private equity report can you sandbag? - home | …/media/files/insights/publications/2002... ·...

What’s Inside

The SEC’s “All Holders/Best

Price Rule” Can Complicate

Management Arrangements

in Tender Offers page 3

Guest Column: Surviving in

Private Equity’s Brave New World

page 4

Trendwatch: Does it Matter

Who Your Fund Advisers Are?

page 6

Caveat Investor: Phase 1s May

Not Be Adequate for Analyzing

Environmental Risk page 8

Employee Leveraged

Co-Investment Plans: Should

You Have One? page 10

Troubling Times for Directors

of Portfolio Companies page 12

The New German Tender Offer Law

page 14

Are Your Fund Marketers Brokers?

page 15

Alert: Removal of the U.K.

20 Partner Limit page 22

Can You Sandbag?

Four Troublesome SituationsYou are a frequent buyer of privately-heldbusinesses. Here are four situations inwhich your knowledge of misrepresen-tations by the seller may limit your abilityto recover damages, and recommenda-tions for preserving your rights.

The Last-Minute Dump. After you sign the purchase agreement and just beforeclosing, the seller’s lawyer hands you aletter listing ten ways in which the seller’srepresentations are not true. The purchaseagreement does not contemplate updatingof the seller’s representations. You ignorethe letter and, relying on your ability torecover for the breaches of the representa-tions pursuant to the indemnificationprovisions of the purchase agreement,close the transaction. Under the law ofsome jurisdictions (including New York),unless you have expressly reserved yourrights (with the concurrence of the seller),you may not have a claim for the breachesof the representations.

A buyer should always include in thepurchase agreement provisions reservingthe buyer’s rights. Otherwise the seller can argue that because the buyer closed,notwithstanding its knowledge that arepresentation was untrue, the buyercould not have relied on such represen-

tation and that by closing the buyer waivedits right to be indemnified. Typical rights-reserving provisions include a provision tothe effect that the seller’s representationsand the seller’s obligation to indemnify the buyer for breaches thereof will not beaffected by any investigation by or onbehalf of the buyer or by the buyer’s know-ledge that any such representation is ormight be untrue, and a provision to theeffect that any waiver of the buyer’s rightsunder the purchase agreement must beexpress and in writing.

Sandbagging. Before the purchase agree-ment is signed, your environmentalconsultants inform you of a potential mate-rial liability uncovered in the course of theirinvestigation of the business. Your lawyerwants to bring this liabilityto the attention of the sellerand negotiate for either apurchase price reduction ora special indemnity. You arereluctant to raise the point.The seller is touchy, and youdo not want to rock theboat. You also do not wantto scare your lenders. Yourlawyer confirms that theliability would constitute a

continued on page 18

Volume 2 Number 2 Winter 2002

P r i v a t e E q u i t y Re p o r t

“Would everyone check to see they have an attorney?I seem to have ended up with two.”©

2002

The

New

Yor

ker C

olle

ctio

n fr

om c

arto

onba

nk.c

om.

All

Rig

hts

Res

erve

d.

When a Buyer Knows that One of the Seller’s Representations or Warranties is Untrue

A buyer of a business generally assumes that if a representation or warranty made by the seller in the purchase agreement survives the closing and is untrue, the buyer will have a rightto recover damages (subject to any materiality standards, deductibles, caps, etc. provided forin the agreement). However, in some situations, a buyer may not be able to recover damages for a breach of the seller’s representation if the buyer was aware of the breach before closing. The relevant case law is confusing, but the purchase agreement can provide buyers (and sellers)with greater certainty.

letter from the editor

Private Equity Partner/ Counsel Practice Group Members

The Debevoise & Plimpton Private Equity Report l Winter 2002 l page 2

Franci J. Blassberg Editor-in-Chief

Ann Heilman Murphy Managing Editor

Please address inquiries regardingtopics covered in this publication to the authors or the members of the Practice Group.

All other inquiries may bedirected to Deborah BrightmanFarone at (212) 909-6859.

All contents © 2002 Debevoise & Plimpton. All rights reserved.

Happy New Year from The Debevoise & PlimptonPrivate Equity Report. 2002 should prove a challengingyear for private equity firms seeking to strike the rightbalance between fundraising, investing and operatingpriorities. We have great faith that the private equityindustry will meet those challenges.

As busted deals become more common, RobertQuaintance, one of our Corporate Partners, explainswhat buyers can do when they discover prior to closingthat one of the seller’s representations is untrue andcautions against the dangers of sandbagging. Our GuestColumnist for this issue, Eric W. Doppstadt, Director of Private Equity at The Ford Foundation, outlinesseveral guiding principles that have characterized themost successful U.S. private equity firms over the last15 years and should be considered by any firm hopingto create value in the current environment of excesscapital, sluggish stock markets, lower returns andreduced leverage.

David Mason and David Lebolt, of our Compensationand Benefits Group, highlight the risks sponsors face innegotiating compensation terms with target manage-ment in advance of a tender offer and offer guidance onhow to structure such arrangements to avoid runningafoul of the All Holders/Best Price Rule. In this issue’sTrendwatch, Woody Campbell focuses on advisers,analyzing the extent to which the choice of law firmsand placement agents can affect deal terms. In addi-tion, Stuart Hammer warns potential buyers ofbusinesses why Phase1 Environmental Assessmentsmay not be adequate to analyze environmental risk.

Beth Pagel Serebransky and Kenneth Berman explainthat, notwithstanding the current environment, now

may be exactly the right time for financial institutionswith private equity operations to develop employeeleveraged co-investment plans. The advice offered byRichard Hahn and Harold Neu to private equity profes-sionals serving on the boards of their firm’s troubledportfolio companies is particularly timely in the currenteconomic environment.

As the German acquisitions that have been widelypredicted are beginning, David Hickok and ThomasSchürrle, Partners in our new Frankfurt office, remindU.S. investors more accustomed to U.S.-style takeoverprotections of the distinct features of the new GermanTakeover Law. Ann Baker of our Paris office alsoexplains the Fonds Commun de Placement a Risque(FCPR), the most common private equity investmentvehicle in France.

As technological advances and other developmentsin the securities markets have increased the numberand types of persons involved in marketing securities,the SEC has made it more difficult to avoid being abroker. Marcia MacHarg, Kenneth Berman and RachelGraham answer some FAQs about how efforts to placeinterests in private equity funds can implicate U.S.broker-dealer regulation and offer guidance on howprivate equity firms can avoid becoming subject toregistration and reporting as a broker/dealer.

As usual, we welcome any comments you may haveon how we can focus the publication on subjects ofpractical interest to private equity firms and theirinvestors.

Franci J. BlassbergEditor-in-Chief

The articles appearing in thispublication provide summaryinformation only and are notintended as legal advice.Readers should seek specificlegal advice before taking anyaction with respect to thematters discussed herein.

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

Private Equity FundsAnn G. Baker – ParisKenneth J. Berman – Washington D.C.Woodrow W. Campbell, Jr.Sherri G. CaplanMichael P. HarrellMarcia L. MacHarg – FrankfurtAndrew M. Ostrognai – Hong KongDavid J. SchwartzRebecca F. Silberstein

Mergers & Acquisitions/ Venture CapitalHans Bertram-Nothnagel – FrankfurtE. Raman Bet MansourPaul S. BirdFranci J. Blassberg

Colin Bogie – LondonRichard D. BohmGeoffrey P. Burgess – LondonMargaret A. DavenportMichael J. GillespieGregory V. GoodingStephen R. HertzDavid F. Hickok – FrankfurtJames A. Kiernan, III – LondonAntoine Kirry – ParisMarc A. KushnerRobert F. QuaintanceThomas Schürrle – FrankfurtAndrew L. Sommer – LondonJames C. Swank – ParisJohn M. Vasily

The Debevoise & Plimpton Private Equity Report is a publication ofDebevoise & Plimpton919 Third AvenueNew York, New York 10022(212) 909-6000

www.debevoise.com

Washington, D.C.LondonParisFrankfurtMoscowHong Kong

´

Nearly every sponsor’s negotiatedacquisitions will involve reaching agreement with the future portfoliocompany’s management team. If theacquisition is structured as a tenderoffer, however, great care must betaken at all stages of the process to tryto minimize the risk that an aggressiveplaintiff lawyer could claim that theagreements violate the so-called “AllHolders/Best Price Rule” (Rule 14d-10under the Williams Act provisions ofthe Securities Exchange Act of 1934).

What Agreements with Management are Typical?At a minimum, the sponsor and themanagement team will usually reachagreement on the broad parameters of the equity incentive plan that thesponsor will put in place after theacquisition. Often, however, the discus-sions with management will be muchmore specific and can cover a muchbroader range of topics, including theterms of new, post-acquisition employ-ment agreements for key members of management (including severance),annual bonus plans, etc. If the acquisi-tion involves a “roll-over” of optiongains or other similar items, the terms

of the equity (or deferred equity right)that management is to receive in theroll-over will be agreed to as well.

None of these agreements are gener-ally improper or inappropriate. They aredisclosed to the target board and to thepublic, and are necessary for both thesponsor and the target company. If thediscussions with management cannotstart until after the sponsor has alreadyacquired the company, the managementteam may well try to extract some hold-up value from the sponsor. Anunderstanding of the post-acquisitioncompensation and other incentivearrangements will also help minimizemanagement concerns during thecrucial period before the consummationof the acquisition, thus helping to avoid a melt-down of target managementbefore the acquisition is completed.

What’s at Stake?The “All Holders/Best Price Rule”imposes two requirements on tenderoffers that are meant to prohibit discrim-ination among holders of the shares that are subject to the tender offer:

• the tender offer has to be open toeach holder of the class of securitiesfor which the tender offer is beingmade (“All Holders”); and

• the consideration paid to every securityholder pursuant to the tender offermust be the highest paid to any holderduring the tender offer (“Best Price”).

If a court determines that the personmaking the tender offer violated this rule– for example, by paying one shareholdermore for his shares than was being paidto the public – the result would be anorder to pay the “extra consideration” toall of the other shareholders.

The risk here – in so far as it relatesto a sponsor’s arrangements withmanagement – is that some item(s) inthe sponsor’s agreements with themanagement team are re-characterizedas disguised payment for shares held bymanagement, and that “extra” paymentmust then be paid to the public share-holders. Perhaps more technically, therisk to keep in mind is that this issuemight get to a jury, although this risk can sometimes be reduced somewhatwith proper planning.

For example, let’s say that someonepurchased a company through a tenderoffer and, in connection with that tenderoffer agreed with the Chairman of thetarget (who was also a shareholder) that he would receive $5 million for a non-competition agreement. A jurysubsequently determines that $2.3+million of this was actually a paymentfor the tender of his shares. Assumingthere are 2,300,000 shares outstanding,this would translate into an additional$1.00 per share that the other share-holders had not received in the tenderoffer, and the purchaser would beordered to pay that additional $1.00 tothe other shareholders, plus interest.Something like this actually happened.(Gerber v. Computer Associates, on appeal)

It is easy to see how this area cansend visions of BMWs and vacationhomes dancing in the minds of plaintifflawyers (and give acquirors, and theirlawyers, nightmares).

The Legal LandscapeUntil the SEC clarifies how the AllHolders/Best Price Rule should apply inthe area of management compensationarrangements or until the Supreme


The SEC’s “All Holders/Best Price Rule” Can ComplicateManagement Arrangements in Tender Offers

Philipp von Holst – Frankfurt

Acquisition/High Yield FinancingWilliam B. BeekmanCraig A. Bowman

–LondonDavid A. BrittenhamPaul D. Brusiloff A. David Reynolds

TaxAndrew N. BergRobert J. CubittoGary M. FriedmanFriedrich Hey – Frankfurt

Adele M. KarigDavid H. SchnabelPeter F. G. Schuur

–London

Employee Compensation & BenefitsLawrence K. CagneyDavid P. MasonElizabeth Pagel

Serebransky

Estate & Trust PlanningJonathan J. Rikoon



Surviving in Private Equity’s Brave New Worldguest column

The U.S. private equity industry has grown to a staggering size in recent years. From 1995 through 2000, annual fundraising by U.S.buyout funds multiplied almost fourfold, from $19 billion to $74.1 billion, with the amount of capital raised in the year 2000 almostdouble the annual average of the prior five years. Over the same period, annual fundraising by domestic venture funds rose anastonishing sixteenfold, from $4.7 billion to $75 billion. More than 500 buyout firms, and over 1,500 venture firms, operate in theU.S. today. And, as the industry’s investment pace has slowed, its uninvested capital has soared, and is now estimated by somesources to be as high as $100 billion in buyouts, and $50 billion in venture capital. Private equity has truly become a full-fledgedcapital market in its own right, comparable in size and complexity to many segments of the liquid capital markets.

Despite private equity’s explosivegrowth, however, there is little or noevidence to date that the industry’sability to create value has grown inproportion to the growth in its assetsunder management. Almost all of the most successful U.S. buyout andventure investments of the last fifteenyears were made when average fundsize, and capital under management,in those sectors was a fraction of whatit is today. Competition for transactionsis as intense as ever, with most trans-actions now involving auctions ormultiple bidders. And with many U.S.industries having been consolidated or rationalized, the flow of attractiveopportunities may even be smallertoday than it was five years ago. All thissuggests that the venture and buyoutsectors may be facing a problem ofexcess capacity, the consequence of an “overbuilding” spree fueled by cheapand readily available investor capital.

In light of this excess capacity, it isnot surprising that returns on capitalare falling throughout the industry. U.S.buyout returns have fallen steadily formuch of the last decade, and, in theaftermath of the Internet-telecom-techbubble, the U.S. venture industry isfacing its steepest losses ever. There isalso a growing realization that the waymany private equity firms create value– through investment structuring andfinancial leverage in the buyout industry,and through public market – momen-

tum investing in venture – are likely to yield still lower returns in the future,as leverage declines, product marketsbecome more competitive, andproduct lifecycles grow shorter.

All this suggests that the comingdecade is likely to be a much moredifficult operating, investing, and fund-raising environment for U.S. privateequity firms. Firms that succeed in this new world are likely to be thosethat follow some key principles thathave made the industry’s best firmssuccessful over time:

Size is usually the enemy of performance.

As average fund sizes have ballooned in recent years, many firms in both the buyout and venture sectors haveadopted an asset-gathering businessmodel, patterned after those of otherlarge money management firms. Thekey driver of such businesses is steadyfee income, spread over an expensebase that grows more slowly than assetsunder management. For the managersof private equity funds that follow this “asset maximization” model, theannuity-like fee stream that is generatedas new funds are layered on top of priorfunds dilutes the incentive effect of thegeneral partner’s carried interest. Overtime, such managers become lessconcerned with achieving significantoutperformance than with avoidingsignificant underperformance. Since thesuccess of a private equity firm is highlydependent on the idiosyncratic skills ofits investment professionals, however, it

is difficult to scale such firms withouteroding returns. Thus, firms that havescaled ambitiously may find it increas-ingly difficult to produce the resultsneeded to keep their asset basegrowing, particularly without the levi-tating effect of a bull market. A moresustainable strategy would be to ensurethat the firm’s assets under manage-ment do not grow faster than its abilityto deploy those assets at consistentlyhigh rates of return.

Focus on company-building, not financial

engineering. Relatively few privateequity firms possess the kind of oper-ating expertise that enables them tobuild fundamentally better and morevaluable assets, as opposed to relyingon financing structures, or risingmarket multiples, to generate returns.In today’s financial world, however,financial engineering and marketmomentum are weak factors, unlikelyto generate acceptable investmentreturns in isolation. Financial engi-neering skills are now widespread, butare less and less important to buyoutreturns as debt availability declines.And venture capitalists following amarket momentum strategy offer littleof value in today’s equity markets. The key to superior performance in thefuture is likely to be operating expertisethat enables investors to fundamentallyimprove the cash flow generating powerof the assets in which they invest.Thus, every private equity firm should


place top priority on enhancing itsoperating skills, no matter what sectorthe firm invests in.

Find your niche, and stick to it. Therising tide of the 1990s bull marketenabled many private equity firms topursue undifferentiated, generalistinvestment strategies, or even to switchstrategies from time to time, withoutsuffering adverse consequences. But“plain vanilla” investment strategies(such as the generic “middle marketbuyout firm”) are likely to generateincreasingly disappointing results in an environment in which deals arehotly competed for, leverage is oftenunavailable, and market multiples mayshrink, rather than expand. A moreeffective approach in this environmentis, instead, likely to be based on a deepfamiliarity with a particular strategy(such as turnarounds of underper-forming businesses) or sector (such as financial services or consumer products) that enables an investor to identify value-added opportunitiesnot obvious to others.

Avoid the “fallacy of composition.”

In classical economics, the “fallacy of composition” describes a situationin which otherwise rational investorspursue opportunities without consid-ering the effects of similar investmentsby others. Recent instances of thisphenomenon at work in the privateequity markets include the massiveoverinvestment in Internet retailers,telecom service providers, communi-cations equipment companies, movietheater chains, and, more recently,biotechnology companies (it has beenreported, for example, that 12 anthrax-related biotech firms have been fundedsince September 11). These episodesmake clear that it is insufficient to lookat a prospective investee’s potentialmarket; evaluating the activities of com-petitors is equally important.

Low cost capital is a dangerous illusion.

A phenomenon closely related to thefallacy of composition is the lure ofcheap capital. At the height of the spec-ulative froth of 1999-2000, seeminglylimitless capital from limited partners,and from the IPO and merger andacquisition markets, caused manyprivate equity firms to lower their riskperceptions and to make investmentsbased on little more than marketmomentum. In retrospect, that artificiallycheap capital was a trap, luring firmsinto making investments that far overraneconomic rationality, as more companiesgot funded in each sector than therewere employees to manage them orcustomers to buy their products.

Be a thoughtful contrarian. It is widelyaccepted that in public market investing,a “good company” is only a good investment if the investor’s view of thecompany’s prospects is not yet reflectedin the market consensus. Likewise, intoday’s competitive private equity envi-ronment, investing on the basis of theconsensus view of a company or sector’sprospects is unlikely to produce superiorreturns, because the consensus view is likely to be already incorporated inthe price. Private equity firms that can,instead, develop a view apart from themarket consensus, based on specializedknowledge of a company or an industrysector, can create opportunities forsignificant returns.

Diversify across market cycles. Privateequity is a cyclical business, andmultiple funds managed by the sameprivate equity firm have performed verydifferently, based on the time period inwhich those investments were made.For this reason, spreading investmentdollars across various economic andmarket cycles is the most importantform of diversification in private equityinvesting. Within reasonable bounds,private equity firms should thus seek to

invest consistently at each part of thecycle. The drastic acceleration in theindustry’s investment pace during thelast few years, particularly in much ofthe venture industry, was in retrospecta form of market timing, the dangers of which have become all too apparent.

Treat your investors like partners, and

your partners like investors. As the financial world becomes ever moretransaction-driven, private equityremains one of the few areas that is stilllargely driven by long-term relationshipsbetween firms and their investors. Themost successful private equity firms willbe those that treat their investors likelong-term partners, by creating fundterms that maximize transparency andalignment of interests between the firmand its investors. One very importantway to align interests is for privateequity fund managers to make signifi-cant personal investments in their ownfunds, alongside their limited partners.

Following these principles cannotguarantee investment success. Butignoring them is riskier. In today’s post-“bubble” environment, the buildingblocks of limited partner asset alloca-tions to private equity – its expectedreturns, estimated risks, and antici-pated correlation with other assets –have all become less favorable thanthey might have appeared in recentyears. Thus, private equity firms thatignore these principles are very likelybetting their future on their investors’continued willingness to accept fallingreturns, and flawed fund terms, at atime when investor allocations toprivate equity may be shrinking. Forprivate equity firms focused on risk and return, the principles above offer a surer route to success.— Eric W. Doppstadt

Director, Private Equity,The Ford Foundation


Over the past 18 months, as numerousdot com, telecom and other “neweconomy” businesses have faltered,many private equity firms have recali-brated their investment mix in favor oftraditional, “old economy” businesses.The resurgence in old economy invest-ments has prompted a need on thepart of private equity firms to evaluatethe greater environmental risks ofteninherent in these more traditional businesses, particularly in the case ofdistressed companies that may lackthe cash flow necessary to addressenvironmental concerns.

In analyzing environmental risk,private equity firms have come to rely heavily on the findings of a Phase 1

Environmental Site Assessment(“Phase1”). Where a Phase1 revealsno significant environmental issues,private equity investors often mis-takenly assume that there are noenvironmental liabilities or obligationsimpacting the subject facility. As dis-cussed below, we believe this relianceis misplaced. Phase1s may not addressimportant elements of environmentalrisk that can significantly undermine a private equity investment.

Overview of Phase 1s. Phase1s havebeen part of the lexicon of investorssince the 1980 passage of the federalSuperfund law, which empowered thefederal government and private partiesto recover costs incurred in cleaningup contaminated facilities. Confrontedwith the prospect of environmentalliability that is retroactive, strict, joint

and several, investors have routinelycommissioned Phase1s as the corner-stone of their environmental duediligence.

Phase1 reports are prepared by anoutside environmental consultant andgenerally consist of the following:

• A review of relevant federal and stateenvironmental databases to deter-mine whether the facility at issue hasbeen the subject of a cleanup orderor for which regulators are proposingcleanup. These databases will alsoreveal other potential environmentalissues, including the generation of hazardous waste, the presence of underground storage tanks andreported releases of hazardous mate-rials. In addition, these databasescan identify environmental concernsat nearby facilities that could affectthe target property.

• Interviews with knowledgeable sitepersonnel and a review of on-site envi-ronmental documentation in order toidentify any environmental concerns.The consultant will also review aerialphotographs and fire insurance maps,which provide information on histor-ical usage of the property.

• An inspection of the facility to determine whether there are any indi-cations of potential contamination,such as discolored soil or distressedvegetation. Particular attention will be paid to possible sources ofcontamination, including lagoons,settling ponds, landfills, storage tanks

and waste disposal areas. Whenmatters of environmental concern areidentified, the consultant may recom-mend a subsurface investigation(commonly referred to as a “Phase 2”environmental investigation).

Limitations of a Phase 1. While a Phase1 is an important tool for iden-tifying potential contamination issues, it does not address other importantelements of environmental risk thatmay bear upon a potential privateequity investment:

• Phase1s generally do not include an analysis of environmental com-pliance issues. Costs associated with environmental compliance cansometimes exceed costs associatedwith contamination. Compliance is a particularly important issue fordistressed or highly leveraged com-panies that have lacked the capitalnecessary to purchase pollutioncontrol equipment and address othercompliance issues. Costs necessaryto bring a facility into compliancewith environmental regulations, par-ticularly those associated with thefederal Clean Air Act, can be millionsof dollars.

• Phase1s do not identify environ-mental liabilities or obligationsassociated with formerly owned oroperated facilities. A target companymay have assumed (whether bycontract or by operation of law) envi-ronmental liabilities associated withprior operations or facilities that it nolonger owns or operates. Remediation

Caveat Investor: Phase 1s May Not Be Adequate For Analyzing Environmental Risk

This article is Part 1 of a two-part series on environmental issues of critical importance to private equity investors. In this article,we address the inadequacies of traditional Phase1 Environmental Site Assessments as a due diligence tool. In Part 2, we willanalyze shareholder liability under environmental laws.


obligations associated with formerfacilities may be significant.

• Phase1s generally do not identifyliabilities associated with the target’soff-site disposal of hazardous wastes.Where cleanup of an off-site disposalfacility is ordered, the target could be required to contribute to cleanupcosts. These costs could be signifi-cant, particularly if the target is one of the largest generators ofhazardous waste at the facility.

• Most Phase1s do not addresspending or threatened environmentallitigation. Not surprisingly, environ-mental litigation can significantlyundermine a private equity invest-ment. Toxic tort claims and asbestosexposure lawsuits can result in multi-million dollar liability verdicts.Actions brought by regulators orenvironmental protection groupscould expose the target not only to expenses, but also to negativepublicity.

• Phase1s do not address certainsubstantive environmental issuesthat could affect an investment decision. For example, Phase1s do not estimate the costs necessary to remove asbestos at a facility.Asbestos removal projects can becostly, particularly if removal isrequired at multiple locations.Similarly, Phase1s do not addressissues associated with wetlands,which can be important, particularlyif future development of the wetlandsareas is planned.

Relying on a Seller’s Phase 1. In auctionsituations, it is fairly common forsellers to commission Phase1s of thetarget’s facilities in order to facilitatethe bidders’ due diligence. Privateequity firms should be cautious beforerelying on these reports, which can

often understate environmental problems at a facility. In some seller-commissioned Phase1s, consultantsmay not be provided with all relevantenvironmental documentation.Similarly, for confidentiality purposes,consultants may not be given accessto knowledgeable facility personnel.Moreover, some sellers retain inexpen-sive and often unqualified consultantswhose reports are inadequate forassessing environmental risk.

To alleviate concerns associatedwith a seller-commissioned Phase1,the scope of work for the Phase1

should be reviewed in order to assurethat no significant limitations wereimposed on the consultant’s review. In addition, the private equity investorshould obtain a “reliance letter” fromthe seller’s consultant, which providesthe investor with recourse against theconsultant for certain deficiencies inthe Phase1.

Additional Investigation. Rather thanmerely commissioning a traditionalPhase1 report, private equity firmsshould consider commissioning amore comprehensive environmentaldue diligence assessment that evalu-ates all relevant environmental risks,including risks not ordinarily identifiedin a Phase1. The scope of this assess-ment will depend on several factors,including (i) the structure of the trans-action (e.g., stock purchase vs. assetpurchase), (ii) the nature of the business (e.g., whether the businesstypically has significant environmentalissues), (iii) the extent to which theseller is retaining liability for environ-mental matters, (iv) the time andfunds available for performing theinvestigation, and (v) the level of environmental risk the private equityinvestor may be willing to accept.

Depending upon these factors, the environmental assessmentcommissioned for a private equityinvestment may need to address the following issues:

• regulatory compliance, including an estimate of the costs necessary tobring the target company’s facilitiesinto compliance with environmentallaws;

• the impact of any impending environ-mental regulations and, in certaininstances, the impact of any proposedenvironmental regulations;

• liabilities associated with off-site wastedisposal practices, including an under-standing as to which off-site facilitiesused by the target are expected torequire clean-up;

• environmental obligations related toformer facilities and discontinuedoperations;

• pending or threatened environmentallitigation, including complaints byregulators, private parties and envi-ronmental protection groups; and

• health and safety issues, includingcomplaints raised and compensation continued on page 22

Rather than merely commis-

sioning a traditional Phase1

report, private equity firms

should consider commissioning

a more comprehensive

environmental due diligence

assessment that evaluates all

relevant environmental risks,

including risks not ordinarily

identified in a Phase1.


Employee Leveraged Co-InvestmentPlans have become an increasinglypopular and attractive recruitment andretention (and wealth creation) vehiclefor many financial firms involved inprivate equity investing. These plansgive employees – including those notdirectly involved in the employer’sprivate equity business – the opportu-nity to use part of their compensationto invest in private equity opportunitieswith leverage provided by their employer.Even in the current economic climate,the availability of such a plan is often a major consideration for prospectiveemployees who may have other oppor-tunities where they can participatedirectly in a carried interest. Most ofthe larger investment banks and manyother financial institutions andconsulting firms have implementedLeveraged Co-Investment Plans orsimilar plans for their key employees.

The funds can also help to focusprivate equity employees on long termreturns, align the interests of employeeswith both their employer and itsinvestors, increase the potential forreferrals to the private equity groupfrom participating employees outsideof the private equity group and increasethe sources of capital available forprivate equity investment.

Notwithstanding a somewhat unfa-vorable private equity environment,there is another reason to considerimplementing a Co-Investment Plan.The SEC has recently given sponsorsthe opportunity to open up the plan toa greater number of employees. Undercurrent law, funds with 500 or moreparticipants may become subject to thepublic periodic reporting requirements.We recently obtained SEC no-action

relief (in many respects the first of its kind) for a group of co-investmentfunds exempting them from thesepublic reporting requirements.

Implementing a Co-Investment Plan raises many of the same issuesinvolved in setting up any privateequity fund, as well as numerousspecial issues due to the involvement of employees.

In most plans, employees investafter-tax funds directly into a co-invest-ment vehicle structured to provideflow-through tax treatment to theemployee. You can also structure afund to permit investment of pre-taxdollars, although it is more difficult to achieve flow-through tax treatmentin that structure.

This article focuses on plans for U.S. employees. (The tax and securitieslaw considerations are substantiallydifferent in each country, and imple-menting a multi-country fund can bedone, but raises complex structuringissues and can substantially increasethe costs of implementing a plan.)

1. Which Employees Should Participate?

There are four primary factors thatdrive employee selection – the desiredfund size, how much capital theemployer is willing to invest in thefund, the overall compensation levelsdesired for employees, and legal andrelated cost factors.

Offering U.S. employees the oppor-tunity to invest in a co-investmentvehicle, like any fund offering, issubject to compliance with the U.S.securities laws. The registrationrequirements of the Securities Act of1933 (the “33 Act”), the requirements of the Investment Company Act of1940 (the “40 Act”) and, if the fund is

sufficiently large, the reporting require-ments of the Securities Exchange Act of 1934 (the “34 Act”), as well as stateblue sky laws, are all potentially impli-cated by the fund offering.

If you expect 100 or more partici-pants, the co-investment vehicle willgenerally need to be structured as an“employee securities company” (orESC) and the employer will need toapply for the 40 Act exemption avail-able for ESCs. The application forexemption must be filed with the SECprior to closing the co-investment fund (and the ESC must operate asdescribed in the application), but the order need not be obtained untilafter the fund closing.1

Many Co-Investment Plans arelimited to accredited investors(employees with at least $200,000 inannual income or $1 million of networth) to fit within the ESC precedentsand the exemption from 33 Act regis-tration provided under Regulation D.Regulation D permits sales to an unlim-ited number of accredited investors and up to 35 non-accredited investors.2

Employee Leveraged Co-Investment Plans: Should You Have One?

1 The order will generally not provide a blanket exemptionfrom all of the provisions of the 40 Act. For example, certaintransactions with the employer or its affiliates which wouldotherwise be prohibited by the 40 Act are permitted subjectto compliance with safeguards designed to protect employees.The books and records of the ESC will be subject to SECinspection.

2 The SEC’s ESC orders generally require the 35 non-accredited investors to satisfy other conditions relating toincome level, education or business experience. It is possibleto structure a co-investment plan that includes more non-accredited investors and may avoid the need for a 40 Actexemption and 34 Act registration through a fund in whichthe employer has a very significant (i.e., majority) equityinterest or through a deferred compensation or phantomplan arrangement. However, unless the investing employeesalso provide services directly to the fund, or the fund isconsolidated on the employer’s balance sheet, the deferredcompensation and phantom plans would not permit adirect investment in the co-investment vehicle and distribu-tions to employees participating in those plans would betaxable at ordinary income rates.


Under current law, co-investmentfunds with 500 or more participantsmay become subject to the reportingrequirements of the 34 Act and berequired to publicly file annual andquarterly reports as to the fund’s activi-ties. Because of the costs involved inpublic reporting, as well as the strongdesire of sponsors to keep confidentialthe terms of the plan, its investmentsand its investment performance, mostemployers try to structure the plans to avoid reporting. This is not alwayspossible, particularly for larger financialinstitutions. We recently obtained SECno-action relief for a group of co-invest-ment funds exempting them from thesepublic reporting requirements. Theemployer was required to fully describethe plan in its request for no actionrelief and the relief was subject to anumber of conditions. For example,employees may not transfer their inter-ests in the fund to third parties. Thefunds must provide annual and semi-annual reports to investors. In additionto financial statements that fundsgenerally provide as a condition toobtaining 40 Act exemptions, thereports will contain additional informa-tion concerning fund investments, the factors that materially affected thefund’s performance and certain otherinformation.

2. Employer Leverage. Most employersenhance the investment potential toemployees from the co-investmentvehicle through employer-providedleverage, either through recourse and/ornon-recourse loans to the employee orthe co-investment vehicle or a preferredequity investment in the co-investmentvehicle. The employer-provided leveragesubstantially enhances the potential

returns from a successful co-investmentvehicle (but increases the risk for unsuc-cessful investments).

The amount of leverage providedand the amount of employee recourseon the leverage varies. Leverage toinvestment ratios are generally within a range of 1:1 to 5:1. Leverage andinterest charges (or preferred equityreturns) are repaid through investmentearnings. Leverage is frequentlyrecourse to the employee (i.e., theemployee is personally liable to repaythe leverage or contribute additionalfunds to the investment vehicle ifinvestment returns are not sufficient to do so), with greater recourse wherethere is greater leverage.

3. Vesting and Forfeiture. Most planscontain vesting provisions, whereby theemployee’s right to the earnings on theleveraged amount of the investment issubject to vesting, generally based oncontinued employment.

Unvested amounts are usually for-feited if employment terminates (withsome exceptions in the case of death,disability or retirement). In addition,“bad leaver” provisions are frequentlyprovided under which the return on theleveraged amount of the investment(either the unvested amount or all vestedand unvested amounts) is forfeited if theemployee joins a competitor, solicitsemployees or is terminated for cause.

4. How Large Should the Fund Be? Thesize of the fund is primarily determinedby the business concerns relating tothe number of employees selected toparticipate, their compensation levelsand the amount of leverage the employeris willing to provide. The fund alsoneeds to be large enough to be able to participate in the intended invest-ments. The size of the fund may

be particularly important for a co-investment fund of funds.

Funds of funds typically invest inother fund vehicles that are exemptfrom the 40 Act under either Section3(c)(1), the exemption for funds with100 or fewer investors, or Section3(c)(7), for funds owned exclusively by qualified purchasers. These exemp-tions contain attribution provisionsthat require the exempt fund to “lookthrough” investing entities and countthe investing entity’s security holders in certain circumstances. To avoid theattribution rules, co-investment plansthat intend to invest in 3(c)(7) fundsmust have more than $25 million ininvestments3 and cannot be formed for the specific purpose of acquiringthe 3(c)(7) fund. To avoid attributionstandards contained in the 40 Act ordeveloped by the SEC staff, co-invest-ment vehicles structured as 3(c)(1)funds (rather than employee securitiescompanies) cannot own more than10% of the voting securities of a 3(c)(1)fund, or invest more than 40% of theircapital in a single 3(c)(1) fund.

3 Investments means investments and capital commit-ments net of any loans. Leverage provided through apreferred equity investment would not be considered a loan.

Notwithstanding a somewhat

unfavorable private equity

environment, there is another

reason to consider imple-

menting a Co-Investment

Plan. The SEC has recently

given sponsors the opportunity

to open up the plan to a

greater number of employees.



While those who have served as a corpo-rate director will be familiar with theseprinciples, it is helpful to review thebasic ground rules under Delawarecorporate law. (Of course, other juris-dictions may follow different principles.In particular, the insolvency law of manyforeign jurisdictions differs markedlyfrom the U.S. framework.)

Back to Basics: Duties of Care and LoyaltyDirectors of a corporation have twoprimary fiduciary duties: the duty of careand the duty of loyalty. The duty of carerequires that each director exercise thedegree of care that an ordinary carefuland prudent person would use in similarcircumstances. This entails informingoneself of all material informationreasonably available and acting with the requisite care. The duty of loyaltydemands that a director act in good faithin the best interests of the corporationand its shareholders and prohibits self-dealing and exploitation of corporateopportunities to personal advantage.

Standards of Review: BusinessJudgment and Intrinsic FairnessGenerally, in exercising these duties,directors are protected by the familiar“business judgment rule,” which estab-lishes a presumption that in making abusiness decision the directors actedon an informed basis, in good faith,and in the honest belief that the deci-sion was in the best interests of thecorporation. In practice, the businessjudgment rule establishes a high bar

for potential plaintiffs to recover fromdirectors personally.

Participation of “interested” directorsin the Board’s decision making, however,strips directors of the protection of thebusiness judgment rule and results in theapplication of a higher standard of reviewknown as the “intrinsic fairness” test. Of course, the intrinsic fairness test is notunique to troubled companies, but it maybe more relevant to directors of troubledportfolio companies because of the likeli-hood that a restructuring transaction willrender investor directors “interested.”

Intrinsic fairness requires that theBoard’s actions must be both substan-tively and procedurally fair. Substantivefairness inquires whether the terms ofthe transaction were fair (i.e., was theprice, fee, asset valuation, etc. fair to thecorporation). Procedural fairness neces-sitates a fair decision making process inwhich material information is adequatelydisclosed, and the transaction is negoti-ated by disinterested directors properlycounseled by qualified advisors in anenvironment free from inappropriatetime and other pressures.

In contemplating a follow-on invest-ment to shore-up a portfolio companythat has unaffiliated investors, consider-ation should be given whether to form aspecial committee of independent direc-tors to review and negotiate the terms ofthe investment. The special committeeshould have separate counsel and finan-cial advisers, and the process should berun formally with careful attention paidto establish a record of procedural andsubstantive fairness. In particular, trans-

action fees and on-going monitoringfees should be reviewed for continuingappropriateness. In addition, it may be appropriate to approach outsidesources of capital as a market check for the proposed investment.

To Whom are Fiduciary Duties Owed?For solvent companies, director’s dutiesrun to the shareholders of the corpora-tion. Creditors are only entitled to thebenefit of their contractual rights. When a corporation becomes insolvent orapproaches the “vicinity of insolvency,”the directors’ fiduciary duties shift fromthe corporation’s shareholders to itsshareholders and creditors. With respectto many decisions that come before theBoard, this shift in duties is insignificant,and directors should simply think in terms of the best interests of the“community of interests” constitutingthe corporation rather than the interestsof the shareholders exclusively. In someinstances, however, the interests of thecorporation’s shareholders and creditorswill diverge. In such cases, the Boardneed not slavishly follow the demands ofthe corporation’s creditor constituencies.However, the directors of a troubledcompany cannot subject creditors toundue risk in the pursuit of a recovery for the shareholders.

How are Insolvency and the Vicinity of Insolvency Defined?Courts define insolvency in two ways:an equity test and a balance sheet test.The equity test inquires whether thecorporation is able to pay its debts as

Serving as a director of its portfolio companies is central to a private equity sponsor’s task of actively managing its fund’s invest-ments. In good times, concerns as to personal liability for one’s actions as a director remain peripheral. In difficult times, such asthese, directors of troubled companies naturally seek to right their foundering enterprise, but must do so with a careful eye on poten-tial sources of personal liability. When a storm appears on the horizon, directors should seek advice concerning the scope of theirlegal duties and consider how best to aid in the recovery without unduly exposing themselves to liability.

Troubling Times for Directors of Portfolio Companies


they become due in the ordinarycourse of business. The balance sheettest finds insolvency when the liabili-ties of the corporation exceed thereasonable market value of the corpora-tion’s assets. Because each company’scircumstance will vary, court decisionsprovide no bright line test and direc-tors should assume that their dutieshave shifted when the corporation hasentered the “vicinity of insolvency.”

Should I Stay or Should I Go?Each director of a troubled company willneed to weigh the advantages and disad-vantages of continuing to serve versusresignation. For individual directorsrepresenting a controlling stockholder,remaining in control of the board is critical to maintaining any value in thefund’s investment. The choice is lessclear if the Board seat is tied to a minorityinterest in the troubled company.

Advantages of Continuing. Once therestructuring process has commencedand counsel and financial advisershave been retained, the risk of liabilitygenerally is lessened. The Board’sactions are subject to heightenedscrutiny from creditors and in somecases a bankruptcy court. As a practicalmatter, however, this enhanced reviewtends to shield the directors fromliability. In addition, a continuingdirector is in a better position toorchestrate a consensual plan of reorganization. In consensual restruc-turings, continuing directors oftenbenefit from releases of liability by the company’s institutional lenders.

Disadvantages. Continuing as a directorof a corporation in financial stress willrequire devotion of a great deal of timeand energy. In addition, while the risk of additional liability is lessened, there is a limited possibility of incurring newliability for actions taken or omitted aftercommencement of the restructuring.

Protections for DirectorsDirectors of all corporations benefit from certain protections againstpersonal liability. The impact of financialtrouble and bankruptcy on these protec-tions should be carefully assessed.

Indemnification. Generally directors areentitled to indemnification from thecorporation under statute, the charter or bylaws of the corporation or pursuantto contractual indemnification rights. In addition to state law principles thatmay limit indemnity payments to direc-tors, bankruptcy imposes limitations ona director’s ability to collect, includingan automatic stay of claims against thedebtor, a requirement to share pro-ratawith other unsecured claims and adisallowance of contingent indemni-fication claims. In addition, in somecircumstances, indemnification claimsmay be equitably subordinated if thedirector engaged in inequitable conductinjuring creditors or giving himself anunfair advantage. Similarly, indemnifi-cation claims relating to securities lawclaims can be subordinated to a levelbelow the underlying security.

Indemnification Trusts. An irrevocabletrust can be established to fundindemnification claims against direc-tors to avoid potential impediments to successful recovery for directors’indemnification claims. However,indemnification trusts must be struc-tured carefully to avoid the reach of theBankruptcy Code and may be subjectto attack in bankruptcy court as afraudulent conveyance or preference.

D&O Insurance. Whether directors andofficers insurance will protect the direc-tors adequately will be a function of thespecific policy terms. Some policiescombine D&O coverage with coveragefor the company, which can raise anissue as to whether the policy is an“asset” of the debtor’s estate and,therefore, not available to the directors.Policy terms also may raise issues as

to advancing defense costs, applica-bility of the deductible to directors andofficers’ claims, coverage in the eventof bankruptcy or insolvency and exclu-sions for claims of fraud.

Common IssuesAs a liquidity crisis nears, officers anddirectors of troubled companies oftenconfront a variety of issues outside theirprevious experience. For example, if thecompany’s stock is publicly traded, whatshould be said in the MD&A of theForm 10-Q or Form 10-K, which requiresdisclosure of known trends and uncer-tainties about the business? Oftentimes,corporate officers and directors will find themselves struggling to balanceconcerns as to compliance with thesecurities laws and fears that poordisclosure will make a difficult situationworse by impairing relations withemployees, customers and suppliers.

Similarly, the company’s revolvingcredit facility likely requires that represen-tations and warranties be repeated priorto each draw, which raises the questionwhether the company can meet theconditions to borrowing. If the companylikely will need covenant relief, what is thebest way to approach the lending group?If the company needs cash, can it fullytap its revolver without first discussingwith its lenders that it may need anaccommodation, or will borrowing underthose circumstances poison relationswith the company’s lenders?

As these examples demonstrate,managing a distressed company canbe expected to raise many challengingissues for its directors. At the sametime, the fiduciary duties remain thesame. As such, with sound judgmentand the assistance of experienced legaland financial advisers, these challengescan prove to be a remarkable opportunityto save an enterprise and create value fora portfolio company’s many constituen-cies, including the fund’s investors.— Richard F. Hahn and Harold A. Neu

On the heels of extensive tax reformlegislation and as previously predictedin our Private Equity Report lastsummer, a new German Tender OfferLaw came into force on January 1, 2002.We believe that this legislation will be of interest to private equity firms inter-ested in the acquisition of German-listedcompanies and will have a significantimpact on mergers and acquisitions ofor by listed companies.

Germany, one of the first EU coun-tries to enact a new tender offer law,has been eager to pre-empt severalother European member states and theEuropean Commission, who have beenhaggling for nearly a dozen years overmore aggressive reforms aimed atlevelling the takeover playing field inEurope by means of an EU directiveconcerning takeover bids. As of January2002, it appeared that the EU debateover takeover reform might be rekin-dled by the publication of an extensivereport by a “High Level Group ofCompany Law Experts” mandated bythe EU Commission to draft proposalsfor modernizing the company lawstatutes of the member states andcreating pan-European takeover rules.While such an EU directive is almost

certain to clash with (and may ulti-mately trump) certain provisions of the new German Tender Offer Act,Germany and a number of othermember states will likely continue tooppose the adoption, or at least delaythe transposition and application, ofany wide-sweeping EU takeover direc-tive for at least a few years. In theinterim, investors interested in Germanyshould understand the new GermanTender Offer Law (the “New Law”).

Private equity investors and othersfamiliar with Delaware law will applaudthe advent of an effective mechanismto squeeze out minority shareholdersfollowing an acquisition. However,investors accustomed to U.S. practicewill be struck by a number of featuresof the New Law, including the right ofgovernment agencies to review theprice and other terms of each offer andthe requirement that bidders launch a compulsory offer for all remainingshares once a controlling interest(defined as 30% of the voting power)has been secured.

The New Law applies to targetcompanies domiciled in Germanywhose stock is traded on an EU stockexchange or regulated markets. Biddersare now required to publish a tenderoffer announcement before submitting a draft offer statement to the Super- visory Authority for Securities Trading(Bundesaufsichtsamt fuer denWertpapierhandel) for review of itsterms. If the Supervisory Authority doesnot object to the offer, the bidder willhave 10 days in which to make an offerto shareholders that must generallyremain open for at least 4 weeks but no more than 10 weeks. Additionally, a qualified financial institution mustcertify that financing sufficient to

consummate the offer is in place, andthe offer may not be subject to condi-tions that are within the bidder’s control.

The target board is obliged to act inthe interest of the target generally butcertain defensive measures may bepermitted if previously authorized bythe general assembly of shareholders at least 18 months prior to the offer.

Investors accustomed to U.S. practice will be particularly struck by the Supervising Authority’s mandatoryreview of the terms of all takeover offers in which the bidder expects toacquire at least 30% of the target’sequity or voting rights. In particular, the Supervisory Authority will have the power to review the offer price for “adequacy.” Although the criteriadefining the “adequacy” of a givenpurchase price are to be defined inmore detail in forthcoming regulations,their current draft form the regulationsgenerally require that the offer be basedon the average trading price of thetarget shares and take into accountprevious tender offers.

If a shareholder so requests, consid-eration must be payable in cash orsecurities which may be traded in theEU. This may mean that U.S. offerorsproposing a share-for-share exchangemay find it beneficial to be listed on anEU stock exchange prior to making anoffer. In order to prevent a bidder fromgradually acquiring a material interest,the New Law provides that the offerprice must be paid in cash if the bidderhas acquired more than 5% of thetarget in the 3 months preceding theoffer. The New Law effectively preventsa control premium by providing thatthe price paid for a privately sold stakeof 30% or greater will be the floor price for further purchases in the year


The New German Tender Offer Law

The New Law also requires

bidders to make an offer to

all remaining shareholders

once a controlling interest

of at least 30% has been

acquired, regardless of

whether such stake has

been acquired privately or

on the open market.


following acquisition of such control-ling interest.

The New Law also requires biddersto make an offer to all remaining share-holders once a controlling interest of at least 30% has been acquired, regard-less of whether such stake has beenacquired privately or on the openmarket. The requirement to make anoffer to remaining shareholders wouldalso appear to apply where a Germanpublic company exchanges 30% ormore of its shares or voting shares for shares of the target. In such case, if a former shareholder of the targetacquires 30%, such shareholder will be required to make an offer to the remaining shareholders of theacquiring public company. This is

expected to complicate transactionsinvolving reverse take-overs andmergers of privately held companiesinto listed stock corporations insofar as the acquisition of more than 30% ofthe shares of a listed stock corporationmay now require the controlling share-holders of the merging company tomake an offer for all the shares of thereceiving corporation – a result clearlynot intended by the legislature.

As part of the New Law, the GermanStock Corporation Act will be amendedto provide for a minority squeeze-outmechanism once 95% of the out-standing shares has been acquired. The squeeze out will be effected byobtaining the approval of the AG share-holders to a cash-only buyout. While

such consideration will still be subjectto court review, some of the uncertaintywill be eliminated by the New Lawinsofar as a squeeze out purchase pricewhich is equal to or greater than theconsideration offered to 90% of theother shareholders may no longer becontested.

While the New Law may fall short of U.S.-style takeover legislation anddoes not necessarily dove-tail with theinvestment invitation afforded foreigninvestors by recent German tax reform,it is clearly a major step in the rightdirection. It remains to be seen if theNew Law will make life easier for thoseinvesting in the German market. — David F. Hickok and

Dr. Thomas Schürrle

Private fund sponsors generally understand that certain marketing techniques, including press releasesand website postings, may endangerthe exempt status of their funds underthe Securities Act of 1933 and theInvestment Company Act of 1940, andthe sponsor’s exempt status under theInvestment Advisers Act of 1940. Theymay not, however, be accustomed tothinking that their efforts to place inter-ests in their funds can implicate U.S.broker-dealer regulations.

Sales efforts by fund sponsors, evenin private placements, can triggerbroker-dealer registration requirements,depending largely on the activities ofthe sponsor’s employees in marketinginterests in the fund and how thoseemployees are compensated. This is anarea in which the SEC staff has leanedtoward regulation rather than deregula-

tion. Set forth below are some questionsfrequently asked by fund sponsorsconcerning U.S. broker-dealer regulation.

FAQ #1: Who is a broker for purposesof the U.S. federal securities laws?It is a somewhat common mispercep-tion that only firms involved in the saleof publicly traded securities need toworry about broker-dealer registration. Inthe broker-dealer context, the law doesnot distinguish between privately placedsecurities and registered securities.

Section 3(a)(4) of the SecuritiesExchange Act of 1934 (the “ExchangeAct”) defines the term “broker” toinclude “any person engaged in the business of effecting transactions insecurities for the account of others.”Factors indicating that a person is“engaged in the business” include,among others, receiving transaction-related compensation; holding oneself

out as a broker, as executing trades or asassisting others in completing securitiestransactions; and participating in thesecurities business with some regularity.

If employees of a private fundsponsor receive commissions for thesale of fund interests, they will bedeemed “brokers.” If employees of afund sponsor are “brokers,” they mustbe “associated persons” of an entitythat is a registered broker-dealer – andin the absence of a registered place-ment agent, the signs may point to thefund sponsor as the entity that needs to be registered because it is exercisingcontrol over the activities of the brokers.(The private fund itself, like any issuer,is not a broker because it is not sellingsecurities for the account of “others”but rather selling interests in the fundfor itself.)

Are Your Fund Marketers “Brokers”?



FAQ #2: What can a sponsor’spersonnel do and be compensated for without becoming brokers? There is a safe harbor rule that mostfund sponsors rely on to avoid character-izing their fund marketing personnel asbrokers, and exposing the firm itself toregistration as a broker-dealer. Rule 3a4-1under the Exchange Act permits the part-ners, officers, directors or employees of a private fund or of its general partner to avoid regulation as brokers if theysatisfy several conditions. An employeeengaging in selling efforts:

• must not have been associated with abroker or dealer during the precedingtwelve months;

• must not participate in selling anoffering of securities for any issuermore than once every twelve months;

• must primarily perform substantialduties for the sponsor other thanselling efforts; and

• must not be compensated for his or her activities by “the payment ofcommissions or other remunerationbased either directly or indirectly ontransactions in securities.”

This last condition often creates someconfusion. What constitutes transac-tion-based compensation is not alwaysobvious. For example, would a bonusscheme not directly tied to sales effortsbut reflecting the overall success of thesponsor in raising capital be viewed as transaction-based compensation?Not all bonus schemes implicate trans-action-based compensation. If bonusprograms are implemented, it is bestthat they not have any elements thatmight be seen to be a form of disguisedcommission, such as a stated compo-nent tied to the amount or size of the

investment commitments obtained orfacilitated by the individual.

The rule is a “safe harbor;” theremay be other means to establish that aperson is not a broker. Because demon-strating that an employee who engagesin selling efforts is not a broker requiresa detailed analysis of the relevant facts,sponsors prefer to rely on the safeharbor, if possible.

Assuming that the safe harbor is not available, another common issue is the extent to which employees of the fund sponsor can be involved inpresentations to prospective clientsthat are designed to solicit investmentin a private fund. As long as the spon-sor’s employees are present to discussthe investment objectives and policiesof the fund and leave to others (prefer-ably registered personnel) the tasks of delivering offering documents andsubscription agreements, negotiatingand accepting subscriptions and makingdirect solicitations, fund sponsoremployees would not be consideredbrokers. Of course, compensating fundsponsor employees based on their“success” in bringing in specificcommitments is likely to be seen to be a form of transaction-basedcompensation.

A private fund sponsor that isoffering a number of funds and is regularly engaged in marketing activi-ties may wish to explore having thoseactivities conducted by a registeredbroker-dealer. One avenue is to marketshares through an already registeredbroker-dealer.

While fund sponsors may rightfullyseek to save placement fees, they needto be careful; instead it may be appro-priate to work with established private

placement agents that specialize inserving as brokers for fund sponsors. Another alternative is to form an affiliated broker and employas registered representatives those individuals responsible for selling thefund’s shares. The advantage to thisapproach is that those individuals canbe rewarded with transaction-basedcompensation. The major disadvantageis the burden imposed by additionalregulation, discussed in detail below.

FAQ #3: Isn’t there a third alternative?Can’t we use a finder that is not a regis-tered broker to identify fund investors?Private fund sponsors may be able to identify potential investors with thehelp of a “finder” – that is, a personwho assists a sponsor in identifyingpotential investors and receivescompensation from the sponsor fordoing so. However, the SEC hasrecently limited further the activities in which a finder may engage withoutbeing considered a broker.

As with Rule 3a4-1, the scope ofactivities in which a finder may engagewithout becoming subject to broker-dealer registration and regulation hasalways been narrow. For example, inone no-action letter, the staff of theSEC’s Division of Market Regulationconcluded that registration as a brokerwas not required where the activities of the finder (Paul Anka – yes, that PaulAnka) were limited to furnishing anissuer (a partnership that was acquiringthe Ottawa Senators hockey club) withthe names and telephone numbers ofpersons with whom he had a bona fide,pre-existing business or personal rela-tionship and whom he believed wouldbe interested in purchasing partnershipunits. The letter contains a litany of

Are Your Fund Marketers “Brokers”? (continued)


activities in which Mr. Anka would not be involved (e.g., negotiations betweenthe Senators and any potentialinvestors and the preparation of anysales or analytical materials).

In more recent no-action letters, theSEC staff has narrowed the scope of the“finders” exception. The SEC staff isconcerned that, because of technolog-ical advances and other developmentsin the securities markets, “more anddifferent types of persons [have]become involved in the provision ofsecurities-related services.” Makingintroductions to persons personallyknown to the solicitor without anyfurther participation in negotiations or in structuring the private placementmay pass muster if it is not part of anongoing pattern of such activity for asponsor.

If the sponsor believes that it willrequire a concerted and broadmarketing effort by a third party andthat commission-based compensationwill motivate successful sales personsto solicit investors for a private fund,the sponsor should retain a registeredbroker-dealer or bite the bullet andregister itself or a subsidiary as abroker-dealer and qualify its salespersons with the National Association of Securities Dealers, Inc. (NASD).

FAQ #4: How tough can it be to register as a broker?Pretty tough, although a motivatedfund sponsor can achieve registrationand employee qualification if it haspatience and a willing “sales force.”Moreover, registration is somethingthat a private fund sponsor with a dedi-cated in-house sales force and plans tooffer a number of funds must consider.

For a private fund sponsor accustomed to minimal regulatoryrequirements, the process of regis-

tering as a broker, which generally takesseveral months, is typically viewed asvery burdensome. In general, a brokermust register with the SEC, the NASDand the securities commission in eachstate in which the broker will operate.The SEC and NASD maintain web sitesthat provide useful informationconcerning the registration process andother matters. (http://www.nasd.com/membinfo/fr_MBR_1.html for the NASDand http://www.sec.gov/divisions/marke-treg/bdguide.htm for the SEC)

While the registration requirementsdiffer among these regulators, eachrequires the filing of Form BD, theUniform Application for Broker-DealerRegistration. Form BD seeks informa-tion about the applicant’s business, itsregulatory and disciplinary history, itsdirect and indirect owners and its exec-utive officers and its affiliations withcertain entities (e.g., securities orinvestment advisory firms, banks). TheSEC may deny registration to any appli-cant that has been subject to certaindisciplinary proceedings.

The NASD registration process ismuch more involved and requires theapplicant to submit a variety of mate-rials for NASD review. In addition to the Form BD, the NASD requires back-ground (including disciplinary)information with respect to each of thefirm’s partners, officers and directorsand each employee who effects transac-tions in securities. The applicant mustalso submit, among other things: adetailed business plan; copies of agreements relating to its securitiesbusiness; information concerning thenature and source of the applicant’scapital; and descriptions of its financialcontrols, communications and opera-tional systems, supervisory system,written procedures and recordkeepingsystem.

A registered broker and its associ-ated persons are subject to fairly broadregulatory requirements, includingantifraud rules, the NASD’s ConductRules and detailed reporting andrecordkeeping obligations. The ConductRules, for example, require the brokerto have reasonable grounds forbelieving a security is suitable for aparticular investor before making thesale. Brokers must comply with netcapital requirements, although therequirements are fairly de minimis forbrokers that do not carry customeraccounts. The sponsor’s offices andemployees must pass exams adminis-tered by the NASD, a prospect thatmany might find unappealing. Finally,brokers are subject to inspections byregulators.— Marcia L. MacHarg, Kenneth J.

Berman and Rachel H. Graham

Private fund sponsors may

be able to identify potential

investors with the help of a

“finder”– that is, a person

who assists a sponsor in

identifying potential investors

and receives compensation

from the sponsor for doing so.

However, the SEC has

recently limited further the

activities in which a finder

may engage without being

considered a broker.


breach of the seller’s representationregarding environmental matters. Youdecide not to raise the issue. Under the law of some jurisdictions (includingNew York), you may not have a claim for the breach of the representation.

If a buyer knows prior to the signingof the purchase agreement that one of the seller’s representations is untrue,the buyer should seek a purchase pricereduction or indemnification for thespecific event or circumstance thatcauses the representation to be untrue.If the buyer depends on its ability torecover for the breach, the buyer couldbe found not to have relied on theseller’s representation when the buyerstruck the bargain and therefore beunable to sustain one element of itsindemnity claim. If for any reason abuyer does not want to or cannot obtaina purchase price reduction or specificindemnity, it should make sure that thepurchase agreement includes the rights-reserving provisions described above. It is not certain, however, that theseprovisions will preserve the buyer’s rightswhere its knowledge of the breach wasacquired prior to signing; none of theNew York cases presents this fact

pattern, and the relevant cases provideambiguous guidance.

Anti-Sandbagging. The seller requeststhat a provision be included in thepurchase agreement to the effect thatyou will not be entitled to be indemnifiedfor any breach of the seller’s representa-tions if you are aware of such breachbefore closing – a so-called “anti-sand-bagging” provision. Sometimes a selleris motivated to demand the anti-sand-bagging provision because of suspicionsraised by the buyer’s request to includethe rights-reserving provisions describedabove. If you agree to a broad anti-sand-bagging provision, you will be limitingyour rights more than even the mostseller-favorable cases, and you will createan extra element of proof (or give theseller a potential defense) on everyindemnity claim.

Buyers should always strongly resist“anti-sandbagging” provisions. Theylimit the buyer’s rights more than the most unfavorable New York cases(principally because they limit thebuyer’s rights even when the buyeracquired knowledge of the breach aftersigning from a source other than theseller – see “The Cases” below). Theycreate an extra element of proof (lack of buyer’s knowledge) or a potentialdefense for the seller in connectionwith every indemnity claim. Theyencourage the seller to play games –such as giving the buyer informationthe significance of which does notbecome clear until the buyer seeksindemnity, or withholding informationuntil just before the closing when thebuyer is so committed to the transac-tion that exercising its walk-away rightis difficult. A buyer who compromiseson this provision should insist that the

seller bear the burden of proof of thebuyer’s knowledge and that the buyer’srights only be limited if the buyer hasactual knowledge of the breach.

Updating. The seller wants to include a provision in the purchase agreemententitling it to update, between signingand closing, the disclosure schedulesetting forth exceptions to the seller’srepresentations. The updated disclo-sure will not affect the conditions toclosing – if any such updated disclo-sure is materially adverse you will nothave to close – but if you do close, youwill not be indemnified for the updatedmatters. You successfully resist thisprovision on the grounds that limitingyour rights to the ability to walk awayfrom the deal does not guarantee youthe full benefit of your bargain. Underthe law of some jurisdictions (includingNew York), unless you have expresslyreserved your rights, your rights couldbe limited anyway.

Whether a buyer accepts a provisionpermitting a seller to update its disclo-sures is a matter of taste and, accordingly,can be handled in different ways. A buyerwho feels that “a deal is a deal” and that if one of the seller’s representations isuntrue – no matter what the reason – thebuyer should have the option of walkingaway from the deal or closing and seekingindemnity should resist any such provi-sion (and make sure that the purchaseagreement includes the rights-reservingprovisions described above). Otherbuyers may wish to compromise byallowing updating to reflect events thatoccur after signing (perhaps with thefurther limitation that the occurrence ofsuch events not be attributable to thefault or breach of the seller) but not tocorrect errors – such an approach keeps

Sandbagging (continued)

If a buyer knows prior to the

signing of the purchase agree-

ment that one of the seller’s

representations is untrue, the

buyer should seek a purchase

price reduction or indemnifica-

tion for the specific event or

circumstance that causes the

representation to be untrue.


pressure on the seller to get its represen-tations right in the first place. A buyer whoaccepts a version of this provision shouldmake sure that if it walks away it retainsthe right to recover damages for represen-tations that were untrue at the time theoriginal contract was signed or thatbecame untrue through fault or breach of the seller.

The CasesIn the leading New York case, CBS Inc. v. Ziff-Davis Publishing Co. (1990), CBSentered into an agreement to purchasecertain businesses of Ziff-Davis. Theagreement provided that each party’srepresentations would “survive theclosing, notwithstanding any investiga-tion made by or on behalf of the otherparty.” After signing and prior to closing,CBS concluded, on the basis of its duediligence investigation, that one of Ziff-Davis’s representations was untrue. Thepurchase agreement excused CBS fromits obligation to close the transaction ifZiff-Davis’s representations were nottrue at closing. Ziff-Davis did not agreethat the representation was breached,and, after negotiation, the parties agreedthat they would close the transaction but that closing “would not constitute a waiver of any rights or defenses.”Following the closing, CBS brought suit for breach of the representation.Ziff-Davis argued, among other things,that because CBS had knowledge of the alleged breach prior to closing CBScould not have been relying on the truthof the representation when it closed and that the absence of such reliancedoomed CBS’s claim.

New York’s highest court, the Courtof Appeals, said that “[t]he critical ques-tion is not whether the buyer believedin the truth of the warranted informa-

tion…, but ‘whether [it] believed [it] waspurchasing the [seller’s] promise [as toits truth].’” The Court of Appeals foundthat the inclusion of the representationin the purchase agreement “as part of the bargain between the parties”evidenced the required reliance andthat “the right to be indemnified… doesnot depend on proof that the buyerthereafter believed” the representation.Accordingly, the court decided (on thispoint) in favor of CBS. Although thecourt mentioned in its statement offacts the survival provision in the orig-inal purchase agreement and the “nowaiver” provision in the agreementsubsequently entered into between theparties, neither provision was cited inthe court’s presentation of the rationalefor its decision. The court emphasizedthat the knowledge of the breach aroseafter signing and that the issue was notwhether the buyer was relying on theseller’s representation when the buyerdecided to enter into the purchaseagreement.

Three subsequent cases, eachdecided by federal courts applying NewYork law, limited the Ziff-Davis rule andheld that a buyer was not entitled torecover for breaches of representationsof which it was aware prior to closing.

In Galli v. Metz (1992), Galli andMetz simultaneously signed a purchaseagreement and closed the sale of Galli’sbusiness to Metz. Galli made one ormore representations in the purchaseagreement that were untrue. Metz sued.One of Galli’s defenses was that he orhis agents had told Metz of the factsgiving rise to the breaches prior toclosing (and therefore prior to signing).Metz cited Ziff-Davis and argued that hisknowledge was irrelevant. The UnitedStates Court of Appeals for the Second

Circuit distinguished Ziff-Davis on thebasis that in Ziff-Davis, unlike in Galli,there was a dispute about the accuracyof the seller’s representation. The courtsaid “where a buyer closes on a contractin the full knowledge and acceptance offacts disclosed by the seller which wouldconstitute a breach of warranty underthe terms of the contract, the buyershould be foreclosed from later assertingthe breach. In that situation, unless thebuyer expressly preserves his rightsunder the warranties (as CBS did in Ziff-Davis), we think the buyer waived thebreach.” Apparently Metz had notexpressly reserved his rights.

In Rogath v. Siebenman (1997),Siebenman sold a painting, supposedlyby Francis Bacon, to Rogath. In the bill of sale, which was presumably deliveredupon the closing of the sale, Siebenmanrepresented that he had no knowledge of any challenge to the authenticity ofthe painting. This was untrue. However,Siebenman maintained that he had toldRogath the relevant facts. Although the

Buyers should always strongly

resist “anti-sandbagging”

provisions. They limit the

buyer’s rights more than the

most unfavorable New York

cases (principally because

they limit the buyer’s rights

even when the buyer acquired

knowledge of the breach

after signing from a source

other than the seller…).



Sandbagging (continued)

sale of a painting, unlike the sale of a business, is subject to the UniformCommercial Code article governingsales of goods, the court (again theUnited States Court of Appeals for theSecond Circuit) purported to follow the law established in Ziff-Davis andGalli and held that if Siebenman hadtold Rogath, Rogath was not entitled to recover. The court elaborated on itsanalysis of Ziff-Davis set forth in Galli bystating that if the buyer’s knowledge ofthe inaccuracy of the seller’s warrantiescomes from the seller, “it cannot be said that the buyer – absent the expresspreservation of his rights – believed he was purchasing the seller’s promiseas to the truth of the warranties.”Apparently Rogath had not expresslyreserved his rights. Although the courtsuggests that a buyer who knows that arepresentation is untrue does not needto reserve its rights if the source of itsknowledge is not the seller, none of thecases actually presents those facts.Accordingly, buyers should assume that

they have to reserve their rights, what-ever the source.

Finally, in Coastal PowerInternational, Ltd. v. TranscontinentalCapital Corporation (1998), the UnitedStates District Court for the SouthernDistrict of New York held that a buyer of a business that learned of breaches of the seller’s representations from theseller, after signing and before closing,but closed without expressly reservingits rights, had waived its right to recoverfor those breaches. The purchase agree-ment in Coastal required the seller toinform the buyer if any of the seller’srepresentations became untrue andconditioned the buyer’s obligation toclose on the continued accuracy of theseller’s representations, but apparentlydid not contain any rights-reservingprovisions.

Analysis and ConclusionZiff-Davis, which was decided by NewYork’s highest state court, was a gooddecision for buyers. It stands for theprinciple that a buyer who knows thatone of the seller’s representations is untrue may close the transaction and still recover, so long as the buyerbelieved it was buying the right torecover when it signed the purchaseagreement and so long as it acquired itsknowledge that the representation wasuntrue after signing. Unfortunately forbuyers, the federal courts that have been

called upon to interpret Ziff-Davis havedistinguished it by reference to facts thatmay not have mattered to the Ziff-Daviscourt. In Galli, the seller did not disputethat the representation was untrue; inRogath, the buyer learned that the repre-sentation was untrue from the seller, notfrom a third party; and – probably thecontrolling factual difference – in eachof the three cases the buyer did notreserve its rights. Until the three federalcourt decisions were handed down, onemight reasonably have predicted thatthe Ziff-Davis court would also protect abuyer’s rights if the buyer acquires itsknowledge before signing (i.e., if itsandbags), but the narrow interpreta-tions in Galli, Rogath and Coastal leaveconsiderable doubt that a court – atleast a federal court – would reach thesame conclusion.

Buyers have to live with, and beguided by, all the cases. So: (1) Sandbagbefore signing at your peril – you maynot have a claim. (2) Do not accept ananti-sandbagging clause just becauseyou do not intend to sandbag – you donot want to have to prove what you donot know, and you do not want knowl-edge acquired after signing to interferewith your rights. (3) Above all, reserveyour rights! — Robert F. Quaintance, Jr.

Ziff-Davis, which was decided

by New York’s highest state

court, was a good decision for

buyers.…Unfortunately for

buyers, the federal courts that

have been subsequently called

upon to interpret Ziff-Davis

have distinguished it by

reference to facts that may

not have mattered to the

Ziff-Davis court.


Employee Leveraged Co-Investment Plans (continued)

5. Taxation. A Co-Investment Planinvolves complicated tax issues,including both compensation tax andtax issues generally applicable to allprivate equity funds. Like mostinvestors, employees want capitalgains (or flow-through) tax treatmenton their investment; and employers willoften accommodate their desire. Thisis easier to achieve when employeesinvest their after-tax dollars. Where pre-tax dollars are used, ordinary incometreatment (with correspondingemployer deductions) is more typical.4

Whether pre-or-post-tax dollars are used, Section 83 of the InternalRevenue Code will generally govern the tax treatment because the planinterests are being offered as acompensation tool. Under Section 83,whenever an employee receives “prop-erty” in connection with his or herperformance of services, the excess (if any) of the fair market value of theproperty over the purchase price paidis taxable to the employee as ordinary

compensation income, and theemployer has a corresponding deduc-tion and withholding obligation. Thetax is payable (and fair market valuedetermined) on the later of the date of acquisition and the date any forfei-ture or transfer restrictions lapse (i.e.,at vesting).

An employee may be able to elect to be taxed at the time of acquisitionrather than at vesting by filing what isknown as an “83(b) election” with theInternal Revenue Service at the time of the initial investment. In most cases,the market value at acquisition will bethe same as or close to the amountpaid, and no or minimal tax will be dueas a result of the election.5 The 83(b)election may, however, only be made if the employee is sufficiently at risk forhis or her investment (including thenon-recourse leverage) to be consid-ered the owner for tax purposes. If thenon-recourse leverage constitutes toohigh a proportion of the total invest-ment, the employee’s investment maynot be substantial enough to qualify.

Because vesting and forfeitureprovisions are typical in co-investmentplans, employees who do not or cannotmake an 83(b) election may have ataxable event upon vesting. Until thattime, the employer would be consid-ered the owner of the property, incomeand losses on the investment would be recognized by the employer and anydistributions made to the employeewould be considered compensation(taxed at ordinary income rates). Toavoid the complications of such delayedincome recognition, many employersrequire all U.S. employees whopurchase fund interests to make the83(b) election, and structure theirfunds accordingly.

Employee Leveraged Co-InvestmentPlans are complicated to implementbut, with the enhanced investmentpotential provided by leverage, togetherwith the vesting and forfeiture provi-sions, such plans can be a powerfulincentive for your key employees.— Elizabeth Pagel Serebransky and

Kenneth J. Berman4 It is possible to structure a hybrid plan funded withpre-tax dollars where gains in excess of the initial invest-ment and the returns on the leveraged amount receiveflow-through tax treatment. Implementation of such aplan is complicated and creates an additional adminis-trative burden for the employer.

5 Certain action, such as appreciation in value of anyinvestments made by the fund prior to the date anemployee receives his or her interest, transferring appre-ciated warehoused investments to the fund at theiroriginal cost or below-market interest rates on theleverage, may cause the fair-market value to exceed theamount paid by the employee. Careful planning canreduce the risk of employee tax recognition.

Under current law, funds

with 500 or more partici-

pants may become subject

to the public reporting

requirements. We recently

obtained SEC no-action

relief… for a group of co-

investment funds exempting

them from these public

reporting requirements.


Alert: Removal of the U.K. 20 Partner Limitalert

The U.K. Government recentlyannounced its intention to eliminatethe 20 partner limit for partnershipsand limited partnerships. The prohibi-tion on the formation of partnershipswith more than 20 partners dates backto 1856. The original justification forthe limit, namely the difficulty of suinga fluctuating body of partners at atime when it was necessary to join allthe partners in an action, has longsince disappeared.

Most professional partnerships are already exempt from the 20partner limit. In investment partner-ships, this restriction is commonlyavoided by establishing a series ofparallel partnerships, each of whichhas no more than 20 partners. Privateequity sponsors and their investorswill now be relieved of the administra-tive burden and costs of running alarge number of parallel partnerships.

The U.K. Department of Trade and Industry proposes to remove the restriction by way of a Regula-tory Reform Order made under the Regulatory Reform Act of 2001. This new parliamentary procedure is designed to fast-track the removalof red tape in business. The abolition of the 20 partner limit is likely tobecome law in mid-Summer 2002.— Colin Bogie and Sherri G. Caplan

Caveat Investor (continued)

claims filed by workers concerningexposure to hazardous materials.

Because only limited informationmay be available in the initial stages of a private equity investment, privateequity firms (and their representatives)may be unable to narrow the scope of the environmental assessment. Inmost instances, for example, little willbe known at the early stages of a trans-action about how environmental riskwill be allocated among the parties. Insuch instances, a broad assessmentthat accounts for all types of environ-mental risk may be necessary.

However, certain information aboutthe transaction may allow the privateequity firm to narrow the scope of theassessment. If, for example, the partiesagree early in the sales process that thetransaction will be structured as an assetsale, there generally will be a lesser needfor the private equity firm to analyze envi-ronmental issues associated with formerfacilities. Similarly, if the seller agrees

early in the sales process to take respon-sibility for all pending litigation (which it might do in order to make it easier forbidders to price the deal), less analysis of pending environmental litigation willbe necessary.

In preparing a comprehensive environmental assessment, certaininvestigative functions will be moresuited to the skills of an environmentalconsultant, while other functions willbe more suited to the skills of an environmental attorney. For example,estimating costs necessary to bring afacility into compliance with environ-mental, health and safety laws(including the cost of pollution controlequipment) and investigating the useof off-site waste disposal facilities arefunctions more suited to the environ-mental consultant. Other tasks, suchas evaluating environmental, healthand safety litigation exposure andanalyzing environmental indemnifica-tion obligations (such as those thatmay be associated with former opera-

tions), are more suited to an environ-mental attorney (who may be able to “smoke out” useful informationthrough carefully drafted environ-mental representations).

Comprehensive environmentalassessments can be significantly morecostly than traditional Phase1 reports.A comprehensive assessment willgenerally add approximately 50% to thecost of a traditional Phase1, thoughsuch additional costs will vary by trans-action. In heavily regulated industriesin which environmental compliance is a major concern, a comprehensiveevaluation can double the cost of aPhase1.

In sum, a comprehensive evaluationof the environmental risks posed by acontemplated investment, rather thana traditional Phase1 report, will be thebest way for a private equity firm toprotect against unanticipated environ-mental costs.— Stuart Hammer


Court weighs in on this topic (if theywere to choose to do so), we are facedwith some starkly different guidingprinciples under the All Holders/BestPrice Rule, depending on whichFederal Circuit’s law applies to theparticular case. Because the plaintiffwill often be able to pick the FederalCircuit in which the suit is brought,plaintiffs will almost assuredly try tobring suit in a Circuit where the law ismore favorable to the plaintiff. Therefore,it is not really practical to try to structurethe arrangements solely in order tocomply with the laws of a particularCircuit that might be more favorable to the purchaser in the hopes of having litigation end up there. However, at aminimum, one would be well advised to work within the guidelines of thatmore favorable law.

Bright LinesThe All Holders/Best Price Rule by itsterms applies only to consideration paid in connection with a tender offerand “during a tender offer.” Reachingthe conclusion that the statute meanswhat it says, and no more, some courtshave found that additional considera-tion will violate the Rule only if it is paid literally during the tender offer.Customary management agreementswill almost certainly not run afoul of the All Holders/Best Price Rule underthis interpretation. Special retentionbonuses that are intended to help retainemployees through the closing of theacquisition would, however, be trouble-some if paid upon completion of thetender offer, even under this most favor-able reading. (In this regard, paymentfollowing completion of the back-endmerger would seem more sensible.)

Courts in the Second and SeventhCircuits, as well as the Fourth andEleventh Circuits, have followed thisbright line approach, although the lineis the brightest in the Seventh Circuit.

Blurry LinesCourts in the vast Ninth Circuit – whichincludes California and many of theWestern States – and the Third and SixthCircuits reject a bright line approach tothe All Holders/Best Price Rule. Thesecourts instead direct the inquiry towhether the additional considerationpaid was an “integral part” of the tenderoffer. A payment might be viewed as an“integral part” of the tender offer if theamount of the consideration was tied tothe final tender offer price or whether thepayment was contingent on successfulcompletion of the tender (or support for the tender offer). Not surprisingly, a payment in exchange for actuallytendering the shares in the tender offerwould also be a violation of the Rule.

This approach will, of course, createfar greater opportunities to argue thatpayments made outside the tenderoffer are nevertheless a violation of the Rule. Indeed, a few bad facts andan adept plaintiff lawyer can probablybring almost anything into the fray.

Some courts have not gone quite sofar as the courts that have adopted the“integral part” test, and instead havefound that only payments that areintended as an “inducement” to therecipient to tender his or her shares or tosupport the tender offer is a violation ofthe Rule. This test is somewhat narrowerthan the “integral part” test, looking onlyat the intentions of the purchaser, butstill open to considerable latitude as towhat payments may or may not in factbe brought under scrutiny.

Keep in MindAs a practical planning matter, if anacquisition is to be structured as atender offer, it may be easy to avoidcertain obviously problematic paymentsfor management (such as a paymentto tender shares in the tender offer – a definite “NO”). Beyond that, giventhe legitimate needs for the sponsorand management to have some levelof understanding and agreement oncertain post-acquisition compensation-related matters, it may not be possibleto structure the arrangements withmanagement in a manner that is invulnerable to attack under the AllHolders/Best Price Rule, given thepotentially all-inclusive reach of the“integral part” test. Through aware-ness of the issue and attention to all of the various and nuanced struc-turing, timing and other factors, it ispossible to reduce risk significantly. — David P. Mason and David S. Lebolt

The risk here – insofar as it

relates to a sponsor’s arrange-

ments with management –

is that some item(s) in the

sponsor’s agreements with

the management team are

re-characterized as disguised

payment for shares held

by management, and that

“extra” payment must

then be paid to the public

shareholders.

The SEC’s “All Holder’s/Best Price Rule”(continued)

February 14 Margaret A. Davenport

Doing Deals, Understanding the Nuts & Bolts of Transaction Practice in an

Uncertain Market: Acquiring a Privately Held Company

New York, NY

February 28 - March 1 Franci J. Blassberg

Special Problems When Acquiring Divisions and Subsidiaries:

Negotiating the Acquisition of the Private Company

San Francisco, CA

Upcoming Speaking Engagements

Recent Publications

Books

Insurance and Investment

Management M&A

in the United States

by Paul S. Bird, Meredith M. Brown,

John Dembeck, Wolcott B. Dunham, Jr.,

Thomas M. Kelly, Ivan E. Mattei,

Steven Ostner, Edward A. Perell,

Nicholas F. Potter, Seth L. Rosen,

Peter F. G. Schuur and James S. Scoville

(Debevoise & Plimpton, 2001)

Takeovers: A Strategic Guide

to Mergers & Acquisitions

by Meredith M. Brown,

Ralph C. Ferrara, Paul S. Bird

and Gary W. Kubek

(Aspen Law & Business, a division

of Aspen Publishing, 2001)

Articles

“Taxation of Tax-Exempt

and Foreign Investors in

U.S. Private Investment Funds”

by Adele M. Karig

(2001, Practising Law Institute)

“Certain Tax Considerations for

Organizing U.S. Hedge Funds”

by Byungkwon Lim, Adele M. Karig,

Huey-Fun Lee and Jonathan Boyarin

(Oct.-Nov. 2001, 516 PLI/Tax 611)

“Private Funds and Recent

Consumer Privacy Regulations”

by Kenneth J. Berman, Woodrow W.

Campbell, Jr., Shannon Conaty and

Michael P. Harrell

(October 2001, Insights)

“Germany: A Primer for

Private Equity Funds”

by Dr. Friedrich E.F. Hey,

and Dr. Thomas Schürrle

(October 1, 2001, International

Financial Law Review)

“A Primer for Private Equity

Fund Sponsors: Part I”

by Kenneth J. Berman, Rachel H.

Graham and Marcia L. MacHarg

(October 2001, Insights)

“A Primer for Private Equity

Fund Sponsors: Part II”

by Kenneth J. Berman, Rachel H.

Graham and Marcia L. MacHarg

(November 2001, Insights)

Client Memos

“Private and Public Acquisitions

under the New Tender Offer Act

in Germany: A Brief Outline”

by David F. Hickok and

Dr. Thomas Schürrle

(December 26, 2001)

“New Chinese Venture

Capital Regulations”

by Andrew M. Ostrognai,

Jeffrey S. Wood and Richard Xu

(September 28, 2001)

“Developments in China’s

New Venture Capital Fund

Rules; Tax Treatment May

Be the Critical Path”

by Jeffrey S. Wood

(January 10, 2002)

For copies of these articles or for

information on how to order books,

please contact Rowena Lui at

[email protected].


private equity report can you sandbag? - home | …/media/files/insights/publications/2002... ·...

Documents