CRC Order will create a “capand trade” emissions trading scheme inrespect of such CO2 emissions, pursuant towhich participants will purchase“allowances” at the beginning of each year(one “allowance” representing the right toemit one ton of CO2) and, at the end ofthat year, each participant will be requiredto surrender allowances equal to theamount of CO2 emitted by thatorganization during that year.

During the introductory phase of theCRC (from April 2010 to March 2013)allowances will be sold by the government

at a fixed price, expected to be £12 perallowance, with the first sale taking place inApril 2011. The government will sell anunlimited number of allowances during thisphase and trading in allowances will not bepermitted. After March 2013, the numberof allowances available for sale will becapped by the government and sold atannual auctions, with purchased allowancesbeing freely tradable by participatingorganizations.

Second, at the end of each reportingyear, a “performance league table” will beproduced, ranking each participant basedon the emissions reduction performance ofall companies in their organization asdescribed below. The rankings are done forall participants in the CRC and are notsegregated by industry. Bonuses or penalties

CONTINUED ON PAGE 6

While private equity and

other affected industry

trade associations have

been lobbying hard to

give the legislation a more

industry friendly caste –

in the case of private

equity, to cut off its

application above the

portfolio company level –

so far there has been little

indication of receptivity

to these efforts.


will be paid to or incurred by eachparticipant relative to their league tableposition. And, of course, no company willwant to find itself at the top of thepenalty table, which there are indicationsis intended to be used to embarrassparticipants into better performance. Incalculating performance, the UKEnvironment Agency (the “EA”) will notonly look at whether a participant has

reduced its absolute emissions from theprevious period, but will also take intoaccount a participant’s growth over theyear (and hence its generation of higheremissions) by looking at the relativeintensity of its emissions. These metricsare fairly complex and beyond the scopeof this article.

The CRC Order will empower the EAto censor publicly and impose fines onorganizations that fail to comply with theCRC. The draft CRC Order also includescriminal offenses (punishable byimprisonment for up to three years or anunlimited fine) for knowingly or recklesslyproviding false information, forattempting to mislead or deceive the CRCadministrators or for failing to comply orco-operate with enforcement actions.

Which Organizations Will the CRC Effect?A UK organization will be required toparticipate in the CRC if it consumedover 6,000 megawatt (“MWh”) hours ofelectricity from at least one half hourlymeter (a type of electricity metercommonly used by UK businesses) withinthe UK during the relevant “qualifyingperiod,” the first such period being fromJanuary 1, 2008 to December 31, 2008.This roughly equates to an annualelectricity bill of $850,000. Groups ofcompanies will be treated as oneorganization, with aggregate electricity usebeing taken into account when applyingthe above test.

According to the CRC Order, theultimate parent organization of acorporate group will be primarilyresponsible for its UK subsidiaries andwill be required to participate in the CRCon behalf of the group, regardless of itslocation or legal form, even when it is aforeign general or limited partnership.Where a parent organization is based

outside of the UK, it will be required tonominate one of its UK subsidiaries or aUK agent to act as “primary member”that will be primarily responsible forcompliance on behalf of the group.

The CRC Order imposes joint andseveral liability on the ultimate parent, therelevant UK organizations and anyintermediate holding entities, even if suchultimate and intermediate parent entitiesare not located in the UK. The purportedextraterritorial application of the CRCOrder has attracted objections andquestions about its ultimate enforceabilityin many quarters, not dissimilar from theresponse of many overseas companies tobroad assertions of extraterritorialjurisdiction by U.S. regulatory authoritiesin the securities and other areas. But as apractical matter, the EA would be morelikely in the first instance to initiateenforcement proceedings against thenominated UK primary member, andthen against the UK-based operations,even though the ultimate non UK parentundertaking would be the “participant”for the purposes of the CRC.

Groups will be determined based ontheir structure as at the end of the relevantqualifying period. The CRC Order adoptsthe definitions of “parent undertaking”and “subsidiary undertaking” set out inthe UK Companies Act 2006 in order toidentify the ultimate parent organization.An ultimate parent organization willtherefore be responsible for any UKcompany, partnership or unincorporatedassociation:

(1) in which it (directly or indirectly)holds or controls a majority of thevoting rights;

(2) of which it (or any of its subsidiariesor any person acting on its behalf ) is amember and has a right to appoint or

How Green is Your Portfolio? (cont. from page 5)


According to the CRC

Order, the ultimate parent

organization of a corporate

group will be primarily

responsible for its UK

subsidiaries and will be

required to participate in

the CRC on behalf of the

group, regardless of its

location or legal form, even

when it is a foreign general

or limited partnership.

...The CRC Order imposes

joint and several liability

on the ultimate parent, the

relevant UK organizations

and any intermediate

holding entities, even if

such ultimate and

intermediate parent entities

are not located in the UK.


Shelter from the Storm: A Discussion with Calvin Reno of Arthur J. Gallagher & Co.About Management Liability Insurance

G U E S T C O L U M N

People often get confused about the differencesbetween directors and officers insurance(“D&O”) and fund liability policies such asgeneral partners liability insurance (“GPL”).What are the basic features?

D&O coverage is much narrower thanGPL coverage. Portfolio companiespurchase D&O policies which coverindividuals solely in their capacity as adirector or officer of the portfolio company.GPL policies are purchased by fundmanagers. They provide coverage at theportfolio company level like D&O policies,but also cover private equity professionals intheir capacity as a director, officer ormanager of the other entities within theprivate equity fund complex, includinggeneral partners, investment managers, andother intermediate group companies. BothD&O and GPL policies cover liabilitiessuch as breach of fiduciary duty, securitiesclaims, and regulatory investigations.However, GPL polices can be furtherbroadened to cover liabilities arising out offailure to provide professional services,

controlling person liability, sellingshareholder liability, and fundmismanagement.

Ideally, the D&O and GPL policywording should be coordinated to provideseamless coverage for the broad range ofexposures a principal or manager may face.Because D&O and GPL policies typicallyprovide overlapping coverage at theportfolio company level for private equityprofessionals who sit on portfolio companyboards, it is important to structure thepolicies so that the portfolio companyD&O coverage pays first and must beexhausted before payment is required underthe GPL policy. This keeps powder dryunder the GPL policy to cover claims at thefund level.

When thinking about purchasing D&O andGPL coverage what are the biggest issuesmanagement should be concerned with?

Management should focus onindemnification, scope and quality ofcoverage, and the quality of their insurer.

An individual’s primary source ofprotection is indemnification. There shouldbe a written arrangement with the relevantentity to defend and indemnify thatindividual in an investigation or lawsuit.The biggest mistake management makes isfocusing on insurance first andindemnification second. Managers anddirectors can find themselves without a

right of recovery either under theirindemnification arrangements or against theinsurer because the company’sindemnification obligation is unclear. Thisoften occurs in those non-U.S. jurisdictionswhere the law relating to indemnification isundeveloped. Also, individuals may findtheir recovery is limited because the relevantentity lacked assets adequate to fund itsindemnification obligations. For a variety ofreasons, it may be difficult to use insurance

1 For more information on the interaction betweenmanagement liability insurance coverage andindemnification, see “Best Planning for the Worst:Assuring Insurance Coverage for Private EquitySponsors and Portfolio Company Directors inBankruptcy” in the Fall 2008 issue and “D&OLiability, Portfolio Company Directors and OfficersMay Need Separate Indeminification Agreements” inthe Summer 2008 issue of The Debevoise &Plimpton Private Equity Report.

Private equity professionals and directors and officers of portfolio companies may face increased litigation and regulatory risk in the currenteconomic environment and should expect difficult negotiations on their next renewal in an insurance market that has been roiled by thefinancial crisis. To help our readers navigate the insurance landscape, on August 20th, 2009, Calvin C. Reno, Global Managing Director ofthe Management Liability Division of Arthur J. Gallagher & Co., sat down with Heidi Lawson to share his insights on the current insurancemarket, claims trends, renewal strategies, and issues to consider in structuring comprehensive management liability insurance.1

Both D&O and GPL

policies cover liabilities

such as breach of fiduciary

duty, securities claims, and

regulatory investigations.

However, GPL polices can

be further broadened to

cover liabilities arising out

of failure to provide

professional services,

controlling person liability,

selling shareholder liability,

and fund mismanagement.

CONTINUED ON PAGE 8


to fill gaps created by unclear or inadequateindemnification, particularly outside of theU.S., where Side A coverage (discussedbelow) may be difficult or impossible toobtain. Private equity managers should seekand encourage portfolio companymanagement to seek counsel’s advice to besure there aren’t any unpleasant coveragetraps lurking in discontinuities betweentheir indemni-fication and insurancearrangements.

Scope and quality of coverage areextremely important and can be easilyoverlooked. All D&O and GPL policies arenot the same — either in form or content.Every insurance carrier has its own policy

form with its own set of terms and conditions.Companies and funds are structured in avariety of different ways and these variationsare seldom addressed by a particularinsurer’s standard form language. Therefore,each policy must be negotiated and tailoredto cover an insured’s specific exposures.

Finally, if your carrier is unable orunwilling to pay a claim your insurancebecomes worthless. Over the past yearseveral carriers have dramatically changedtheir underwriting guidelines by reducinglimits, altering terms, or completely leavingthe D&O and GPL market. The carrieryou choose must be well capitalized,committed to writing D&O and GPLpolicies in good and bad markets, andexperienced in paying claims.

Does a global D&O or GPL policy providecoverage for all international entities?

D&O and GPL policies are usually writtento cover claims on a worldwide basis;however, laws often prohibit foreign insurersfrom covering individuals or assets locatedwithin a particular country. For example,under Russian law a non-Russian insurercannot cover individuals or assets locatedwithin Russia. D&O and GPL coveragemust be provided by a Russian insurer.There are a long list of countries that havesimilar laws, including Brazil, China, andMexico. A thorough review of a company’soperations and locations is necessary toassess the need for separate D&O or GPLpolicies in such countries. The wording ofthese “local policies” should be coordinatedwith the global D&O or GPL policy toprovide seamless coverage in a cross-borderinvestigation or litigation. Because the legalissues are complex when assessing andcovering international exposures, we usuallyrecommend that our clients get legal adviceto make sure coverage is appropriate.

What is benchmarking and how is itbeneficial?

Brokers use benchmarking to comparecertain features of an insurance policy(coverage amount or type) to what isperceived to be the industry standard. Westart with information from two dataproviders, Advisen and Tillinghast. Then,we factor in the experience of our ownclients; apply certain proprietary lossmodels, and consider additionalinformation provided to us by insurancecarriers. Because it is very hard to find twoprivate equity firms that have similarexposures, the benchmarking data availableis limited and weak. As a result, I go a stepfurther and spend a considerable amount oftime conducting a detailed risk assessmentof the management liability exposure andprovide further insight regarding coverageamount and type. This kind of detailedreview provides an opportunity for privateequity managers to participate in the riskanalysis and, as a result, make a betterdecision on amount and type of coverage.

In light of the current economic environment,have you seen an increase in the number ofclaims? In what areas of liability are thoseclaims?

The number of claims has been steadilyincreasing over the past year. The tighteningof the credit markets and growing inabilityof firms to fund their operations andportfolio companies have led to an increasein the number of bankruptcy-related claims.In addition, we are seeing more deal-relatedclaims from failed transactions and claimsagainst fund managers relating to poorperformance of funds.

Have you identified any changes in capacityand premiums within the current market?The number of insurers willing to writeD&O and GPL coverage and the amountof capacity they are willing to devote to thisline of business has remained relativelystable over the past year as new entrants or

Shelter from the Storm (cont. from page 7)

The number of insurers

willing to write D&O and

GPL coverage and the

amount of capacity they are

willing to devote to this line

of business has remained

relatively stable over the

past year....However, there

have been substantial

premium increases.

Premium increases range

from 0% to 45%,

depending on the risk. We

estimate that premiums are

increasing an average of

20% and expect this will

continue for at least the

next twelve months.


Purchase price adjustments — typicallybased on some variant of net workingcapital — are de rigeur in acquisitionagreements for private companies andcorporate carveouts. Buyers want them topolice leakage if the target is notcompletely sealed off and to avoid“surprise” needs to “prime the pump” orotherwise furnish cash so the business cangenerate the anticipated cash flow. Sellersoften want them as well, either so they canassure themselves of the benefit ofoperations prior to closing or to extractvalue from various financing opportunitiesinherent in the business’s current assetsand liabilities. In addition, suchadjustments provide a handy mechanismfor allocating a number of more specificeconomic items — transactions costs, staybonuses and various tax benefits.

But purchase price adjustments arenasty, intricate things with lots of traps forthe unwary and many opportunities forshifting value. These provisions merit earlyand systematic attention and have asurprising ability to puzzle even veterannegotiators. In this article we review thebasics of purchase price adjustments andthen look at how two specific andcommon fact patterns fare in purchaseprice adjustment negotiations.

The BasicsAt first blush, a working capitaladjustment is a simple drafting andaccounting exercise — determine theamount by which the sum of current assets(typically excluding cash) minus currentliabilities is greater or less than a target,and adjust the purchase price accordingly.Sometimes adjustment provisions startwith an estimate of the adjustment atclosing to get the numbers pretty closewhen payments are first made and then

true up post-closing. Other times, theyjust do it all post-closing.

But there’s a lot going on under thehood. And buyers and sellers are likely tohave pretty different perspectives on allthat activity. The seller likely wants tokeep the exercise as mechanical as possible— its goal is simply to compare closingdate net working capital to the targetusing exactly the same measurementmechanics and metrics. The buyer,however is usually pleased to have a littlewiggle room — an opportunity tochallenge accounting practices, claiminventory reserves are too low, and argueabout revenue recognition. That disparityof views typically leads to a fairly spiritednegotiation of provisions through whichthe seller seeks to protect itself, forexample by tethering the adjustment tospecific accounting rules or includinglanguage allowing for a readjustment ofthe target if it wants to add new liabilitiesor actuarial techniques. In essence, theseller wants to make this a “counting”exercise while the buyer is quite content tolet it evolve into an “accounting” exercise.

In addition, there are a surprisingnumber of drafting quirks and pitfalls —how to dovetail the adjustment provisionswith any indemnification arrangements inthe deal; how to specify the exact momentat which working capital is measured so itcaptures those aspects of the transaction itis intended to capture and no more; howto narrow and streamline the scope of theinevitable arbitration mechanism; how todeal with disagreements over the pre-closing estimate; and many more.

Two Perennial ProblemsTwo common issues illustrate the power ofworking capital adjustments as well as theneed to assess and frame the issues early in

a negotiation. The first concerns accruedtaxes and stems from the mildlyremarkable fact that our tax colleagueshave persuaded the world that under nocircumstances should buyers be responsiblefor income-based taxes attributable to thepre-closing period. Because we generallyapproach deals with that in mind, we havean urge to strip accrued taxes out of theworking capital adjustment — but whatexactly does that mean? Clearly it’s notenough to take account of them in settingthe target and exclude them in thedetermination of closing date workingcapital, because that just makes the buyerpay a positive purchase price increase equalto the amount of the tax accrual in thetarget working capital number. Therefore,the argument goes, accrued taxes shouldbe taken out of the working capital targetas well.

But why? If the company accrues $10million of taxes per quarter and paysestimates quarterly that means it has anaverage “float” or free financing for taxesof $5 million. If the goal of the purchaseprice adjustment is to determine thecompany’s average or normative workingcapital needs, why shouldn’t that financingopportunity be taken into account? Whatis it about the fact that it happens to be atax liability that leads to a different result?

This is a pretty common debate, andone that can be expanded to otherliabilities and to quirkier working capitalissues (for example, if the working capitaltarget for some negotiated reason includesprojected growth in accounts receivable,there is a strong argument that a taxprovision should also be included in thedetermination for that target). There are anumber of ways of thinking about and


Unlocking the Purchase Price Adjustment Puzzle



negotiating these “tax target” type issuesand all of them benefit from an earlyeffort to see if this will be a significantissue in the deal in question and, if so, tocharacterize and structure the debate in away that increases the likelihood ofprevailing.

The second example arises frequentlyin the purchase of businesses (such asinvestment management or personalservices businesses) that defer until theend of the year a substantial amount oftheir compensation expense — usually inthe form of bonuses. In such a situation,the seller might well structure thetransaction using for target workingcapital the amount at December 31,which, let’s assume, would include as aliability the prior year’s $100 million inbonuses. Assuming a debt-free/cash-freestructure and a closing date at the end ofthe first quarter, the buyer could wellfind itself faced with a $75 millionpurchase price increase because of thepositive working capital adjustment (theprior year’s bonus will have been paidand the accrual for the current yearwould only be $25 million).

The buyer’s first reaction is likely tobe that it should not have to pay, directlyor indirectly, any amount in respect ofpre-closing bonus accruals and that theaccruals should be yanked out of thetarget balance sheet to achieve this result(sounds a little like the tax argument).The theory would typically be that thesebonuses related to earnings on the seller’swatch from which the seller benefited.While that is all true, just about everyliability on the closing or the targetbalance sheet relates to earnings on theseller’s watch and therefore this argumentcan be tough sledding. Moreover, theseller forcefully makes the contraryargument, which is that the free

financing inherent in the bonusarrangement is an immutablecharacteristic of the current asset andliability cycle of the business and is aserious asset that reduces the cashrequired to generate earnings.

A second way to discuss the issue isnot to argue about inclusion of thebonus liability from the start, but ratherto assert that that accrual should beincluded at an average level rather than atthat its maximum, December 31 level.This, in our experience, is a notuncommon way of equilibrating workingcapital issues (and on our facts wouldreduce the upward purchase priceadjustment to $25 million). It effectivelyconcedes the seller’s logical point butasserts that the value of the financingopportunity is the average balance, notthe minimum balance (which certainlydoes seem more nearly right).

It’s worth noting that there really isnot a right or wrong answer to the bonusquestion — it just depends on where yousit. Seller is saying “you are buying abusiness that allows you to pay last year’sbonus out of next year’s income — allyou need to do is draw down yourrevolver at bonus time and then pay itback the next year. That is what I havealways done and it is what you will dopost-closing.” And buyer is saying thereverse: “you got the earnings, youshould pay your bonuses and I will paymine” (although in reality buyer willpresumably do exactly what seller says —that is, he will draw down on his revolverto pay the purchase price, pay it back ascash flow comes in and then draw itdown again at bonus time).

Once the bonus issue has become partof the working capital debate it becomes,in our experience, difficult to extract itfrom that debate, and splitting the

difference through some form of averageworking capital target becomesirresistible. A buyer determined to obtainmaximum value would therefore be well-advised from the very outset to excludebonus accruals from the entire workingcapital mechanism and insist that theyshould be treated as debt. Sometimes anearly assertion of that position willsimply carry the day without furtherexplanation. And sometimes it’s necessaryto argue either that bonus accruals justfeel more intimately related to priorearnings than other expenses, or that theability to so defer compensation may notbe an enduring feature of the businessmodel.

ConclusionA myriad of issues, many quite factspecific, should shape the parties’ viewsof the best way to structure and negotiatea particular purchase price adjustment.The side that masters those issues earlyand proposes a structure that channelsthe negotiation in a felicitous direction(from its perspective) can often extractreal value from the process. There are, inshort, many “right” answers to the issuesthat arise in the negotiation of workingcapital adjustments, but, dependingwhere you sit, some are more right thanothers.

Jeffrey J. [email protected]

Michael A. [email protected]

Unlocking the Purchase Price Adjustment Puzzle (cont. from page 9)


In the Spring 2009 edition of TheDebevoise & Plimpton Private EquityReport, we discussed the growing use bystrategic buyers of reverse termination feesand suggested that this trend could helpprivate equity bidders in auction settingsby eliminating the historical advantagestrategic buyers have had with respect todeal certainty. While not yet a trend, weare now observing some examples ofstrategic buyers utilizing another mainstayof private equity transactions instructuring their acquisitions:management equity incentives at the levelof the target (as opposed to at thestrategic buyer itself, which is the usualform of equity incentive in strategicdeals). Unlike reverse termination fees,however, the use by strategic buyers of thekind of management equity incentivesoften used by sponsors, could becompetitively disadvantageous to PE firmsby reducing the historical advantage PEsponsors have had with respect to wooingmanagement of a target with attractiveequity arrangements.

Management EquityArrangements in Private Equity DealsAs our readers know well, management ofa target in a typical private equityacquisition usually acquires or retains anequity interest in the target.Management’s equity is a “pure play” —that is, because the private equity firm isnot combining the target with a largerbusiness venture, the value of the equityrelates solely to the target’s business andassets. This structure is designed to ensurethat the target’s management has “skin inthe game” and to thereby alignmanagement’s economic interests with theinterests of the investors. To further align

management’s and investors’ interests,management equity programs are designedwith a focus on the private equity firm’sexit, usually through a private sale or apublic offering. For example, vestingconditions, including IRR hurdles,encourage an exit within the privateequity firm’s investment horizon; transferrestrictions lapse only upon an exit; andother liquidity restrictions prevent anexecutive from converting equity to cashbefore the private equity firm does so.

While management equity incentiveprograms in private equity deals differwidely, they do share some commonalities,including:

� The size of the management equitypool usually falls within a range of 5%to 15% of the equity value of theportfolio company.

� Management typically purchases thetarget’s equity with cash, by “rollingover” stock of the company that theycurrently own or with other deferredcompensation.

� Financial sponsors may also cause thetarget to help executives finance theirinvestment in the target’s equity withloans or loan guarantees especially innon-public companies.

� Target equity that is purchased (usingone of the methods mentioned above)is typically fully “vested” when it isacquired.

� In addition to the purchased equity,management may also receive equityawards, such as restricted stock or stockoptions, that are subject to vesting.Vesting for this “free” equity istypically time-based, or performance-based, or both, and varies widely

among PE firms. Common vestingschedules include vesting tied tocontinued employment for a numberof years (typically three to five years)and/or the achievement of performancegoals or the attainment of certain ratesof return to the private equity sponsorupon an exit event.

� On termination of employment priorto the PE firm’s exit, all of anexecutive’s equity is usually subject torepurchase by the company or thefinancial sponsor. The price paid onexercise of this call right usuallydepends on the reason for the

Convergence, Part 2: Have Strategic Buyers Begun to Replicate PE-Style Management Equity Arrangements?

Unlike reverse termination

fees...the use by strategic

buyers of the kind of

management equity

incentives often used by

sponsors, could be

competitively

disadvantageous to PE

firms by reducing the

historical advantage PE

sponsors have had with

respect to wooing

management of a target

with attractive equity

arrangements.



termination, with “good leavers”typically receiving more for theirequity than “bad leavers.”

Other common features ofmanagement equity incentive programsinclude transfer restrictions (withexceptions for estate planning purposesand exercises of puts and calls), anddrag-along or tag-along rights. Inaddition, management may havelimitations on voting and other rightsdepending on circumstances.

Management EquityIncentives in Strategic DealsThe types of management equityarrangements described above have notbeen customarily used in strategic dealsfor a number of reasons.

First, strategic buyers, unlike PEfirms, often do not view themselves asbuying a management team along withthe target business and often have nospecial need to retain an existing

management team. Simply put, theyoften believe they have the know-how torun the target company as well as oreven better than the target’smanagement. Thus, maintainingmanagement may not be an importantconcern of a strategic buyer.

Second, unlike private equityinvestors, who typically have aninvestment horizon of five to sevenyears, strategic buyers tend to buy targetswith the intention of owning the targetindefinitely and/or integrating the targetinto their company group. As a result, anequity package for management that ismonetized only upon a liquidity event ofthe target is of uncertain value tomanagement and can be cumbersome fora strategic buyer to structure.

Third, even in those circumstanceswhere a strategic buyer does wish toretain some or all of a managementteam, the strategic buyer often has nodesire to offer the management team a“pure play” on the target’s equity. Often,the buyer intends that the executives ofthe target provide value to the buyer’sbusiness as a whole rather than simplyincrease the equity value of the targetcompany, and its equity awards arestructured accordingly.

Fourth, strategic buyers often havecommitted credit lines and significantinternal cash or stock that they may useas currency in the deal. Strategic buyerstherefore do not need to “finance” anyportion of the deal with target equity inthe way sponsors sometimes do in orderto fill out their capital structure andreduce their equity check.

And fifth, strategic buyers have beenhesitant to accept the fiduciary dutiesand other limitations and obligationsassociated with having a minorityinvestor in one of their subsidiaries.

These can be significant and include, forexample, limitations on transactionsbetween the parent and the target(because the interests of minorityshareholders must be taken into accountby the board of the subsidiary); thornyaccounting and financing issues relatingto non-wholly owned subsidiaries; accessto target financial statements by theminority shareholders (includingfollowing their termination ofemployment); and, in some cases,dissenters’ and appraisal rights in certainexit transactions.

A Blurring of the LinesThese broad distinctions between privateequity investors and strategic buyers maybe blurring as the deal market evolves —in particular to the extent strategicbuyers’ stock prices continue to declineand their access to liquidity continues todwindle. In one recent strategic deal, forexample, the key executive of the targetcompany acquired an interest in thetarget that resembles a managementequity incentive program in a privateequity deal. The primary reasons for thisarrangement were that the executive isexpected to be vital to the continuedsuccess of the target company and he isnot expected to produce much, if any,value for the buyer (other than throughthe future success of the target).Accordingly, his compensation is linkeddirectly to his performance and thetarget’s equity value. Moreover, perhapsfamiliar with the attractive incentivesthat executives have long received fromfinancial sponsors, the executive wantedto receive a private equity-like incentivepackage.

The principal terms of thearrangement are as follows:

Convergence, Part 2 (cont. from page 11)


The... broad distinctions

between private equity

investors and strategic

buyers [regarding

management equity] may

be blurring as the deal

market evolves — in

particular to the extent

strategic buyers’ stock

prices continue to

decline and their access

to liquidity continues to

dwindle.


Mezzanine lenders are increasingly findingthemselves without a seat at the table in UKrestructuring proceedings and with no valuefor their loans at the end of the process.This trend could chill mezzanine lending inthe UK long after the credit marketsotherwise begin to thaw.

Before the economic downturn, a UKprivate equity portfolio company infinancial difficulties was often able to agreeon an informal restructuring with itslenders rather than enter formal insolvencyproceedings. With the recognition bylenders in the current cycle that much oftheir debt may be written off, even in aconsensual deal, formal processes havebecome more common in the UK. The pre-packaged administration (or “pre-pack”)and the scheme of arrangement have beenthe most controversial, with lower-rankingcreditors — both secured and unsecured —not only wiped out, but excluded from theprocess if the senior debt exceeds the valueof the company as a going concern.

Although mezzanine debt holders havebeen increasingly vocal about how pre-packs and schemes of arrangementdisadvantage them, the UK courts haveshown little sympathy, with the HighCourt’s recent and much anticipateddecision in the IMO Car Wash case dealinga further blow to mezzanine lenders.Recognizing how UK insolvency procedureswork is important to understanding themezzanine lenders’ mindset.

Pre-Packaged AdministrationIf a court grants an application foradministration of an insolvent company, itappoints an administrator (a licensedinsolvency practitioner) whose priority is torescue the company as a going concern.Only if this aim is not reasonablyachievable is the insolvency practitionerable to liquidate the company — either toachieve a better result for the company as a

whole than would be likely if the companywere wound up without going intoadministration or to dispose of property forthe benefit of one or more secured orpreferred creditors.

In a pre-packaged administration, thecourt-appointed insolvency practitionerworks with the directors and some of the

creditors of the company (typically themost senior lenders) to arrangeimplementation of a sale. The sale is oftento a new, special-purpose acquisitioncompany controlled by the senior securedlenders and former managers and othersecurity holders of the insolvent company,

Recent Developments in the English Restructuring MarketMay Leave Mezzanine Lenders Out in the Cold


Proposals for Insolvency Law ReformIn June, the UK Insolvency Service published a consultation paper which contains anumber of proposals aimed at facilitating corporate rescues and which, if adopted, willalign UK practices more closely with those used in the U.S. There are two key proposals.

The first is to extend the moratorium on enforcement of security andcommencement and continuation of proceedings which may currently be enjoyed bysmall companies under a Company Voluntary Arrangement1 to large and mediumcompanies. If extended, large and medium companies would be able to apply for either(1) an out-of-court 28-day moratorium if an insolvency practitioner will state that theCVA has a reasonable prospect of success and of being approved by 75% in value of thecreditors or (2) a three-month court sanctioned moratorium, if, in addition to thestatement from the insolvency practitioner, the company is able to satisfy the court thatit is unable to or likely to become unable to pay its debts within three months of thehearing and the moratorium is in the best interests of the creditors as a whole. Thisproposal has been received with interest by practitioners in the English market as thethree-month court sanctioned moratorium is similar to a U.S.-style debtor-in-possession proceeding. There is a concern, however, as to whether in practice the CVAprocess is compatible with the complex finance arrangements that larger companiesusually have in place.

The second proposal is to facilitate the provision of rescue finance to companies inadministration by introducing legislation to provide super-priority and security rightsto lenders of such finance and to override negative pledge clauses, thus introducing theDIP financing concept familiar in the U.S. market to England. This proposal may raiseparticular concerns among lenders in existing secured transactions whose position couldbe undermined. There has been speculation that, going forward, lenders may increasetheir pricing and adjust their risk models to recognize the uncertainty that theseproposals introduce. Sponsors, however, may embrace the proposals as it may make iteasier for them to improve their negotiating position and rescue a company as a goingconcern by providing new money which would rank ahead of the claims of the existingsecured creditors.

1 A scheme whereby a company can propose a compromise or other arrangement with its creditors and whichis implemented under the supervision of an insolvency practitioner. The arrangement is binding on creditorsif the relevant majorities vote in favor of the scheme at properly convened meetings of creditors and shareholders.


leaving the liabilities in the existingcompany. This makes a pre-pack attractiveto purchasers and those secured creditorswhose interests are above water, but veryundesirable for more junior securedcreditors and unsecured creditors.

Although not a new phenomenon, pre-packs became increasingly attractive inrecent months as creditors’ exit optionsbecame more limited, focusing a spotlighton the fairness of the process. While pre-pack proponents point to the relativespeed of the process, maintaining that thisresults in less value destruction for adistressed company than otherrestructuring alternatives, critics of thepre-pack technique make a number ofarguments:

� The value of the asset may not be fullyexploited as the pre-pack is a “donedeal” as a result of which other avenuesfor achieving value are cut off.

� Because standard intercreditorarrangements in the UK marketcontain enforcement standstills andrights for the security agent to releasesecurity, there is no transparency forsubordinated secured creditors, whocan be excluded from theadministration process and left simplywith a claim against an insolventcompany with no assets.

� Administrators do not have to obtainthe approval of the courts or the othercreditors (although the right of othercreditors to bring an action against theadministrator in certain circumstancesmeans that the administrator is likelyto obtain legal advice before agreeingto a pre-pack).

� A pre-pack to the former managers ofthe insolvent company amounts to thecreation of a “phoenix” company — anostensibly new company with the sameassets, management and, often, similarname as the former company — apractice which is prohibited underEnglish law.

In an attempt to address some of theseconcerns, a Statement of Best Practice forInsolvency Practitioners (which includesadministrators) was issued in January2009, focusing on transparency anddisclosure. Although not legally binding,an administrator may face regulatory ordisciplinary proceedings if the Statementis not followed. Essentially, the Statementrequires that the administrator maintaindetailed records which demonstrate that ithas considered the duties and obligationsowed to creditors in the pre-appointmentperiod as well as explain and justify why apre-pack was undertaken. These guidelinesare being monitored by the InsolvencyService, and the House of Commons’Business and Enterprise Committee hasindicated that if they do not prove

effective, more radical action will betaken.

An English court recently consideredthe merits of a proposed pre-pack in lightof the Statement of Best Practice and heldthat the court must consider the merits ofan intended sale in deciding whether tomake an administration order, inparticular whether the transaction is in thebest interests of the creditors as a whole.1

In two recent cases arising from theadministration of Lehman BrothersInternational (Europe)2, however, thedecisions reflected the courts’ traditionalreluctance to interfere in the conduct ofan administrator’s work or to give specialtreatment to individual creditors,suggesting that the English courts willcontinue to give significant deference toadministrators decisions in pre-packs.

Schemes of ArrangementA scheme of arrangement is anothermethod to “cram down” minoritycreditors. A scheme of arrangement can beused for many purposes under Englishcompany law, but in the context of acompany facing insolvency, it is acompromise between a company and itsmembers or creditors (or any class ofthem) for the purpose of avoidingliquidation. If approved by a majority innumber who represent at least three-quarters in value of the creditors (or anyclass of creditors, if relevant) who vote atthe meeting to approve the scheme, thescheme binds all of the parties to thescheme. Once agreed, the company’s assets

Recent Developments in the English Restructuring Market (cont. from page 13)


Although mezzanine debt

holders have been

increasingly vocal about

how pre-packs and

schemes of arrangement

disadvantage them, the

UK courts have shown

little sympathy, with the

High Court’s recent and

much anticipated decision

in the IMO Car Wash case

dealing a further blow to

mezzanine lenders.

1 Kayley Vending Ltd, Re Insolvency Act 1986[2009] EWHC 904 (Ch).

2 RAB Capital Plc and RAB Capital Market(Master) Fund v. Lehman Brothers International(Europe) [2008] EWHC 2335 and Re LehmanBrothers International (Europe) [2008] EWHC2869 (Ch).


Dealmakers beware: employment practicesthat may appear to be innocuous can ringup serious damage awards if they involvethe failure to fully compensate a wholeclass of employees over long periods oftime. In a number of recent transactions,we have come across two types of claimsthat fall comfortably within thisdescription: so-called “whipsaw” claimsunder ERISA and “wage and hour” suits inCalifornia. Successful class-based claims ineither of these areas can result in liabilitiesin the tens or even hundreds of millions ofdollars, so dealmakers are well advised toinclude a thorough assessment of suchrisks in their diligence checklists.

Whipsaw ClaimsWhipsaw claims are a potential concernfor companies that sponsored cash balanceretirement plans at any time prior to thelegislative reform in the Pension ProtectionAct, which became effective on August 17,2006.1 The claims arise from a standardfeature of cash balance plans giving aparticipant in the plan the right, upontermination of employment, to adistribution of his or her accrued benefitsin the plan.

Under a traditional defined benefitpension plan, benefits are paid periodicallyafter an employee retires, with the size ofthe payments based on a formula thatusually includes factors such as length ofservice and the employee’s salary or wagesat the time of retirement. Benefits in cash

balance plans, however, are based on thebalance of the employee’s notional“account” under the plan, which builds upduring the employee’s tenure. Atretirement, a participant can choose tohave his or her account paid out in thetraditional manner, as annuity or a seriesof installment payments followingretirement, or as a lump-sum payment. Heor she may elect to receive such paymentimmediately after employment ceases,whether in the context of retirement, avoluntary termination or involuntarytermination. Employees who took pre-Pension Protection Act lump-sum payouts,however, are in some cases entitled to anamount—known as a “whipsaw”payment—in excess of their accountbalance calculated as described below. Ifwhipsaw payments were not made to theemployee, or were not properly calculated,participants may sue the plan to recoverthe unpaid amounts. In certaincircumstances — where the terms of theplan involved are generous and asubstantial number of participants areaffected — the resulting liabilities can besubstantial.

The Whipsaw Calculation As noted above, cash balance plansmaintain notional accounts forparticipants. A participant’s accountbalance is equal to the credits made to hisor her account by the employer. Employersare required to give two types of periodiccredits to participant accounts: fixedcontributions for the employee’s serviceduring a given period, and “interest”credits, which represent a notional returnon the participant’s existing accountbalance during that period. The amountsof credits are calculated in accordance withthe rules of the plan. Service credits are

typically defined as a percentage of theemployee’s salary for the given period;interest credits may be based on a fixedrate or tied to other non-discretionarymetrics such as, for example, the ten-yeartreasury rate or the investment return onassets in the pension trust fund.

Under ERISA, employees have a legalright to receive their accrued benefit undera pension plan regardless of the date of, orreason for, their departure. For definedbenefit plans, the value of a participant’saccrued benefit is required to be calculatedby reference to his or her normalretirement date.2 As a result, paymentsreceived by a participant who leaves mustequal, at a minimum, the present value of

Whipsaw Claims and Wage and Hour Suits:Potentially Expensive Employment Liabilities to Watch for in Litigation Diligence


1 After the Pension Protection Act of 2006 wasenacted, the IRS issued Notice 2007-06 confirmingthat lump-sum payouts would not violate ERISA ifthey were equal to the employee’s notional accountbalance at the time of departure — essentiallyeliminating the whipsaw payment. This changeapplies to payouts made after August 17, 2006.

…[E]mployment practices

[such as so-called

whipsaw “claims under

ERISA” and “wage and

hour” suits in California]

that may appear to be

innocuous can ring up

serious damage awards if

they involve the failure to

fully compensate a whole

class of employees over

long periods of time.

2 Despite having readily assessable accountbalances, which are reminiscent of definedcontribution plans, cash balance plans are consideredby ERISA to be defined benefit plans.


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quam, iaculis eget, molestie

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In hac habitasse platea

dictumst. Cras et diam sed

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the payments that the participant wouldbe entitled to receive at his or her normalretirement date, using a discount rateprescribed by ERISA.

The “whipsaw” problem arises whenthe present value of the lump sumpayment an employee would be entitledto receive at normal retirement exceedsthe value of his account balance. Thismay occur because the courts havedetermined that a participant’s accruedbenefit includes not only his or hercurrent account balance, but also theright to receive future interest credits onthat account balance, and the interestcredit rate under the plan may be greaterthan the discount rate used to present-value an accrued benefit. A participantwho departs from a cash balance planand takes a lump sum is entitled, inaddition to his or her account balance, tothe present value of the interest creditsthat would have been credited to his orher account through normal retirementage. (At termination, employees whodon’t take lump sums typically cease toreceive additional service credits butcontinue to receive interest credits ontheir existing balances.) This accrued

benefit is considered non-forfeitable, andexists regardless of the reason for theemployee’s departure.

To illustrate, the present valuediscount applied to the lump sumpayment is required by ERISA to be the30-year treasury rate. If a plan’sestablished rate of return is also equal tothe 30-year treasury rate, then thepresent value of the future returns underthe plan is zero, and the employee isentitled to only her account balanceupon departure. However, many cashbalance plans provide for a rate of returnthat is, or is likely to be, higher than the30-year treasury rate, in which case theemployee is entitled receive her accountbalance at the time of departure plus awhipsaw payment, which together totalthe present value of her accrued benefitthat would be payable at normalretirement age under the plan. Theamount of the whipsaw payment is equalto the total of the “interest” credits thatwould have been made from the date ofdeparture until the employee’s normalretirement age, discounted using theprescribed rate. Where the plan providesfor a variable rate of return, thecalculation necessarily involves estimatingfuture rates. In the context of a whipsawsuit the district court will likely bedeciding the proper estimate of thefuture rates of return.

Wage and Hour Claims Most people in the deal business know toavoid the Texas courts but not as manyrecognize that buying businesses withlarge numbers of employees in Californiacan impose potentially expensive risks.California’s labor law requires strictcompliance with the fairly complex rulesgoverning employees’ rest and mealbreaks, and other circumstancesinvolving unpaid work. Class-action suitsbased on non-compliance with these

rules, known as “wage and hour” suits,have, in many cases, led to very largesettlements. These cases received nationalmedia attention in 2005 when a juryawarded plaintiffs $172 million in a caseagainst Wal-Mart for failing to provideadequate meal breaks (thus prompting apainful number of “no free lunch inCalifornia” headlines).

The question of whether an employeris required to ensure that adequate breaksare being taken — as opposed to merelymaking them available — is currentlypending before the California SupremeCourt. The outcome of this case, Brinkerv. Superior Court,3 could require largeemployers to make major enhancementsto their policies and complianceprocedures.

A ruling in favor of the employers inBrinker, however, will not change the factthat in most wage and hour suits theemployer bears the burden of provingadequate compliance. To guard againstcostly litigation, companies must adoptinternal policies which reflect currentlaw, monitor their own compliance, andmake sure that accurate and thoroughrecords of employee’s hours are kept.

The Employer’s ObligationsCalifornia’s labor code requires thatemployees working more than five hoursper day be provided with anuninterrupted 30-minute meal break thatis free of any work duties. An employerand employee may waive the meal breakby mutual consent only if the total workday is no more than six hours. If anemployee works ten hours per day, he orshe must receive a second uninterrupted30-minute break period. This secondmeal period may be waived by mutual

Whipsaw Claims and Wage and Hour Suits (cont. from page 15)


Most people in the deal

business know to avoid

the Texas courts but not

as many recognize that

buying businesses with

large numbers of

employees in California

can impose potentially

expensive risks. 3 80 Cal. Rptr. 3d 781 (2008).


Two recent U.S. appellate court decisionssuggest that the old real estate adage —Location! Location! Location! — mayapply equally to leveraged acquisitions, atleast when it comes to insulating suchtransactions from fraudulent conveyancerisk. The decisions by the Sixth andEighth Circuit Courts of Appeals makeclear, in those jurisdictions at least, thatpayment of deal consideration through aqualifying financial institution protectssuch payments under Section 546(e) ofthe U.S. Bankruptcy Code fromsubsequent challenge as a fraudulentconveyance, even in a private saletransaction.

Well-counseled investors selling sharesin a leveraged transaction know well therisk of a later fraudulent conveyanceaction under Section 548 of theBankruptcy Code or comparableprovisions of state law. Once a companyfiles for bankruptcy protection, thedebtor-in-possession may seek recovery ofthe purchase price of the shares, evenyears after the closing of the transaction,where the acquired company at theconclusion of the transaction wasinsolvent, left with an “unreasonably smallcapital” or intended to incur or believedthat it would incur debts beyond itsability to pay.

For some time, investors that sold theirequity position through the publicmarkets have often been able to useSection 546(e) of the Bankruptcy Code tofend off such suits. Under Section 546(e),which was enacted “ ‘to minimize thedisplacement caused in the commoditiesand securities markets in the event of a

major bankruptcy affecting thoseindustries,’ ”1 the debtor-in-possession“may not avoid a transfer that isa...settlement payment...made by or toa...stockbroker, financial institution,financial participant, or securities clearingagency that is made before thecommencement of the case.” SinceSection 546(e) was modified in the 1980’sto expand its reach, the courts haveregularly held that transfers in publicly-traded securities in the context of aleveraged buyout are protected by theprovision.2

Until recently, however, it was far fromclear that Section 546(e) applied to cashor other consideration received in LBOsinvolving privately traded securities. Inrecent months, however, the Sixth Circuit(with jurisdiction over Kentucky,Michigan, Ohio, and Tennessee) and theEighth Circuit (with jurisdiction overArkansas, Missouri, Iowa, Nebraska, theDakotas and Minnesota) have each ruledthat Section 546(e) protected sell-sideparties who received cash paymentsthrough a “financial institution” inconnection with an LBO.

In the Sixth Circuit case, In re QSIHoldings, Inc.,3 the court addressed cashpayments received as consideration byindividual shareholders and employeeparticipants in the company’s EmployeeStock Ownership Trust, and who, as partof the 1999 merger of Quality Stores, Inc.into Central Tractor Farm and Country,Inc., had received payments through thebuyer’s exchange agent, HSBC BankUSA.4 In the Eighth Circuit case,Contemporary Industries Corp. v. Frost,5 the

court considered fraudulent conveyanceclaims against former owners of aprivately-held Nevada corporation whohad received a $26.5 million payoutfacilitated by First National Bank ofOmaha under an escrow agreementgoverning a buyout of their equityinterest.6

In both cases the appellate panels reliedon the definition of “settlement payment”set forth in Section 741(8) of Title 11,namely, a payment “commonly used inthe securities trade” and held thatCongress intended the exemption to reachbroadly to include cases such as “acommon leveraged buyout involving themerger of nearly equal companies.”7 In sodoing, the Sixth and Eighth Circuitsrejected or distinguished most of the lawdeveloped on this subject in the UnitedStates District Courts.

Although the law in this area remainsunsettled, with most of the courts ofappeals having yet to weigh in, the recentSixth and Eighth Circuit rulings providesubstantial comfort to sell-side parties inthose jurisdictions, and suggest that sell-side parties in leveraged transactionsnationwide should work with counsel to

ensure that payments flow through aqualifying financial institution andthereby arguably fall within Section546(e) — at least until the SupremeCourt of the United States steps in andfinally settles the matter.

Richard F. [email protected]

Steven S. [email protected]

Good News for Selling ShareholdersWorried About Fraudulent Conveyance Risk

1 Kaiser Steel Corp. v. Charles Schwab & Co.,Inc., 913 F.2d 846, 848 (10th Cir. 1990) (citingH.R. Rep. No. 420, 97th Cong., 2d Sess 1, reprintedin 1982 U.S. Code Cong. & Admin. News at 583).

6 Id. at 984.7 2009 WL 1905237*4 (citing and quotingContemporary Industries, supra).

2 Id.3 2009 WL 1905237 (6th Cir. July 6, 20094 Id. at *1.5 564 F.3d 981 (8th Cir. 2009).


charges. Similar to the discussion ofM&A deal costs and expenses above, theincrease in the amount of restructuringcosts required to be expensed makes itimportant to review whether or not CreditAgreements permit the relevant restructuringcosts to be added back to ConsolidatedEBITDA. In addition, the add-back toConsolidated EBITDA, if any, would nowneed to be drafted with sufficient flexibilityto be applicable for the periods duringwhich such costs are expensed.

Contingent Consideration and Earn-OutsUnder the previous rules, contingentpurchase price payment obligations(“earn-outs”) payable in connection withan acquisition were added to the purchaseprice and therefore did not flow through“consolidated net income.” This is nolonger the case. Indeed, the new rulesrequire that earn-out payment obligationsthat are to be paid in cash be recorded asa liability at their fair value on the closingdate and marked to adjusted fair value in

subsequent reporting periods. This hastwo consequences. First, changes in theestimated fair value of the earn-outpayment obligation will flow through“consolidated net income” (on the date ofpayment, however, unless there is a needto true up the amount of the earn-out,the payment will not be an expense thatflows through consolidated income butrather a payment of a previously recordedliability which is neutral from an incomepoint of view). Borrowers should considerthe impact of adjustments to earn-outpayment obligations on the calculation ofConsolidated EBITDA and whether aspecific add-back (for instance as an itemresulting from the application of thepurchase accounting rules) is appropriate.Second, the treatment of an earn-outpayment obligation as a liability increasesthe amount of debt taken into account incomputing the leverage ratio under thoseCredit Agreements that compute theleverage test by reference to allindebtedness of the borrower that isreported as a liability under GAAP (it isneutral, however, under those CreditAgreements that compute the debt portionof a leverage ratio by taking into accountonly indebtedness for borrowed money).

Bargain PurchasesUnder the new rules, an acquisition (suchas a distressed acquisition) could create aboost to Consolidated EBITDA to theextent the fair value of the acquired assetsexceeds the purchase consideration.Indeed, the new rules require the excess ofthe fair value of the acquired assets overthe purchase price to be recognized as again in current period’s earnings. WhileCredit Agreements often carve out fromthe Consolidated EBITDA calculationgain on sales of assets or businesses (otherthan in the ordinary course of business), itis less frequent to see a carve-out for gainsresulting from the acquisition of a business.

This may unexpectedly turn one bargaininto two for the wise acquirer.

IP R&DIntellectual property research anddevelopment (“IP R&D”) that is acquiredin an acquisition used to be written off onthe day following the completion of suchacquisition. It is now recorded as if it hadbeen developed by the acquirer. As aresult, the acquirer will at some point,potentially long after the closing of therelevant acquisition, determine whetherthe acquired IP R&D has value (in whichcase the acquirer will turn it into an asset)or not (in which case the acquirer willexpense it). Expensing the acquired IPR&D would reduce “consolidated netincome” and therefore potentially impactthe calculation of Consolidated EBITDA.Borrowers may want to specifically identifyacquired IP R&D expenses as an item that isadded back to Consolidated EBITDA.

* * *The changes discussed above may or maynot impact existing Credit Agreementsdepending on (1) when the relevantCredit Agreement was entered into and(2) whether it contemplates that financialcovenants will be determined based onGAAP as in effect on the date the CreditAgreement was entered into, or GAAP asin effect from time to time. These changeswill inform the structuring of covenantpackages for newly negotiated CreditAgreements and may also be the impetusfor some amendment requests. Thethoughtful borrower has alreadyrecognized that recycling covenants frombefore the credit crunch for newtransactions will clearly not work as thecredit markets revive – not only have thosemarkets changed but so has GAAP.

Pierre [email protected]

Rewinding the Clock (cont. from page 4)

Under the previous rules,

contingent purchase

price payment

obligations (“earn-outs”)

payable in connection

with an acquisition were

added to the purchase

price and therefore did

not flow through

“consolidated net

income.” This is no

longer the case.

remove the majority of the board ofdirectors;

(3) over which it has the right to exercisea dominant influence;

(4) over which it (directly or indirectly)has the power to exercise, or actuallyexercises, dominant influence orcontrol; or

(5) that is managed on a unified basiswith such parent undertaking.

Any UK subsidiary that would havequalified for the CRC in its own right(i.e., its UK operations consumed morethan the 6,000MWh threshold) will beclassed as a “principal subsidiary,” and theparticipating parent undertaking may haveadditional reporting obligations in respectof that “principal subsidiary.”

What Are the Ramificationsfor Private Equity Sponsors?The concept of ultimate parentresponsibility was incorporated into theCRC Order in order to simplifyadministration and reporting proceduresand to achieve maximum coverage. Thisreasoning makes sense for large operatingcompanies with numerous integratedoperations in the UK, and group

reporting may simplify the administrativeburden. However, private equity fundsusually invest on a short- or medium-termbasis in a wide variety of businesses oftenwith little or no integrated operationalrelationships. Portfolio companies of aprivate equity fund are not considered a“group” in the conventional sense, andindeed are not usually treated as such fortax purposes.

The government, however, has statedthat it will not afford special treatment toprivate equity funds or venture capitalfirms. In its March 2008 consultationdocument, the Department forEnvironment Food and Rural Affairs

confirmed that a specific derogation forprivate equity and venture capital firmshad been investigated, but that it wouldpresent “significant legal difficulties” assuch firms do not differ structurally orconstitutionally from other entities.

More recently, the British VentureCapital Association has advocated, amongother things, applying UK generallyaccepted accounting principles indetermining the existence of a group forpurposes of the scheme, correctly arguingthat such an approach would bring theCRC in line with the standards appliedunder other regimes such as tax andaccounting. Again, however, it is unclearwhether this approach will gain anytraction.

Unless a workable modification orexemption can be proposed on behalf ofthe private equity industry and agreed bythe UK government, it is likely thatprivate equity firms will have to complywith the CRC, provided that the usage

threshold is reached by its UK entities as awhole.

The chart below provides a generalsummary of the entities that will beincluded in the operations for which afund or its general partner or manager willbe responsible under the CRC Order.

Within the Fund, Who Is Responsible?If implemented in its current form, theCRC Order will impose responsibility onthe person ultimately controlling therelevant UK operations. In some cases,control may be exercised by one or moreindividuals, who would not carry liabilityunder the CRC Order as the CRC onlyapplies to “undertakings” (unless of coursethat individual is guilty of one of thecriminal offenses, whether directly or asan officer of a guilty undertaking). Eachfund structure will need to be reviewedcarefully to identify the ultimate parent in




Included

� UK portfolio company controlled bythe fund.

� UK operations of non-UK portfoliocompany controlled by the fund.

� UK operations that are “principalsubsidiaries,” for the entire year even ifthe portfolio company is acquired atyear-end.

Not Included

� Non-UK portfolio company controlledby the fund with no UK operations.

� Non-UK operations of UK portfoliocompany controlled by the fund.

� All operations (UK and non-UK) ofcompanies owned by a “club” of fundsso long as no club member hascontrol; note, however, that theultimate parent controlling anoperating company with the requisiteUK nexus will be the responsibleparent organization for CRC purposes.

� Non-control investments.

� UK operations that were “principalsubsidiaries,” for the entire year if suchoperations were disposed of duringsuch year.



each case, taking into account allcircumstances. Depending on thecircumstances and any clarifications thatmay be made in the final legislation, it ispossible that the ultimately responsibleparticipant entity could be the fund itself,its general partner, its manager, or theundertaking that controls the generalpartner or manager. Much will depend onthe specific facts.

There may be special considerations forfund groups where a common parent

company owns each fund’s general partneror manager, which may then be consideredas the responsible person for all of the groupfunds’ UK operations. Moreover, in such astructure, each of the funds across the groupand their portfolio companies would betreated as a single organization for purposesof the CRC scheme, creating somepotentially thorny cross-fund allocationissues.

In any case, the CRC Order couldimpose a novel type of liability on thegeneral partner or manager (or its owner)which it typically does not face for otherpurposes.

What to Do Now?The CRC Order raises a number of issuesfor action and further consideration. Giventhe cost of compliance — even of preparingfor compliance — and that someuncertainty continues to exist as to thecontours of the final legislation, privateequity sponsors face a difficult choice as tohow much work to do at this stage inpreparing for implementation of thescheme. Nevertheless, because there arecertain near-term reporting obligations, andbecause implementation will be a majorundertaking, some foundational work andanalysis seems prudent at this stage.

Determine Who Is the ParentAs stated above, private equity funds withUK portfolio companies (includingportfolio company subsidiaries) shouldreview their group structure carefully, inorder to establish the extent of the group forCRC purposes, and to identify the“ultimate parent.” Sponsors of multiplefunds should consider structuring theirultimate “parent” companies so that nosingle parent entity controls more than onefund.

Monitor. Private equity funds that hadUK portfolio companies in 2008 should, inconjunction with those companies, begin

obtaining and measuring energy data toassess whether they will be subject to theCRC. At the very least they will need tocomplete the qualification packs duringSeptember 2009 which the EnvironmentalAgency is requiring be completed prior tothe adoption of final CRC legislation.Funds with UK portfolio companies willneed to evaluate how they will staff theresources necessary for compliance with theCRC, as well as how they intend toimplement their own internal allocation ofresponsibility, which is discussed brieflybelow.

Allocate ResponsibilityA sponsor may find it prudent to enter intoCRC liability sharing arrangements (like taxsharing agreements) with the fund’sportfolio companies to address allocation ofresponsibility between the fund and a UKportfolio company, presumably with theportfolio company shouldering allcompliance costs. The fund may also wantto consider how misallocations within thegroup should be handled under such asharing arrangement. For example, the fundmay find it more beneficial for UKportfolio company A to sell its excessemission allowances to UK portfoliocompany B, rather than sell them on theopen market or have UK portfoliocompany B go to the market for allowances.

In addition, a fund may want toconsider how the potential bankruptcy of aUK portfolio company would affect thefund’s and the group’s allocation ofresponsibility. A fund may ask a UKportfolio company to pledge its allowancesto the fund as a matter of course or requirethem to transfer allowances to the parent(or the nominated “primary member”) inadvance of the end of the compliance year.

A fund may also want to considerwhether any of the direct or indirectminority owners of a UK portfolio


...[P]rivate equity funds

with UK portfolio

companies (including

portfolio company

subsidiaries) should review

their group structure

carefully, in order to

establish the extent of the

group for CRC purposes,

and to identify the

“ultimate parent”

[, and]...private equity

funds that had UK

portfolio companies in

2008 should, in

conjunction with those

companies, begin obtaining

and measuring energy data

to assess whether they will

be subject to the CRC.


company should share responsibility forcertain aspects of compliance with theCRC. For example, if a general partnerincurs CRC-related liability for a bankruptUK portfolio company, the fund may askfor the portfolio company’s minorityshareholders to carry their share of thisliability.Finally, the sponsor entity with ultimateresponsibility under the CRC, shouldevaluate the proper risk allocation betweenit and the fund and then determine whetherthe typical fund indemnification provisionsafford sufficient protection without furtheramendments.

Conducting Due Diligence on New InvestmentsThe potential CRC implications of makingnew investments in UK companies (andincreasing holdings in existing UKcompanies) will need to be consideredcarefully and the necessary due diligenceundertaken. Once the first trading periodbegins, the CRC position of a UK targetcompany or an existing subsidiary may bean important factor in assessing the relevantcompany’s value.

Buying and Selling Portfolio Companieswith UK OperationsWhen assessing an acquisition or a sale of acompany with UK operations, the partieswill want to assess whether deal termsshould reflect compliance costs under theCRC.

The CRC has a simple compliance yearcut-off provision for principal subsidiariesbought and sold during a year.Responsibility for a participant or principalsubsidiary’s emissions will transfer to thenew owner on purchase of such entity, andthe participants affected will be required toinform the EA of such “DesignatedChanges.”

Designated Changes will be deemed tohave occurred at the start of the emissions

year during which the change to took place.In theory, this will mean that noapportionment of emissions will be requiredas between the transferor and transferee. Forany changes that are not DesignatedChanges, the seller will be responsible forthe target’s emissions up to the date ofcompletion of the sale and the purchaserwill be responsible for its future emissionsand will have to buy additional allowancesaccordingly.

For example, in the case of the purchaseof a “principal subsidiary,” a buyer mayrequest a closing adjustment, to becalculated post closing on the basis ofassessment of emissions through closing, tocover the cost of any allowances not on thebooks of the target company. Anotheralternative would be for the selling fund totransfer certain allowances to the buyer tooffset the actual or estimated amount ofCO2 emitted by the UK target up toclosing. This may be complicated tocalculate, as the acquisition of a “principalsubsidiary” by a CRC participant couldhave a positive effect on the participant’sperformance in a compliance year (andcould therefore increase its recyclingpayment) if the target company reduces itsemissions during that year.

The situation with the buyer and seller’srelative performance under the year-endbonus/penalty scheme is even more difficultto address since it is not possible to know,mid-year, how a target (or the organizationof which it is or will become a part uponcompletion of the sale) is performingrelative to other participants in the CRC. Asbonuses are awarded and penalties incurredrelative to a participant’s league tableposition, the financial consequences ofselling or purchasing a UK undertaking interms of the CRC will in part depend onhow well all other CRC participants haveperformed during that year.

There are as many potential solutions to

these issues as buyers and sellers havemanaged to dream up in allocating riskswith regard to other types of operationalliabilities.

ConclusionThe CRC raises several novel issues forfunds by imposing parent company liability,even extra-territorial liability, for funds andsponsors that control UK entities withsignificant CO2 emissions. Many of theuncertainties in the law may be addressed asit continues through the legislative processin the UK. For now, an affected fundshould give careful consideration to theCRC and its implementation.

Geoffrey P. [email protected]

Russell D. [email protected]


A sponsor may find it

prudent to enter into

CRC liability sharing

arrangements (like tax

sharing agreements) with

the fund’s portfolio

companies to address

allocation of responsibility

between the fund and a

UK portfolio company,

presumably with the

portfolio company

shouldering all

compliance costs.


Shelter from the Storm (cont. from page 8)

capacity has replaced insurers exiting orreducing their exposure to this market.However, there have been substantialpremium increases. Premium increasesrange from 0% to 45%, depending on therisk. We estimate that premiums areincreasing an average of 20% and expectthis will continue for at least the next twelvemonths.

What’s driving the premium hikes if it’s not aloss of capacity in the market?

Premiums are rising because claims arerising, particularly for financial institutions.The same underwriters who underwritefinancial institutions typically underwriteprivate equity and hedge fund risks as well.Even though the risks are different and notnecessarily correlated, the financial crisis hastainted the underwriters’ view of the entiremarket. To help keep premium increases toa minimum, we recommend starting apolicy renewal process months in advance.If the underwriters have the opportunity tomeet with the fund sponsors or portfoliocompany to get a more nuanced view oftheir business and potential exposures, theyare likely to become more comfortable withthe risk profile. The result will be betterpolicy terms and premiums.

Have you noticed any changes in buyingtrends in the last 12 months?

We have not seen a meaningful change inthe amount of coverage purchased.However, we have seen a shift in buyingpatterns. Some insureds are buying morespecialized D&O insurance referred to as“Side A D&O.” Side A D&O coversdirectors in certain circumstances when acompany is unable or unwilling toindemnify. This kind of coverage isparticularly critical in a bankruptcy scenariowhere a company is financially unable toindemnify a director.

What are the common issues to be wary ofwhen reviewing coverage in the context of apotential bankruptcy situation?

Management must ensure the D&O orGPL policy is available for their primarybenefit in a bankruptcy. Certain provisionsshould be requested while the company isstill financially viable and not on the eve ofa financial meltdown. There are a numberof key provisions to consider, includingpriority of payments, bankruptcy clauses,financial insolvency clauses and insuredversus insured exclusions.

In a U.S. bankruptcy, the “automaticstay” prevents claims against the bankruptcyestate, including insurance policies andcertain insurance policy proceeds thatbelong to the estate. However, theautomatic stay will not prevent claimsagainst individuals, so management may beleft without coverage if the proceeds of theD&O or GPL policy are deemed to belongto the estate. A “priority of payments”provision provides that non-indemnifiableclaims by management against theinsurance policy have priority over claimsby the company. Bankruptcy courts haveconfirmed that the “priority of payments”provision has the effect of excluding fromthe bankruptcy estate certain of theproceeds of the policy, thereby conferringmanagement access to those policy proceeds.

You said that priority of payment clausesensure payment for non-indemnified claims.What about indemnified claims?

That’s where the bankruptcy clause comesin. Together with the “priority of payments”provision, the “bankruptcy clause” shouldensure that the policy proceeds are availableto individuals in all circumstances. Aproperly drafted “bankruptcy clause”evidences, among other things, a clearintention that the entity’s policy is intendedto protect and benefit individuals and that,in the event of bankruptcy of the entity, the

automatic stay will be lifted to the extentthe stay is preventing any individuals fromaccessing the policy.

You also mentioned financial insolvencyclauses and “insured versus insured” exclusions?

Yes. A properly drafted financial insolvencyclause enables an individual to access thepolicy from the first dollar (i.e., eliminatingthe retention or deductible) in the eventthat the entity is unable to payindemnifiable claims of individuals due toits insolvency.

Finally, in a bankruptcy, an “insuredversus insured” exclusion is problematicbecause if a trustee or other partyrepresenting the interest of the company (aninsured) brings a claim against the directorsand officers (also insureds), the exclusion istriggered. Therefore, it is important that thepolicy include an exception to the normalexclusion to allow coverage for claimsbrought by a bankruptcy trustee, anexaminer, a creditors’ committee, and theirrespective assignees and functional (and,where relevant, foreign) equivalents.

At what point in a potential claim situationshould insureds begin talking to our insurersregarding coverage? And to our attorneysregarding coverage?

At any time an insured becomes aware of aclaim, or a situation that they believe couldgive rise to a claim, they should seek theadvice of counsel. Depending on the factsand circumstances, it may be best to speakwith your counsel and insurance brokerfirst, and then involve the carrier if it isnecessary to report the claim orcircumstance.

The policy typically requires that thecarrier be kept informed and gives thecarrier a right of consent with respect to anysettlement. Failure to comply couldjeopardize the availability of coverage underthe policy for the related claim.



Ownership Interests: The buyerestablished a limited liability holdingcompany to acquire 100% of theinterests of the target company. Thelimited liability holding company hastwo classes of interests, one of which —the Class A interests — is wholly ownedby the buyer, and represents the bulk ofthe target’s value at the time of the deal.The Class A interests accrue a preferredreturn of 10%. The second class ofinterests — the Class B interests — isheld 75% by the buyer and 25% by theexecutive. The executive’s Class BInterests are fully vested.

Interests Valuation: The executivepaid an appraised fair market value forhis interest in part with deferredcompensation owed to him by the targetcompany and in part with a loan fromthe buyer. The loan bears interest at theapplicable federal rate, has a maturity ofeight years (subject to mandatory pre-payment upon a sale of the interests andcertain other customary events) and issecured by the Class B Interests andother assets held by the executive.

Right of First Refusal: The executiveis prohibited from disposing of theequity interest without the buyer’sconsent for six years following theclosing of the transaction. Following thesixth anniversary of the closing, theexecutive may sell the interests subject toa right of first refusal in favor of thebuyer. Moreover, except with respect tothe transfer of interests to otheremployees of the buyer or itssubsidiaries, the buyer agreed that it willoffer the executive the right of firstrefusal should the buyer seek to transferan agreed upon portion of its interests.

Put/Call Options: The buyer has acall option, from the fourth anniversaryof the closing through the sixth

anniversary of the closing, to purchasethe executive’s interest based on the fairmarket value of the interest at the timeof purchase. For a period of 30 daysfollowing each of the sixth, seventh andeight anniversaries of the closing, theexecutive would have a put optionpursuant to which the executive has theright to require the buyer to purchase upto one third of his interests at the thenfair market value. For purposes of theput and call, the fair market value willbe determined by the mutual agreementof the buyer and the executive or, if thebuyer and the executive cannot agree, byan independent appraiser, without takinginto account the lack of an active tradingpublic market for the interests, anyrestrictions on the transfer of suchinterests, or any minority discount.

Other Terms: The limited liabilityholding company’s operating agreementalso provides for customary preemptiverights and tag-along and drag-alongprovisions and provided for vesting uponagreed upon EBITDA targets.

Some Familiar and Unique IssuesIn the process of providing privateequity-like arrangements to executives,strategic buyers will need to considersome of the same types of issues faced byfinancial sponsors in this area, and someadditional issues unique to them.

Securities Law Issues: For example,shares granted to management must beregistered with the Securities andExchange Commission (SEC) inaccordance with the federal securitieslaws, unless there is an availableexemption from registration. Often, apublic company strategic buyer usesequity that is available under its equityincentive plan for its other employeesand that it is already registered with the

SEC. Or, it may use new shares andsimply register them on a Form S-8, aneasy, efficient and inexpensive way toregister shares used in a publiccompany’s equity incentive programs.Form S-8 is not available to privatecompanies, however, such as a targetwhich becomes a subsidiary of a publiccompany buyer. Instead, privatecompanies, as in the case of many PEdeals, rely on an exemption fromregistration, such as Regulation D foraccredited investors, or Rule 701 forcompensatory equity programs.

Sarbanes-Oxley: The Sarbanes-OxleyAct (SOX) prohibits a public companyfrom extending or “arranging” for theextension of personal loans to any of itsdirectors or Section 16 officers. UnlikePE firms, which are not subject to SOX,public strategic buyers are thereforeprohibited from helping (or causing thetarget to help) any member of thetarget’s management team who isdeemed to be “a Section 16 officer”finance his or her investment in thetarget’s equity with loans or loanguarantees. (In the transaction describedabove, the employee is not a Section 16officer of the strategic buyer.)

Exchange Issues: By issuing equity ina target which becomes a subsidiary, apublic company strategic buyer may alsobe able to avoid the thorny issue ofshareholder approval of any equityarrangements for target’s management atthe buyer level since major stockexchanges and NASDAQ requireshareholder approval of compensatoryequity incentive plans by publiccompanies. This may not be an issue ifthe buyer has a sufficient number ofshares to issue under its shareholder-approved plan that it uses for its




employees generally. But, if it has aninsufficient number of shares, the buyerwould need to either seek shareholderapproval or rely on an exemption fromshareholder approval — if one isavailable. These issues are avoided byissuing equity of a non-public subsidiaryof a public buyer since privatecompanies are not required to obtainshareholder approval for their equityincentive programs.

Accounting Treatment: Publiccompanies tend to be more concernedthan private equity buyers about theimpact of acquisitions on their financialstatements. In the deal described above,for example, the buyer was interested indevising the management’s equity in amanner that did not give rise to profit

and loss charges on its income statementfollowing the closing. For this reason,the accountants recommended that theawards should not be subject to a servicevesting condition (i.e., continuedemployment) and great care was taken todesign the award so that it “vests” basedon financial parameters (in this case,EBITDA targets) rather than continuedemployment. In addition, because theequity granted to target management is aminority interest, public companies needto be mindful of the accounting impactof granting such equity on both theirfinancial statements and their loancovenants. See “Rewinding the Clock:The Impact of Changes to GAAP onleveraged Loan Covenants,” elsewhere inthis issue. In contrast, financial sponsorsusually impose service vesting conditionson management’s equity awards, withoutregard to the accounting charge.

Tax: A strategic buyer wishing toissue equity of the target to managementwould also have to address the seeminglyever-present Section 409A of theInternal Revenue Code of 1986, asamended, which imposes strict rules onhow and when deferred compensationmay be paid. Among other things,Section 409A limits the terms andconditions that may apply to equityawards that are granted in exchange fordeferred compensation that is otherwiseowed to the executive. In the transactiondescribed above, for example, theexecutive “bought” his equity interestwith deferred compensation that was

otherwise to be paid to him inconnection with the transaction. As aresult, the buyer (and the executive) hadto grapple with the terms of the equityaward to ensure that payment was madein compliance with Section 409A. As ithappened in this transaction, the partiesbecame comfortable relying on a limitedexception related to the so-called “short-term deferral” rule. However, Section409A analyses are highly technical,nuanced and fact-specific.

ConclusionIt is too early to tell whether privateequity-like incentive packages will beembraced broadly by strategic buyers, letalone even become a discernable trend.Despite the transaction described above,such arrangements remain rare. Still, ifoffering private equity-like incentivepackages to target’s management givesstrategic buyers a competitive advantageover private equity bidders and/or helpsstrategic buyers finance transactions, itwould not be surprising to see themoffering such packages in the future,opening an additional competitive frontfor private equity investors.

Stephen R. [email protected]

Jonathan F. [email protected]

Charles E. [email protected]

Public companies tend to

be more concerned than

private equity buyers

about the impact of

acquisitions on their

financial statements....

[B]ecause the equity

granted to target

management is a minority

interest, public companies

need to be mindful of the

accounting impact of

granting such equity on

both their financial

statements and their loan

covenants.


Recent Developments in the English Restructuring Market (cont. from page 14)

are transferred into a new company. The company has discretion to

determine who will be a party to aproposed scheme, so long as all creditorswhose rights will be altered by theproposed scheme are included.Accordingly, English courts have held thata company may exclude creditors if theirrights will not be altered by the scheme,either because those rights are leftuntouched or because the excludedcreditors lack an economic interest in thecompany. Moreover, the company mayhave latitude to group holders of differentsecurities together as a single class forpurposes of a scheme if their rights againstthe company are similar.

Not surprisingly, lenders arechronically concerned that classdeterminations may be manipulated toensure passage of a scheme at the expenseof one or more groups of creditors. Theintroduction of “stretched” senior trancheswith relatively thin mezzanine tranchesmay exacerbate this concern formezzanine lenders. If secured mezzaninelenders are found to form the same classas secured senior lenders, and the seniortranche is, by value, three times that ofthe mezzanine tranche, the mezzaninelenders can effectively be dragged along by

the senior lenders. Recent English court decisions have

underlined the weak position ofmezzanine lenders in restructuringschemes. In McCarthy & Stone,3 whichconsidered a scheme involving an Englishconstruction company, the courtreaffirmed that when a company’s value isless than the outstanding senior debt, theremaining creditors can be excluded fromthe scheme because they lack an“economic interest” in the company. Thisled the court to approve a schemewhereby the senior lenders rolled much oftheir existing loan into the new company,while the mezzanine lenders were forcedto write off their loans completely.

The recent decision in IMO Car Wash,4

which involved the English subsidiaries ofthe biggest carwash business in the world,was the first case in which the Englishcourts addressed the question of whethersubordinated lenders have an “economicinterest” in a scheme where senior andjunior lenders presented competingvaluations. In arriving at his decision, thejudge accepted the senior lenders’ lower

valuation of the company on a goingconcern basis, finding that the mezzaninelenders’ higher valuation was based on astatistical analysis of possible outcomesrather than a true estimate of the probablevalue of the company. He thus held thatthe holders of IMO’s mezzanine debt hadno “economic interest” in the companyand no right to object to the proposedscheme of arrangement. He alsoemphasized that in the scheme the seniorlenders would effectively receive what theywere entitled to under the intercreditoragreement in effect between the parties.

ConclusionWith the current economic downturnpushing more highly-leveraged Englishcompanies to consider insolvency,England’s insolvency procedures havecome under closer scrutiny. Private equitysponsors and investors should be awarethat recent developments in Englishrestructuring practice may affect not onlyexisting investments, but the availabilityand structure of English financing foryears to come.

Katherine A. [email protected]

Katherine [email protected]

3 McCarthy & Stone PLC [2009] EWHC 116(Ch).4 Bluebrook Ltd and IMO (UK) Ltd andSpirecove LTD and Companies Act 2006 [2009]EWHC 2114 (Ch).

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article?

A complete article index, along with

all past issues of the Debevoise & Plimpton

Private Equity Report, is available in the

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www.debevoise.com.


Whipsaw Claims and Wage and Hour Suits (cont. from page 16)

consent only if the total work period isno more than twelve hours and theemployee did not waive the first mealperiod. California law also requires thatemployees receive at least one paid ten-minute rest break for every four hoursworked, and a proportional break formajor fractions thereof.

California’s courts have been dividedover the question of whether an employerhas an obligation to ensure that therequired breaks are taking place, or ismerely required to make them available.The state agency charged with enforcingstate labor laws (the California Divisionof Labor Standards Enforcement)originally interpreted the labor code asaffirmatively requiring employers toensure that employees are in fact takingthe 30-minute meal break. In Cicairos v.Summit Logistics, Inc.4, a Californiaappellate court endorsed this reasoning,finding that it was insufficient foremployers to assume break periods weretaken: rather, employers had anaffirmative duty to ensure workers wererelieved of all obligations during rest ormeal periods.

More recently, some appellate courtshave recognized that it would beimpracticable for a large corporation to

ensure that every employee tookadvantage of his breaks each day, findingthat an employer’s duty is to make thebreaks available. In Brinker, the case nowpending on appeal before the CaliforniaSupreme Court, restaurant workersclaimed they were denied their requiredmeal and rest periods and notcompensated for work before and afterscheduled shifts, as well as during mealperiods. The appeals court ruled in favorof the employers, finding that while

employees must have the opportunity totake their statutorily mandated breaks,employers are not required to ensureevery break is taken. The court made itclear that employers cannot dissuade,impede, or discourage employees fromtaking their allotted meal periods. Inaddition, the court ruled that employerscan only be held liable for employeesworking “off the clock” if the employerknew, or should have known, such workwas occurring.

The California Supreme Courtgranted plaintiff ’s petition for review inBrinker, signaling that it might not agreewith the appeals court’s decision. Theoutcome of this final appeal is notexpected until this fall, at the earliest.The California Division of LaborStandards Enforcement withdrew itsopinion interpreting labor code torequire employers to ensure breaks aretaken, endorsing the Brinker rationaleuntil the Supreme Court rules. Legalanalysts are largely uncertain about howthe court is likely to rule.

Strict Compliance andDocumentation Are Key Regardless of the outcome in Brinker,employers will continue to face a seriousrisk of wage and hour litigation inCalifornia, which can only be mitigatedby adopting and enforcing policies thatfully reflect the applicable laws. Not onlydo the correct policies need to be inplace, but training to ensure thatemployees are aware of those policies,and documenting the company’scompliance with its own policies are alsocritical.

Accurate and thoroughdocumentation is important in wage andhour cases because companies facingthese claims will need to prove

affirmatively that the required breakswere provided and that workers wereproperly compensated for the time theyactually worked. Courts will assume thatif no break was documented, no breakwas taken. Thus, companies may beliable in wage and hour claims even ifthey otherwise have the right policies inplace, if their record keeping isinadequate.

Documentation can be particularlychallenging for operations in whichemployees are working in the field —and thus may not be able to “punch-in.”More sophisticated time-keeping systems,such as those that are accessible bytelephone or other electronic devices,may be useful in addressing theseproblems.

* * *Whipsaw and wage and hour claims

can be very expensive to resolve.Dealmakers contemplating theacquisition of a company with asignificant number of employees are well-advised as part of their due diligenceinvestigation to obtain informationsufficient to assess whether the potentialfor such claims exists and, if so, toquantify any potential liability and itsimpact on valuation and transactionfinancing.

Mark P. [email protected]

Jennifer E. [email protected]

4 133 Cal.App.4th 949, 962-63 (2005).


The FDIC's Policy on Failed Bank Acquisitions (cont. from page 1)

deals, the FDIC has assumed more than80% of the losses on specified levels of afailed bank’s loan portfolio, making manyacquisitions highly attractive toprospective buyers.

The less good news is that, as wedescribe below, the Policy Statement, likethe July proposal, continues to setsubstantive hurdles for private equity,hedge fund and other private capitalinvestors interested in investing in failedbanks and falls well short of creating thelevel playing field for which some hadhoped. In addition, despite all theattention being paid to the PolicyStatement as we go to press, it isimportant to keep in mind that it has noimpact on the separate qualificationstandards and regulatory requirementsimposed by the Federal Reserve (“Fed”)and Office of Thrift Supervision (“OTS”)with respect to acquisitions of bothhealthy and failed banks or thrifts. Theserequirements are evolving but can beexpected to continue to pose additionalchallenges to private equity acquisitions ofU.S. depository institutions. Ultimately, itwill be the interplay of the FDIC’srequirements, on the one hand, and theFed or OTS’s requirements, on the otherhand, that will determine the viability ofprivate equity investment activity in thissector, pointing to the desirability of acoordinated and comprehensiveframework adopted by all regulators withrespect to investments by private equityfirms in failed financial institutions.

The Policy Statement1

ScopeBy its terms, the Policy Statement appliesto “private investors” (1) in any companyproposing, directly or indirectly, to assume

the deposit liabilities, or both theliabilities and assets, of a failed insureddepository institution; and (2) involved inapplications for deposit insurance in thecase of de novo charters issued inconnection with the resolution of a failedinsured depository institution.

As worded, the Policy Statementappears to have broad reach. For example,the term “private investor” is not definedand, thus, could potentially extendbeyond private equity and hedge funds toinclude other sources of private capital,potentially even individuals.

The Policy Statement does not apply inthe following circumstances:

� Unlike the proposal, the PolicyStatement will apply only prospectivelyand not to acquisitions of faileddepository institutions made prior tothe adoption of the Policy Statement.This will come as welcome news to theprivate equity investor syndicates in,for example, Indy Mac andBankUnited; that said, the PolicyStatement would appear to apply ifeither of those banks were to acquireanother failed depository institution.

� The Policy Statement will not apply toinvestors entering into partnershipswith bank or thrift holding companiesthat have “a strong majority interest” inan acquiree depository institution andan established record of successfullyoperating insured depositoryinstitutions. In the Policy Statement,the FDIC “strongly encourages” suchpartnerships but refrains from definingwhat constitutes an adequate “strongmajority interest” to satisfy thisexception. Given their experiences inWashington Mutual and National City,private equity firms will want to lookhard at their prospective partner beforetaking a non-controlling investment in

a banking enterprise. But minorityinvestments appear to be the cleanestinvestment structure under the PolicyStatement.

� The Policy Statement generally willnot reach investors owning 5% or lessof the total voting power of a bankingenterprise, provided there is noevidence of concerted action with otherinvestors. Assuming the FDIC does notaggressively apply a “concerted action”approach to negate the benefits of thisexception, this provision should behelpful in attracting small investmentsto plug financing holes in failed bankdeals.

The Policy Statement expresslydisallows in failed bank deals certain typesof structures that private equity firms havefavored. The Policy Statement prohibits“complex and functionally opaqueownership structures,” including“organizational arrangements involving a

1 For a more detailed description of the PolicyStatement, see our Client Alert, dated August 27,2009.

...[T]he Policy Statement,

like the July proposal,

continues to set

substantive hurdles for

private equity, hedge

fund and other private

capital investors

interested in investing in

failed banks and falls

well short of creating the

level playing field for

which some had hoped.




single private equity fund that seeks toacquire ownership of a depositoryinstitution through creation of multipleinvestment vehicles, funded andapparently controlled by a parent fund.”The prohibition appears aimed at certain“silo” structures, permitted in the past bythe OTS, which seek to expose oneinvestment fund or structure to bankregulatory restrictions but to hold otherfunds and structures managed by the sameprivate equity firm (and the private equityfirms themselves) outside the regulatoryreach.

Key Substantive ProvisionsThree elements of the July proposalcreated the greatest concern: the bankcapital levels, the need for private equityfunds to serve as an ongoing “source ofstrength” to the bank, and the ability ofthe FDIC to use a private equity firm’sinterests in one banking structure toreimburse the agency for its costs relatedto the failure of another bank under somelevel of common ownership (the so-called“cross-support” requirement). The PolicyStatement retreats somewhat on theharsher components of these elements inways that may be helpful to private equityinvestors, but, as discussed below, certainissues still remain.

Capital Commitment Under the Policy Statement, an investeedepository institution must maintain aminimum ratio of 10% Tier 1 commonequity-to-total assets for a period of threeyears and, thereafter, be “well capitalized”for the remaining period of ownership bythe private equity investors. These capitallevels generally should be less onerous toprivate equity investors than what theFDIC proposed in July. The FDICoriginally proposed a three-year 15% Tier1 leverage ratio but also defined thenumerator of the ratio to include certainequity interests in addition to commonstock. The Policy Statement limits thenumerator to straight common equity.

The July proposal contained languagethat would have required private investorsto “agree” to cause an acquired bank tomeet its capital requirements and “toimmediately facilitate” restoring a bank tothe required capital standards. Consistentwith the elimination of the “Source ofStrength” provisions discussed below, thislanguage has been removed from thePolicy Statement.

On paper, these capital requirements

appear to put private equity buyers at acompetitive disadvantage to strategicbuyers, which are not subject to the samerequirements. But given that privateequity buyers are likely to be at acompetitive disadvantage to strategics inthe banking sector as a practical mattereven without this additional burden, theserequirements are likely to be germanemost often in transactions in whichprivate equity investors are the solebidders for a particular target. In thesesituations, these capital requirements willreduce IRR, and their inclusion in thePolicy Statement may ultimately putpressure on the FDIC to accept a lowerpurchase price for a failed institution so asto enable a private equity investor tomodel the acquisition consistent with itstarget returns.

Source of StrengthThe FDIC’s July proposal would haverequired investors in certain organizationalstructures “to commit” to serve as a sourceof strength and support the depositoryinstitutions being acquired. This languagearguably could have been read to imposeunlimited liability on private equity funds(and conceivably their investors) withrespect to the liabilities of an acquiredbank and therefore could have been a“showstopper” for private equityinvestment in failed financial institutions.Happily, the Policy Statement drops thissource of strength commitment.

Cross SupportThe statutory framework under which theFDIC operates includes a “cross-guarantee” provision that permits theFDIC, under certain circumstances, to useinterests in a healthy bank to reimburseitself for funds expended to resolve acommonly controlled failed bank. In the

Three elements of the

July proposal created the

greatest concern: the

bank capital levels, the

need for private equity

funds to serve as an

ongoing “source of

strength” to the bank,

and the ability of the

FDIC to use a private

equity firm’s interests in

one banking structure to

reimburse the agency for

its costs related to the

failure of another bank

under some level of

common ownership.... CONTINUED ON PAGE 29



July proposal, the FDIC had proposed avery expansive application of thisrequirement. Basically, the proposal wouldhave required private investors whoseinvestments, individually or collectively,constituted a majority of the direct orindirect investments in more than onebank to commit their investments to theFDIC to reimburse the agency if any ofthe banks failed. Because of its broadwording, this provision could have put atrisk even a 1% private equity investor inmultiple banking enterprises.

The Policy Statement scales back to adegree the July proposal’s cross-guaranteerequirement (which the FDIC has re-labeled as “cross support”). The new cross-support requirement provides that if oneor more private investors own at least80% of multiple insured depositoryinstitutions, these investors’ interests incommonly owned banks and thrifts wouldbe pledged to the FDIC to cover potentiallosses sustained by the agency from thefailure of any one of these institutions.The mechanics of this pledge are notspecified. It is also reasonable to assume,but not entirely clear, that pursuant to theapplication provisions set forth above, aless than 5% owner in an investee bankwould not be subject to the cross-supportrequirement, at least unless it was clearlyacting in concert with more significantinvestors.

Even as revised, these rules expose anyinvestor holding a differing but greaterthan 5% ownership percentage interest intwo syndicates, each of which owns atleast 80% of an insured depositoryinstitution, to a disproportionate share ofliability with respect to a failure of theinsured depository institution owned bythe syndicate in which such investor holdsa lesser interest. While this potentialexposure could be addressed under anindemnity arrangement or the like among

members of the syndicate, private equityclub deals also may be structured goingforward to avoid 80% overlappingownership with a prior consortium deal.

Other Substantive ProvisionsThe Policy Statement contains a numberof other provisions, which may not be asproblematic or noteworthy as theprovisions discussed above, but which stillmay be highly relevant to a potentialprivate equity investor. Of particularrelevance here, these provisions:

� Preclude an entity existing in a “banksecrecy jurisdiction” from participatingin a failed bank deal unless (1) itsparent is subject to comprehensiveconsolidated supervision as determinedby the Fed, and (2) it enters intoinformational and other commitmentswith the FDIC. The Policy Statementdefines a “bank secrecy jurisdiction” toencompass any country that “applies abank secrecy law that limits U.S. bankregulators from determiningcompliance with U.S. laws or preventsthem from obtaining information onthe competence, experience andfinancial condition of applicants andrelated parties, lacks authorization forexchange of information with U.S.regulatory authorities, or does notprovide for a minimum standard oftransparency for financial activities.”The FDIC does not specify whichjurisdictions would fall within thisdefinition and, given the breadth andseeming elasticity of the definition, thislanguage may apply to many countriesin which non-U.S. private investmentvehicles are frequently organized, suchas the Cayman Islands. Subject to taxplanning, one way around thislimitation may be for well-advisedfunds to utilize the AIV (AlternateInvestment Vehicle) provisions of their

limited partnership agreement to forma special purpose vehicle in ajurisdiction that clearly does notconstitute a “bank secrecy jurisdiction,”such as Delaware.

� Generally preclude a private equityinvestor from transferring ownership ina banking enterprise for three years.These provisions obviously couldnegatively impact a fund’s ability togenerate targeted IRRs by requiring athree-year holding period. The scope ofthe provision is unclear, and it couldalso be implicated in the event of asecondary sale of interests in the privateequity fund.

...[E]ven if a group of

private equity firms

decides to buy a failed

bank from the FDIC and

meets all of the Policy

Statement’s guidelines,

one or more of the

acquirers may still need

to undergo a lengthy

process with a different

federal banking agency

to determine if they will

need to register, and be

subject to supervision

and regulation, as bank

or thrift holding

companies.




Impact of SeparateRegulation by the Fed and OTSAs mentioned above, the Policy Statementdoes not supplant the qualificationstandards and regulatory requirementsimposed by the Fed and OTS under theBank Holding Company Act (“BHCA”)or Savings and Loan Holding CompanyAct (“SLHCA”), respectively.

Accordingly, even if a group of privateequity firms decides to buy a failed bankfrom the FDIC and meets all of the PolicyStatement’s guidelines, one or more of theacquirers may still need to undergo alengthy process with a different federalbanking agency to determine if they willneed to register, and be subject tosupervision and regulation, as bank orthrift holding companies. Most privateequity investors cannot easily satisfy therequirements to become a bank or thriftholding company consistent with theirbusiness models and, thus, the impositionof those holding company requirements

can be a bar to investment activity in thissector.

The BHCA and SLHCA requirementsapply to entities that “control” a bank orthrift, respectively. “Control” can befound, under these statutes, if an investorowns or controls, directly or indirectly,25% or more of the voting securities of abank or thrift. Control also can be foundin numerous other circumstancesinvolving lesser levels of ownership, basedon a facts-and-circumstances assessmentby the regulatory agencies. For example,in certain situations, the Fed can requirean investor owning as little as 10% of thevoting securities of a bank to agree to bean entirely “passive” investor to avoidbeing deemed to be in a “control”position.

Both the Fed and OTS have takensome steps to encourage private equityinvestment in the banking sector. TheFed, which has consistently been the mosttentative in this area, issued its own policystatement in September 2008 to liberalize— to a limited extent — the ability ofprivate equity and other investors to takestakes in banks and bank holdingcompanies without being deemed to“control” such organizations. The Fed’spolicy statement provides useful guidanceand relief, for example, with respect to theextent to which investors may havedirector interlocks with, make non-votingequity investments in, and communicatewith management of bankingorganizations without becoming subject tothe BHCA. For its part, the OTSgenerally has been more receptive than theFed (and FDIC) to private equityinvestors. The OTS has, for example,approved certain “silo” structures and clubdeals that likely would have raised issuesunder the Fed’s interpretations of theBHCA.

ConclusionWhether the Policy Statement, inconjunction with the loss-sharingagreements into which the FDIC hasentered, encourages significant privateinvestment in failed banks should becomeevident over the coming months. Overthat period, we also may get further clarityon how the FDIC intends to interpretcertain of the Policy Statement’sambiguous and expansive provisions.

In taking its recent actions, the FDICacknowledged the need for additionalcapital in the banking system. If anything,that need for capital is expected toincrease significantly; some analysts expectanother 150 to 200 bank failures this year(on top of the 84 to date). If thesenumbers hold true, the FDIC likely willface significant pressure to reconsider itsapproach and to be even moreaccommodating to private equityinvestors. That step alone may not besufficient to spur significant privateinvestment in the banking sector, unlessthe Fed and OTS also are willing toalleviate their respective rules.Encouraging meaningful private equityparticipation in the banking sector mayrequire the adoption of a coordinated,transparent, and comprehensiveframework by federal banking regulatorsthat is more clearly receptive to privateequity investment.

Satish M. [email protected]

Paul L. [email protected]

Gregory J. Lyons [email protected]

In taking its recent

actions, the FDIC

acknowledged the need

for additional capital in

the banking system. If

anything, that need for

capital is expected to

increase significantly;

some analysts expect

another 150 to 200 bank

failures this year (on top

of the 84 to date).


July 13, 2009Jennifer J. Burleigh“Raising a Private Equity Fund”Tenth Annual Private Equity Forum 2009Practising Law InstituteNew York

July 13, 2009Christopher J. Ray“Principles Based Regulation and CorporateGovernance: How Many Actuaries Are onYour Board?”Compliance and Legal Sections AnnualMeeting 2009 ACLI Boston

July 21, 2009Heidi LawsonKeith J. Slattery “Corporate Insurance and Indemnification forRussian Directors”Debevoise & Plimpton LLP and AonCorporationMoscow

September 12, 2009Sean Hecker“Following the Fraud: Litigation Risks fromMismanagement During a Downturn”Deloitte DbriefNew York

September 22-24, 2009Thomas M. Britt III“Chairman’s Opening Address”

“SE Asia Country Clinic: To What Extent Isthe SE Asia Region a Less Crowded Marketwith Many Undiscovered Opportunities or aPolitical and Economic Risky Option in aRisk-Averse Environment?”

“Focus on Buyouts: End of the LBO? WhatStrategies Are Buyout Firms Adopting in aCredit-Poor Environment? Where Are CapitalDeployment Opportunities to Be Found?”SuperReturn Asia 2009ICBIHong Kong

September 25, 2009Michael P. Harrell“PE/VC Firms: Getting Ahead of the Curveon Partnership Terms Trends in PartnershipTerms and Conditions”Thomson Reuters Webinar

October 21, 2009Satish Kini Gregory Lyons“FDIC – Private Equity Investors AcquiringFailed Banking Institutions”Practising Law InstituteNew York

October 28, 2009Andrew Berg“Tax Strategies for Corporate Acquisitions,Dispositions, Spin-Offs, Joint Ventures,Financings, Reorganizations andRestructurings 2009”Practising Law InstituteNew York

October 29-30, 2009Franci J. Blassberg, Program Co-Chair“Special Problems when Acquiring Divisionsand Subsidiaries"

“Negotiating the Acquisition of the PrivateCompany”25th Annual Advanced ALI-ABA Course of Study on Corporate Mergers and AcquisitionsALI-ABA Committee on ContinuingProfessional EducationBoston

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Institutional Limited Partners Association Releases PrivateEquity Principles Report Listing Private Equity Preferred Terms

A L E R T

On September 8th, the InstitutionalLimited Partners Association (“ILPA”), anot-for-profit association representingcertain institutional private equity investors,released a report titled Private EquityPrinciples (the “IPLA Report”). The ILPAReport describes “preferred” private equityfund terms. The preferred terms, notsurprisingly, incorporate many of the pro-investor (“LP”) comments that LPs oftenmake to fund sponsors (“GPs”) whennegotiating the terms of a private equityfund. The ILPA Report, like the “MercerReport” sponsored by nine state retirementplans in 1996, appears to be an attempt tomove the market to terms that the authorsbelieve are more LP-friendly.

In a number of respects, however, theILPA Report goes beyond being acomprehensive LP “wish list.” The reportalso recommends certain economic andother terms that many LPs rarely request,and that are not standard (i.e., terms thatare not “market”) for most buyout andventure capital funds.

The preferred terms called for by theILPA Report include the following:

� carried interest should be distributed toGPs only after all contributed capitalplus a preferred return on that capitalhas been distributed to the investors inthe fund (as contrasted with the U.S.standard “deal by deal” waterfall, whichallows earlier carried interestdistributions);

� funds that do not follow the “all capitalfirst” distribution model, but insteadallow for “deal-by-deal” payouts ofcarried interest, should:

� establish large reserves if a “clawback”obligation arises,

� return all management fees and otherexpenses funded by the LPs throughthe date an investment is realized (notjust a portion of total expensesapportioned to that realizedinvestment), and

� require joint and several guarantees ofany clawback obligation (and notrequire each carried interest recipientto guarantee only his or herproportionate share of any clawback);

� the GP should make a “substantial”investment in the fund, and thatinvestment should be primarily in cash(whereas use of the management feeoffset mechanisms that so many firmshave adopted is discouraged);

� any clawback should be calculated on agross basis (not on an after-tax basis);

� fund partnership agreements shouldprovide for payment of clawbackobligations within two years ofrecognition that a GP has received morethan 20% of the cumulative net profitsof the fund (rather than requiringpayment of clawback amounts only at

the end of the term of the fund);

� 100% of any transaction andmonitoring fees that are charged by aGP or its affiliates should accrue to thebenefit of the fund (and not only the50% to 80% that is most commontoday);

� a mere majority-in-interest of the LPsshould be able to require suspension ortermination of the investment periodwithout cause (and not thesupermajority vote that most fundpartnership agreements now require);

� indemnification should be capped andlimited in other respects (as contrastedwith the broader indemnificationhistorically contained in most fundpartnership agreements); and

� reporting to the LPs should besubstantially beefed up, and shouldinclude disclosure of each individualinvestment professional’s share of thecarried interest and share of the GP’scapital investment in the fund.1

In addition to setting forth proposedbest practices and a list of preferred fundterms, the ILPA Report includes a numberof interesting and detailed suggestionsconcerning reporting to LPs and theoperation of LP advisory committees.

Many of the recommendationscontained in the ILPA Report arethoughtful and sensible, and will beseriously considered by GPs. Otherrecommendations made by the report,including several of those listed above,represent departures from current marketterms — in a number of cases from marketterms that go back to the beginning of thebuyout business in the late 1970s. Whilemarket practices can and do change, manyof the recommend-ations contained in theILPA Report will undoubtedly provecontroversial and will be resisted by manyGPs.

Michael P. [email protected]

1 For a discussion of clawbacks and the “allcapital first” vs. “deal-by-deal” distributionmechanics discussed in this article, see “Clawbacks:Protecting the Fundamental Business Deal inPrivate Equity Funds” from the first issue (Fall2000) of The Debevoise & Plimpton Private EquityReport.

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