private equity report what’s inside - debevoise &...

Down Rounds: How to Protect

Against Future Uncertainty

page 3

Guest Column: Europe: Finding

the Sweet Spots for U.S. Investors

page 4

Private Equity Funds Abroad:

Establishing a London Office

page 6

Trendwatch: Private Equity Funds

Sponsored by Non-U.S. Managers:

How Different Are Their Terms ?

page 8

Protecting Shareholders from

Superfund Liability page 10

Recent Developments in

Anti-Money Laundering Laws

and Their Impact on Private

Investment Funds page 12

Italian Corporate Law

Reform Promises Friendlier

Deal Environment page 14

Marketing Guidelines in

Private Placements page 16

Alert: Recent Amendments

to CERCLA Limit Liability

for Purchasers page 24

What’s Inside

Sponsored Spin-Offs: The Private Equity Fund as Anchor Investor

Structure of TransactionIn order to effect a tax-free spin-off inanticipation of an investment by a privateequity fund, parent typically would firstdistribute all of the stock of an existing or newly created subsidiary to its share-holders on a pro rata basis in the form of a special dividend. If the target business is held in a separate subsidiary or consti-tutes a relatively small portion of parent’svalue, parent generally would spin off thetarget business. The distribution would be followed by a pre-arranged investmentby the private equity fund in the spin-offcompany. As described below, however, in some situations, parent and the fundmay prefer that parent spin off all of thenon-target businesses so that the fund canacquire shares in the parent (containingonly the target business) after the spin-off.As used in this article, “Spinco Target”refers to the business in which the privateequity fund will make its investment, and“Parent” refers to the spinning or spin-offcompany, as the case may be.

For a spin-off to qualify as a tax-freetransaction, generally the private equityfund’s investment must be structured as a primary investment (that is, a purchase

of newly issued shares) and the fund mustacquire less than 50% by vote and value of the shares of Spinco Target. If the spin-off fails to qualify as tax-free, both Parentand its shareholders may be subject tosignificant taxes in connection with thedistribution.

Advantages/DisadvantagesThere are a number of reasons why a spin-off to facilitate a private equity fund’sinvestment may be advantageous to boththe fund and Parent. From the fund’s per-spective, the target business may be anattractive investment opportunity becauseit is not correctly valued by the market (for example, because Parent trades at a lower P/E ratio than theappropriate ratio for the targetbusiness). From Parent’sperspective, the spin-off mayfree Parent to focus on itscore business while preservingfor Parent’s shareholders ashare of any future increase invalue that the private equityfund brings to Spinco Target.The investment by the privateequity fund may also enhance

continued on page 18

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In these times of tight financing, finding a buyer for a non-core line of business presents real challenges for a corporate parent. A spin-off may be an attractive structure to facilitate a private equity fund’s interest in such an investment. Unlike a cash sale of a subsidiary or a division, if the spin-off qualifies as a tax-free investment, the parent will not incur any taxcost in disposing of the target business. As a result, the spin-off may create an investmentopportunity that would otherwise not be available to the private equity fund. This articlediscusses the structural, legal and tax issues that must be carefully analyzed in structuring a spin-off for a private equity investment, including the new guidelines on structuringconstraints contained in the so-called “Anti-Morris Trust” rules issued by the IRS in 2001.

Volume 2 Number 3 Spr ing 2002

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

letter from the editor

Private Equity Partner/ Counsel Practice Group Members

The Debevoise & Plimpton Private Equity Report l Spring 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.

In this issue of The Debevoise & Plimpton Private Equity Report, we focus on two broad themes ofinterest to private equity investors in the current economic climate: how to tackle the Europeanmarket for private equity investment and how the shrinking pool of financing available for acquisi-tions is affecting deal structures and subsequent financing rounds.

On our cover, Paul Bird, the Co-Chair of the firm’s Mergers and Acquisitions Practice Group, and Peter Schuur, a Tax Partner in our London office, discuss how a structured spin-off of a non-core line of business to a private equity investor can unleash the unrealized value of such a businessfor the corporate parent and the private equity investor alike. David Schwartz, a Partner in ourPrivate Equity Funds Group, also discusses how private equity and venture capital investors canprotect themselves against future uncertainty in the event of later stage lower priced financingtranches, so-called “down rounds.”

Our Guest Columnists for this issue, Geoffrey Cullinan, Tom Holland and Simon Baines of Bain & Company’s global equity practice warn that while Europe presents opportunities for private equityinvestment, there is room for caution, and address some of the misconceptions that investorscontemplating entering the European market may have. In another article, we review the tax andregulatory issues that U.S. fund managers contemplating setting up operations in London shouldbe familiar with to avoid ugly surprises and unanticipated delays. Also, in this issue, Maurizio Levi-Minzi, a Partner in our Corporate practice, and Giancarlo Capolino Perlingieri, an InternationalCounsel in our London office, report that recent developments in Italian corporate law should makeItaly more hospitable to leveraged acquisitions in the future.

This issue’s Trendwatch column analyzes how the terms of funds with non-U.S. sponsors differ fromtheir American cousins and reveals that the gap is narrowing as the non-U.S. marketplace matures.

As usual, we also focus in this issue on U.S. legal developments impacting private equity fundsand their portfolio companies. Stuart Hammer reminds private equity firms returning to investmentsin “old economy” businesses of the potential for firm exposure to Superfund liability, but also high-lights new federal legislation limiting environmental liability for purchasers of property. We alsoreport on how the new anti-money laundering legislation adopted in the aftermath of September 11has created a new era of regulation and oversight for financial institutions, including private equityfunds, and we remind fund managers of the dangers marketing and press activities can pose to theirprivate placement exemption.

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 and 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


Down Rounds: How to Protect Against Future Uncertainty

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

In sharp contrast to the recent boomyears, subsequent rounds of venturefinancing are now generally priced lower– substantially lower – than the priorrounds. In reaction to this change ofclimate and in anticipation of potentialfuture “down rounds” investors are (i)insisting on stronger contractual protec-tions, such as milestones, “full rachet”anti-dilution protection and senior liquidation preferences, (ii) finding thatprotective provisions negotiated byinvestors in earlier higher-priced roundsmay impose impediments to structuringthe down round and (iii) facing addi-tional legal issues. This article willexplore these provisions and highlightthe issues savvy investors should focuson when investing in this climate.

Contractual Protections.Milestones. Rather than invest allcommitted funds at one closing, many investors now insist on dividinga financing into several tranches orstages and funding only after agreed-upon milestones have been met by theCompany. The milestones are generallytied to more objective standards, suchas revenues or governmental approvals,and are sometimes tied to more subjec-tive standards, such as stage of productdevelopment.

Milestones help investors limit theirexposure if the Company fails to meetits plans. Companies, however, oftenresist milestones since they limit flexibility and if an investor defaults on its obligation to fund a tranch, the Company generally has neither the time nor resources to pursue legalremedies. One alternative to serialfunding based on milestones is auto-matic adjustment of the conversionprice (effectively lowering the purchaseprice) if the Company fails to meet amilestone. This gives the Companycomfort that all funds will be investedand the investor price protection in the event the milestone is not reached.

Liquidation Preferences. Investors typi-cally purchase convertible preferredstock which returns to investors, inpreference to any junior securities, theiroriginal cost (or, as discussed below, a multiple thereof) in the event of aliquidation, sale or change of control of the Company and are convertibleinto common stock at the option of the investor. In the boom years, theliquidation preference of later roundswas generally parsi passu with earlierrounds of preferred stock. However, in a down round the liquidation prefer-ence of the existing preferred stock isby definition over-priced, and the newinvestor usually insists that the liquida-tion preference of the new money besenior to the liquidation preference ofexisting preferred stock. Furthermore,as additional compensation, the newmoney may insist upon a liquidationpreference equal to a multiple (2x or more) of the original cost and/orparticipating preferred. (Participatingpreferred entitles the investor to itsliquidation preference plus the amountit would have received in a liquidation

had it converted its preferred stock into common stock.) Holders of theexisting preferred stock and commonstock, who will only participate in theproceeds of a liquidation event afterpayment to the preferred stock issuedin the down round frequently resistthese provisions. However, often theonly choice is between approving theissuance of senior preferred stock with a multiple liquidation preference or bankruptcy.

Price Anti-Dilution Provisions. Investorsoften protect themselves against sub-sequent down rounds with “weighted-average” or “full rachet” anti-dilutionprovisions. Weighted average anti-dilu-tion reduces the initial conversion priceof the preferred stock (and increases thenumbers of shares of common stockinto which the preferred stock is convert-ible) to a weighted average price basedon the numbers of shares outstandingand the number of shares issued in thenew round. Full rachet anti-dilutionreduces the conversion price all the waydown to the dilutive issuance price.Often investors in down rounds insistupon full rachet anti-dilution provisionsto fully protect themselves againstsubsequent down rounds.

Companies generally object to fullrachet anti-dilution. Since an investor’sconversion price will adjust to thelowest price of any subsequent financing,it has less incentive to participate in asubsequent down round. Therefore,companies often insist on a “pay-to-play” provision as a compromise. Inorder for an investor to take advantageof the full rachet anti-dilution protec-tion in a subsequent down round, itmust purchase its pro rata share ofsecurities in such down round.continued on page 21


Europe: Finding the Sweet Spots for U.S. Investorsguest column

Europe has traditionally been seen by U.S. private equity investors as a market rich in opportunities. While it remains true that the European private equity market is less mature than in the U.S., the market is becoming increasingly competitive. Operating as a U.S. private equity investor in Europe is complex, requiring an understanding of multiple national markets. Notwithstandingthe fact that interesting opportunities for U.S. investors do exist, it is still too early to tell whether the initial U.S. entrants have been successful. This article will address the top questions that U.S. investors contemplating a European investment are posing.

Is there lots of low-hanging fruit for

private equity investors in Europe?

No, the European private equity marketis at least as competitive as the U.S.,with more deals conducted by invest-ment bank auction and fewerproprietary deals.

The last few years have seen a surge in European LBO activity. In 2001, the value of deals done in Europe out-stripped the U.S. market for the firsttime. However, despite growing oppor-tunities in Europe, the private equitymarket has become highly competitive.

On the one hand, the flow of fundsinto private equity has risen dramati-cally as institutional investors continueto increase allocations to private equity.One result of this is that the markethas seen major European players, suchas Apax, Candover, Doughty Hanson,Cinven and CVC Capital Partners,raising billions of dollars for Europe-focused funds.

Added to this has been the growth in auctions as a means of conductingacquisitions. Auctions are particularlyprevalent in the UK market. But they areincreasingly being used to increase theefficiency of the acquisition process else-where. Across Europe, virtually all largedeals are now conducted by auction.

This has made it harder for privateequity funds to find proprietary deal flow.The auction process, often conducted bythe large U.S.-based investment banks,has made it very difficult to find dealsbelow fair market price, and has pushedprices up and expected returns down.As a result, the focus of private equity

funds has shifted strongly toward how to add value to their transactions ratherthan merely relying on financial engi-neering to generate returns.

Europe is one market these days, right?

Wrong. Europe is still a multitude ofdifferent country markets each providingdiffering opportunities and requiringlocal knowledge and networks.

Europe is not really one market forprivate equity, despite the launch of thesingle currency and growing harmo-nization of legislation. Opportunitiesdiffer considerably by country, with theprivate equity market at varying stagesof maturity across Europe.

The UK market has traditionallybeen the most advanced, andaccounted for 50% of all Europeandeals by value 1997-2001. However,recent growth has been stronger inGermany, Italy and Sweden, and muchof the current effort of Europeanprivate equity investors has shiftedtoward such markets.

European governments and theEuropean commission have realized the great potential economic benefits of private equity. As a result, structuralreforms are in progress in the majormarkets and at the EU level, for exampleGermany’s removal of capital gains taxon the sale of shareholdings and recentcorporate law reforms in Italy. (See“German Tax Reform: A Primer for FundManagers,” The Debevoise & PlimptonPrivate Equity Report, Summer 2001 and“Italian Corporate Law Reform PromisesFriendlier Deal Environment” elsewhere

in this issue.) These reforms will provebeneficial in the medium term byincreasing deal flow and flow of capitalinto the asset class, but in the short-term significant differences exist inlegislation between countries which willcontinue to mean that market dynamicsdiffer between states.

Furthermore, the competitive situa-tion and key success factors requiredwithin each market create different levelsof opportunity for private equity investors.For example, the Italian market is muchless penetrated by private equity thancomparable countries, but is very diffi-cult for foreign funds to operate in part due to the importance of strongdomestic political and business contacts.Scandinavia, on the other hand, hasopened up rapidly to external privateequity investors, with external investors’share of deals by value rising from 28%in 1997 to 61% in 2001.

The key to operating in Europe is to understand that private equity ispredominantly a local business. Someof the larger deals can be conducted on a pan-European basis from onelocation. But for mid-market deals it iscritical to have a local presence, a localnetwork, local advisors who understandnational and European industry struc-tures and trends and a familiarity withlanguage, customs and culture – thistakes time to build.

So where’s the angle?

Opportunities exist in Europe to createvalue by restructuring acquisitions.However, this can be difficult to achievegiven government regulation, employ-


ment legislation and union strength in some countries, and the pool ofEuropean turnaround management is small.

Compared to the U.S., European laborlaws generally afford a far greaterdegree of employee protection. Thiscan be problematic for private equityfunds hoping to create value fromrestructuring their investments.

Legislation differs across Europe.One example of legislation makingrestructuring very difficult exists inFrance. There, layoffs must follow astrict procedure, which takes not lessthan 180 days before they can finally be implemented. If changes are made to the proposed retrenchments duringthe period, the 180-day period restarts.

Another problem facing privateequity investors in Europe is scarcity ofmanagerial talent available to executeturnarounds. First, the talent pool issmall overall, and, second, for any givendeal there exist national, language andgeographic barriers to accessing thattalent. Some U.S. investors have resortedto bringing in U.S. management, butthere have been high-profile cases wherethis has failed to work due to a clash ofmanagement styles and culture.

When the talent is available, incen-tivizing that talent appropriately can betricky. UK managers typically respond toU.S.-style incentives, like stock options.But continental managers do not always.For example, in Germany, managementtends to put a higher priority on commu-nity standing and cooperation at thework place than on financial incentives.Furthermore, some U.S. private equityinvestors have provoked a strong nega-tive reaction in the business communityin some countries by announcing U.S.-style management compensationpackages that are viewed as excessivecompared to local norms.

Despite the difficulties, there aresome examples of U.S. private equityinvestors taking a value-added approachand successfully improving perform-ance of their acquisitions in Europe. Forexample, Texas Pacific Group is in theprocess of driving growth and increasingEBITDA ahead of the industry at its UKpub chain, Punch Taverns.

What’s the opportunity for taking public

companies private?

Taking public companies private is arapidly growing source of deals, withthe advantage initially of allowing “quasi-proprietary” deal flow for private equityfunds.

Historically, public to private deals inEurope have been rare given complexlegislative requirements and corporatecontrol rules. But transactions of thistype are growing. European stock marketsentiment has moved away from smallerstocks, and this has led to a growing per-ception among private equity investorsthat many smaller stocks are under-valued. This has fueled public-to-privatetransactions, which rose from less than4% of European deals by value in 1997to 20% by 2001.

Public-to-private deals can allow aprivate equity investor to understandthe company better and potentiallydevelop an advantageous relationshipwith an incumbent management teambefore they bid, after which manage-ment is required by law to disclose thebid and thereby open up the acquisi-tion to other players.

Are there any interesting exit

opportunities?

The secondary market (sales of com-panies from one private equity investorto another) is providing a greateropportunity for exit.

The secondary market provides agrowing source of potential exit forEuropean private equity investors.

From 1997-2001 approximately 8% of European private equity deals weresecondary market sales, and this islikely to increase as long as IPO marketconditions remain difficult.

Are there many privatization

opportunities left?

Interesting state privatization oppor-tunities still exist; however, networksand political connections are key.

Following hectic activity in the late1990s, the rate of privatization inEurope is slowing, with $47 billionraised from privatizations in the EU in 2000 vs. $60 billion in 1999. Thisdrop can be attributed partly to areduction in the number of assets leftto be privatized, but also to unfavor-able equity markets that have causedstates to postpone privatization plans.

However, attractive opportunities do still exist, particularly in EasternEurope and in sectors where liberaliza-tion is incomplete, such as telecomsand energy. And there is evidence thatprivate equity investors will play a biggerpart in privatizations going forward, withgovernments increasingly seeing privateequity as an alternative to the IPO.

One of Europe’s high-profile privateequity investors, Guy Hands, formerhead of Nomura’s Principal FinanceGroup, has recently set up his ownfirm, Terra Firma Capital Partners.Terra’s goal is to invest about 40% of its new fund in German governmentprivatization projects.

The major U.S. private equity players

have already been successful in Europe,

haven’t they?

It is too early to tell whether any of themajor U.S. players have been successfulin the European market, as there havebeen few exits. Those that have not yetentered are behind the game, particu-larly given barriers to entry.continued on page 20


For most managers, establishing an office in the U.S. is almost a non-event: the manager may need toqualify to do business in the local state(normally satisfied by a routine filingand, in some cases, also by a publica-tion requirement) and, in some states,may have to comply with local registra-tion requirements, but is exempt fromregistration with the SEC under theInvestment Advisers Act of 1940 (the“U.S. Act”) as long as the managerhas no more than 14 clients in any 12-month period and does not holditself out generally to the public as aninvestment adviser. For purposes ofdetermining the number of clients,each fund is generally regarded as oneclient; however, the client countingrules are complex and often parallelfunds and co-investment vehiclescount towards the 14-client limitation.Thus, a newly established firm canbegin fund raising and making invest-ments without first registering as an investment adviser. In fact, manymanagers may never need to registerwith the SEC.

In contrast, a fund manager estab-lishing an office in the UK will inalmost all cases be required to obtainauthorization from the FinancialServices Authority (the “FSA”) beforeundertaking investment-related activi-ties. The Financial Services and MarketsAct 2000 (the “UK Act”) requirespersons carrying on “regulated activi-ties” in the UK to be authorized by the FSA. Most activities that a fund

manager would want to conduct areregulated activities, including raisingan investment fund, providing invest-ment advice and structuring portfolioinvestments. Although there are many technical exemptions that allowcertain regulated activities to takeplace without FSA authorization, mostfund managers establishing a perma-nent London office find it impracticaland too restrictive to rely on operatingexclusively within the exemptionsystem. Furthermore, engaging inregulated activities in the UK withoutFSA authorization or an exemption is a criminal offense and can rendertransactions voidable at the option of the other party.

U.S. fund managers contemplatinga London office should bear in mindthat the process can be time-consumingand that FSA authorization can takethree to six months.

The structure of a fund manager’sLondon office must also be carefullyvetted from a UK and U.S. tax per-spective, with a view to minimizing the double taxation of the manager’searnings and structuring the Londonoperations so that the manager and its principals do not become subject to UK tax on income that is unrelatedto the London office’s operations.

Structuring the London OfficeSubsidiary or Branch Office. To establishan office in London (or elsewhere inthe UK), a U.S.-based manager willtypically form an English limited com-pany as a subsidiary and apply for

authorization from the FSA. The alternative to forming a subsidiary isopening a branch office. Either alter-native requires FSA authorization, butfor the reasons described below a U.S.manager will in most cases prefer asubsidiary to a branch.

If the fund manager undertakesinvestment advisory activities in itsLondon office through a UK subsidiary,the manager typically retains thesubsidiary under an advisory agree-ment between the manager and thesubsidiary. That way the subsidiaryacts for only the fund manager.

Limited Liability. One advantage ofestablishing the London office as asubsidiary of the U.S. firm is that theU.S. firm is normally insulated fromthe liabilities that the London officemay incur in the course of doing busi-ness. Under English law, a parentcompany is generally not liable for thedebts and obligations of its subsidiarybeyond the amount of the parent’sunpaid shares in the subsidiary. If theLondon office is established as abranch office of the U.S. firm insteadof a subsidiary, there is no structure toinsulate the U.S. firm from the liabili-ties of its London branch. As a result,the assets of the U.S. firm remainexposed and potentially available tosatisfy those liabilities. To maximizethe likelihood that the limited liabilityand separate legal identity of a UKsubsidiary will be respected by theEnglish courts, U.S. firms and theirUK subsidiaries are well advised to

Private Equity Funds Abroad: Establishing a London Office

For many fund managers, there comes a time when establishing a London office begins to make sense, whether to increase thefirm’s visibility and be closer to UK and other European investment opportunities, to support the monitoring of existing portfolioinvestments, or to launch a European-based initiative, such as a new fund with a predominantly European investor base. Settingup operations in London, however, is not as simple as it is in the U.S. and can result in surprises for U.S.-based managers unfamiliarwith the regulatory and tax issues involved. We review below some of the issues that U.S. fund managers should be aware ofwhen preparing to open a London office.


adopt good corporate “housekeeping”practices when conducting and documenting their business activities(in particular board meetings) and to consult with in-house or outsidecounsel as appropriate.

UK Tax Considerations. The UK taxconsequences of operating a Londonoffice through a subsidiary or a branchare generally similar. Profits attribut-able to the subsidiary or branch will be subject to 30% UK corporation tax;no UK tax will be imposed on divi-dends from the subsidiary to the fundmanager or on repatriations of earn-ings of the branch to the U.S. Onesignificant advantage of operatingthrough a subsidiary rather than abranch is that only the UK subsidiarywill be required to file a tax return withthe UK tax authorities, which tends toinsulate the fund manager from UK taxscrutiny. A branch, on the other hand,may be required to supply informationconcerning the fund manager’s overalloperations and income in addition tothe branch’s own income.

To preserve the UK tax advantagesof operating a London office in asubsidiary form, the fund managermust avoid creating a taxable presencein the UK other than through thesubsidiary. In particular, the fundmanager should not have its own UKoffice. Employees of the managershould not enter into agreements onbehalf of the manager while they arepresent in the UK. In addition, theemployees of the UK subsidiary gener-ally should not have the power to enterinto agreements on behalf of the fundmanager or on behalf of private equityfunds that are advised by the manager.

Under the UK transfer pricing rules, transactions between the fundmanager and its UK subsidiary mustbe on an arm’s-length basis. Caremust be taken in structuring the advi-sory agreement between the parent

and subsidiary to ensure that thesubsidiary receives adequate remuner-ation for the services it renders andcan operate profitably in the UK. Inorder to minimize the value that can be ascribed to the subsidiary’s servicesfor UK tax purposes, it is best to avoidtransfers of potentially valuable assetsto the subsidiary, such as long-termcontracts or the right to use themanager’s name in the UK, unlessthey can be revoked by the fundmanager at any time.

U.S. Tax Considerations. From a U.S. tax perspective, operating a Londonoffice through a branch may be moreappealing than a subsidiary for thereasons described below. Fortunately,under the U.S. “check-the-box” rules, a fund manager can get the best ofboth worlds and elect to treat a wholly-owned UK subsidiary as a branch for U.S. tax purposes. The principaladvantages of making the check thebox election are that (i) U.S. transferpricing requirements will not apply to transactions between the managerand the subsidiary, which will preventthe manager from being whipsawed bythe U.S. and UK tax authorities’ takinginconsistent transfer pricing positions;(ii) the subsidiary will not be subject toseparate U.S. tax reporting requirementsunder the U.S. “controlled foreigncorporation” rules; and (iii) if the fundmanager is owned by U.S. individualsand is structured as a pass-through forU.S. tax purposes, making the electionwill enable the individuals to claimU.S. foreign tax credits in respect ofthe subsidiary’s UK income tax.

Regulated Activity in Other European

Jurisdictions. Another potential advan-tage of a U.S. firm choosing toestablish a UK-domiciled subsidiaryinstead of a branch is that thesubsidiary, if authorized to conductregulated activities in the UK, benefitsfrom the Treaty of Rome and certain

European directives that may allow itto conduct regulated activity elsewherein Europe. This means that the sub-sidiary may, for example, provideinvestment advice or engage in otherregulated activities in these jurisdic-tions without having to obtain localauthorization, although certain for-malities may need to be observed. The treaty and the directives do notoperate in favor of the London branchof a U.S. firm because the branchremains part of a U.S. entity.

Filing of Accounts. One potential disadvantage of establishing a UKsubsidiary instead of a branch is that asubsidiary company must prepare andfile its own audited accounts in accor-dance with the requirements of theCompanies Act of 1985. A branch office,on the other hand, can file auditedaccounts prepared in accordance withthe practices of the U.S. firm, althoughfor UK tax purposes the branch is also required to produce unauditedaccounts for the UK operation only.

Employee-Related Taxes. The fundmanager’s UK branch or subsidiarygenerally will be required to withholdUK income and employment taxesfrom compensation paid to UK-basedemployees, and to remit the withhold-ings to the UK tax authorities. Thebranch or subsidiary will also have anindependent obligation to pay theemployer’s portion of UK employment

continued on page 22

U.S. fund managers

contemplating a London

office should bear in mind

that the process can be

time-consuming and that

FSA authorization can

take three to six months.


As private equity firms increasinglyrecalibrate their investment mix in favorof traditional, “old economy” busi-nesses, they need to ensure that theirinteraction with these businesses doesnot expose the firm to environmentalliabilities. Of particular concern is thefirm’s potential liability under the Com-prehensive Environmental Response,Compensation and Liability Act(“CERCLA”), the federal Superfund law,whose broad liability scheme has in thepast burdened shareholders with multi-million dollar cleanup obligations. Asdiscussed below, shareholders thatengage in certain activities can subjectthemselves to CERCLA liability. Thisissue’s “Alert” focuses on recent amend-ments to CERCLA which have expandedthe exemptions from liability for certainpurchasers of contaminated businesses.These changes do not impact share-holder liability under CERCLA discussedherein.

CERCLA. CERCLA empowers thefederal government and private partiesto recover costs incurred in cleaning up a facility. While cleanup costs aregenerally sought from the parties thatowned or operated the polluting facility,shareholders are also often sued, evenwhere they had little or no connectionto the polluting facility. Shareholdershave been particularly susceptible toCERCLA suits in situations where a com-pany no longer exists or is incapable ofpaying its share of cleanup costs due toinsolvency or bankruptcy.

For many years, courts were dividedas to the circumstances under which

shareholders could be held liable underCERCLA. Most courts held shareholdersliable under CERCLA where plaintiffsdemonstrated that the shareholderswere “actively involved” in managingthe activities of a corporation. Thesecourts would consider various factors,including whether the shareholderscontrolled a corporation’s daily oper-ations, supervised its financial decisions,approved significant transactions orplaced its personnel in managementpositions. Other courts held share-holders liable under CERCLA where theshareholders merely had the authorityto control a corporation’s operations,even if such authority went unexer-cised. Still other courts refused to holdshareholders liable unless the require-ments necessary to pierce thecorporate veil were met.

United States v. Bestfoods. A 1998 deci-sion by the U.S. Supreme Court helpedbring clarity to the issue of shareholderliability under CERCLA, and in theprocess, helped slow the tide of CERCLAlawsuits brought against shareholders.The Court’s decision in United States v. Bestfoods limited the circumstancesunder which shareholders and corpo-rate parents could be held liable underCERCLA.

The Court in Bestfoods held thatthere were only two theories underwhich shareholders and corporateparents could have CERCLA liability:

First, the shareholder/corporateparent could have “direct liability” whenit directs the workings of, manages orconducts the affairs of a company’s

polluting facility. Specifically, a share-holder/corporate parent will be heldliable when it manages, directs, orconducts activities at a facility that were specifically related to the pollution,such as operations having to do withthe leakage or disposal of hazardoussubstances or compliance with envi-ronmental laws.

Second, the shareholder/corporateparent could have “derivative liability”when the extent of the shareholder’scontrol over the company has destroyedthe legal formalities of separatenessbetween parent and company such thatthe corporate veil is properly piercedunder traditional corporate law principles.

As discussed below, Bestfoods, andthe cases interpreting it, have developedsome important principles that share-holders must consider in seeking toshield themselves from CERCLA liability.

Shareholder Activities. Bestfoodsprovided a safe harbor for shareholdersto engage in general corporate activitieswith a corporation without subjectingthe shareholders to direct liability underCERCLA. Shareholders will be shieldedfrom CERCLA liability if their activitiesare consistent with their investor status.Protected activities include monitoringthe performance of a company, super-vising the company’s finance andcapital budget decisions and articu-lating general corporate policies.

However, shareholders can be helddirectly liable when they involve them-selves in the environmental activities of a facility. In this respect, the cases thathave interpreted Bestfoods have estab-

This is Part 2 in a two-part series on environmental issues of critical importance to private equity investors. In Part 1, we addressedthe inadequacies of traditional Phase 1 Environmental Site Assessments as a due diligence tool. In this article, we address theliability of shareholders under the federal Superfund law.

Protecting Shareholders from Superfund Liability


lished certain guidelines that should helpinsulate shareholders from CERCLAliability:

• Shareholders should not assume anyresponsibility for, or oversight over,environmental matters of a facility.Environmental matters include anymatters related to waste disposal,cleanup or environmental complianceactivities.

• Where environmental regulators orothers regard the shareholder as thetrue operator of the facility, directliability is likely to be found. In thisrespect, shareholders should notinteract or correspond with environ-mental regulators or waste haulers ona facility’s behalf.

• A facility’s environmental permitsshould not be registered in the shareholders’ name. Moreover, theshareholders should not play a role inobtaining environmental permits for a facility and should not liaise with reg-ulators with respect to such permits.

• Shareholders should not retain envi-ronmental attorneys, consultants,engineers or contractors to addressenvironmental issues at a facility.While these activities alone may notsubject a shareholder to CERCLAliability, they likely will be factors in acourt’s analysis of direct liability.

• Shareholders should be cautiousbefore advising a facility about issuesrelating to the facility’s sewer system,drainage system and wastewatertreatment systems, which often serveas conduits for contamination.

• Shareholders should not require acompany to notify the shareholders ofany contact the corporation has withenvironmental regulators.

• Shareholders should not settle thecorporation’s environmental lawsuits.

• Having an employee of a share-holder/corporate parent serve as anofficer of a subsidiary will not in itselfsubject the shareholder to directliability. Bestfoods recognized that it isentirely appropriate for directors andofficers of a shareholder/corporateparent to serve in a similar capacityfor a subsidiary. Courts will presumethat joint officers and directors haveacted properly, and to overcome this presumption, a plaintiff mustdemonstrate that the joint officersand directors were really acting for the shareholder/corporate parentwhen they were ostensibly acting onbehalf of the subsidiary.

• Where shareholders dominate theactivities of a company, but are notinvolved in the company’s environ-mental activities, direct liability is notlikely to be found. However, suchactivities expose the shareholders toderivative liability.

Veil Piercing. Shareholders will be heldderivatively liable when they control acompany such that the corporate veil is properly pierced under traditionalcorporate law doctrines. Bestfoods leftopen the question as to whether federalor state veil piercing law should beused to analyze derivative liability. Thisvoid has created a split among courtsas to whether federal or state lawshould be applied. Nonetheless, veilpiercing factors likely to be consideredunder both federal and state lawinclude the following:

• inadequate capitalization of assets,

• extensive or pervasive control by theshareholder,

• intermingling of properties or funds,

• failure to observe corporate formali-ties and separateness,

• siphoning of funds, and

• the absence of corporate records.

Whether a court applies federal orstate veil piercing law, it will be moreinclined to hold shareholders liablewhen they misuse the corporate formto accomplish some wrongful purpose,such as fraud.

Conclusion. Bestfoods was an importantdecision for shareholders as it limitedthe circumstances under which theycould be held liable under CERCLA.Nonetheless, four years after theBestfoods’ decision, shareholders con-tinue to be sued in CERCLA actions. As companies continue to falter andare unable to pay their share of cleanupcosts, CERCLA suits against share-holders are expected to increase asplaintiffs seek out “deep pockets” tohelp pay for cleanup costs. To helpprevent such suits, private equity firmsshould adhere to the guidelines out-lined above.— Stuart Hammer

Bestfoods provided a safe

harbor for shareholders to

engage in general corporate

activities with a corporation

without subjecting the share-

holders to direct liability under

CERCLA. Shareholders will be

shielded from CERCLA liability

if their activities are consistent

with their investor status.


Actions That Private Funds Must Take

Now. Private funds, which have beenlargely unregulated in the U.S. untilnow, have had to act quickly to estab-lish internal anti-money launderingcompliance programs by the April 24,2002 deadline. The Treasury Departmentis expected to have issued regulationsspecifying the steps that private fundsmust take. Private funds are required bythe Act to adopt compliance programs,however, even if the regulations are notissued in time, so it has been necessaryto develop programs without detailedguidance from the regulators.

We are working with private equityfirms and other fund sponsors to put inplace compliance programs customizedto their particular businesses. In everycase, however, the firm must (1) develop internal policies and proceduresdesigned to prevent the laundering ofproceeds of criminal acts through thefund, (2) designate a compliance officer,(3) establish an ongoing employeetraining program and (4) create anindependent audit function to test theanti-money laundering program.

These requirements will affect thefund during its capital raising processand throughout the life of a fund. Forexample, the policies and proceduresreferred to in clause (1) above couldprovide that, during the fund-raisingprocess, fund sponsors will: undertakedetailed due diligence investigationswith respect to the identities of investors,

such as obtaining representations and, in appropriate cases, supportingdocumentation as to the identities of investors; make disclosure in theiroffering memoranda of the new regula-tory regime; and obtain covenants insubscription documents from investorsthat they will supply information on an ongoing basis as needed to assurecompliance with the new rules.(Additional due diligence procedureswith respect to certain types ofaccounts will be required by July 23,2002.) Once the fund has been formedand is operating, ongoing monitoringof investor activity will be required.

Future U.S. Regulation of Private Funds.

Additional direct regulation of privatefunds is almost certain. The USAPATRIOT Act requires the Secretary ofthe Treasury, the SEC and the FederalReserve to recommend to Congress theexpansion of the U.S. Bank Secrecy Actto cover investment companies,including private funds. It is possible,for instance, that private funds will berequired to file reports of suspiciousactivity involving fund accounts.

The Act also requires the TreasuryDepartment to promulgate, by October26 of this year, new regulations settingforth the minimum standards for finan-cial institutions, including private funds,to verify the identity of their customers(their investors). While it is impossibleto know exactly what these rules will say,it is likely that the “know-your-customer”

rules applicable to other financial busi-nesses will greatly influence the contentof the Treasury regulations. Some of ourclients – particularly those not nowraising a new fund – may decide to waituntil the regulations are issued beforeasking investors for information anddocumentation verifying their identity.Other clients – particularly those raisinga new fund – are asking potentialinvestors now for the detailed informa-tion that is expected to be required bythe upcoming regulations. Their thinkingis that it is preferable to gather the infor-mation before bringing an investor intothe fund, rather than trying (perhapsunsuccessfully) to chase down the infor-mation later and, possibly, discover aproblem. Whichever approach fundsponsors decide to take, they should beaware that the anti-money launderingpolicies and procedures that privatefunds must have in place as of April 24require at least some heightened level of due diligence regarding investors.

Regulation of Other Institutions That is

Likely to Impact Private Funds. Under the USA PATRIOT Act and NASD rulesproposed in January 2002, registeredbroker-dealers, like private funds, alsomust establish anti-money launderingcompliance programs. In addition,Treasury Department regulations thatwere proposed in December pursuantto the Act, as well as the proposedNASD rules mentioned above, will

In the aftermath of the September 11th terrorist attacks, American lawmakers aggressively worked to tighten and strengthen U.S. anti-money laundering laws. On October 26, 2001, President Bush signed into law the USA PATRIOT Act, which is aimed at stemming theflow of illegal funds to terrorists around the world. Among other things, the Act required that “financial institutions” adopt anti-moneylaundering compliance programs by April 24, 2002. As we reported to our clients and friends in February, the U.S. Treasury Departmentapparently views the term “financial institution” as used in the Act as encompassing private equity funds, hedge funds and other privateinvestment funds. (Editor's note: As we went to press, the April 24 deadline for putting in place compliance policies and procedures wasextended to October 24, 2002.)

Recent Developments in Anti-Money Laundering Laws andTheir Impact on Private Investment Funds


require broker-dealers, like banks, tosubmit “suspicious activity reports” to regulators.

This regulation is likely to affectprivate funds that are affiliated withbroker-dealers, as well as funds andfund sponsors that hire broker-dealers(placement agents) and even privatefunds that merely maintain accountswith U.S. financial institutions. Forexample, private funds should recog-nize that placement agents are now (orshortly will be) subject to much stricterrecordkeeping and reporting require-ments. So, a fund sponsor using aplacement agent to help raise a fundcan expect to receive more (and moredetailed) requests from the placementagent about the fund and about thefund’s investors (at least, thoseinvestors who are not also clients ofthe placement agent) than was thecase in prior years.

Recent Developments in Cayman Anti-

Money Laundering Laws. The U.S. is notalone in strengthening its anti-moneylaundering legislation. For example, lastyear the Cayman Islands, where a greatmany non-U.S. private equity funds andhedge funds are organized, greatlystrengthened its anti-money launderinglegislation. Current Cayman anti-moneylaundering laws predate the U.S. lawsdescribed above, and impose similarrequirements, including “know yourcustomer” rules. As part of the Cayman“know your customer” rules, funds areobligated to perform relatively detaileddue diligence on investors to establishand verify their identities and sourcesof funds. This may include obtainingcertified copies of passports with respectto individual investors and variousorganizational and authorization doc-uments with respect to institutionalinvestors; however, the level of due diligence required may be less when an investor funds its capital contribu-tions from a country deemed to have

anti-money laundering legislationequivalent to that of the CaymanIslands. Sponsors of funds organizedunder Cayman Islands law may also beobligated to report suspicious investoractivity to the Cayman ReportingAuthority, which means that funds willneed to establish means of monitoringinvestor activity. Funds that haveemployees or a physical presence in the Cayman Islands are also required to designate anti-money launderingcompliance officers and to conductregular employee training.

Priorities and Some Suggestions.1. Compliance Program. As stated at thebeginning of this article, U.S. privatefund sponsors are required to have in place anti-money laundering com-pliance programs for their funds as of April 24, 2002. Any such programshould be crafted to fit the circum-stances, policies and procedures ofeach fund. As part of this program, any fund seeking investors shouldinclude language in its subscriptiondocuments that requires that itsinvestors (limited partners) provide tothe fund’s general partner all informa-tion that the general partner deemsnecessary in order to comply with anti-money laundering or anti-terrorist lawsor regulations. We have updated theform of subscription agreement thatwe prepare for clients accordingly.

2. Know Your Customers. As part of itscompliance program, and in anticipa-tion of the “know-your-customer” rules to take effect later this year, fundsponsors should begin consideringnew procedures designed to verify theidentities of existing and prospectiveinvestors in their funds.

3. Investment Activity. During due diligence on potential portfolio invest-ments that are subject to theseregulations (e.g., investment by a fundin a brokerage firm) or that are expected

to be subject to these regulations (e.g.,investment by a fund of funds in otherprivate funds), the fund considering the investment should seek informationabout the target’s anti-money launderingcompliance efforts.

4. Dealing With Other Regulated Entities.

Private funds should considerincluding appropriate provisions intheir contracts with placement agentsand with acquisition targets that are in financial services businesses,regarding anti-money launderingcompliance. For example, in an acqui-sition agreement where the target is a financial services business, a fundshould consider obtaining a represen-tation from the seller or target that it is in compliance with anti-money laundering and anti-terrorist laws andregulations.

5. Non-U.S. Funds. Fund sponsors shouldconsult local counsel for informationregarding the impact of Cayman Islands,EU or other anti-money launderinglegislation on non-U.S. funds.

Conclusion. Recent developments inU.S. anti-money laundering legislationmay well have ushered in an era of regu-lation for private funds. At a minimum,these developments have imposednew burdens on private investmentfunds that, in many cases, are unac-customed to regulatory oversight. Thenext year will bring a series of regula-tions and recommendations that couldhave additional effects on the ways inwhich private equity funds raise andinvest their capital. Private funds andfund sponsors need to be aware ofthese regulations not only because ofthe need to comply with the law, butalso because of the reputational risksassociated with such matters.— Kenneth J. Berman, Michael P.

Harrell, Shannon Conaty and Jennifer Spiegel

In the past, Italy has not been a veryfriendly environment for mergers andacquisitions in general and particularlyleveraged acquisitions. It seems,however, that this environment is aboutto change. In the late fall of 2001, theItalian legislature adopted a series ofchanges to its corporate law to facilitateinvestment. These changes, knownbroadly as the Reform Project, areexpected to, inter alia, make LBOseasier when the rules implementing the Reform Project are announced inthe next six months. In the meantime,private equity investors consideringinvestments in Italy should be aware oftwo significant innovations promisedby the Reform Project: a more favorabletreatment of leveraged acquisitions andthe broader array of choices of corpo-rate governance mechanisms that willbecome available to Italian companies.

Leveraged acquisitionsIn the past, Italian law imposed severerestrictions on LBOs. Article 2357 of the Italian Civil Code (the “Civil Code”)provides that an Italian corporation mayonly purchase its own shares through

distributable profits and reserves. Thefinancial assistance rules in Article 2358of the Civil Code provide that an Italiancorporation may neither subsidize norprovide any guarantee for the acquisi-tion or subscription of its own shares.Both provisions were used to void LBOsin a number of cases in the early 1990s.

A more encouraging treatment ofLBOs emerged from the Trenno case in 1999. Snai Servizi acquired a con-trolling interest in Trenno though anacquisition vehicle financed with theissuance of equity securities and withcertain credit facilities. The acquisitionvehicle, which had also acquired fromSnai Servizi certain other related busi-nesses, was then merged into Trennothrough a reverse merger. The court ofMilan, holding that a leveraged mergeris not a per se violation of the financialassistance provisions of the Civil Code,suggested a case-by-case approach. The court reasoned that such a lever-aged acquisition, if part of a broadercorporate objective aimed at creatingsynergies for increasing the cash flowcapacities of the companies involved,would be compatible with the financialassistance provisions contained in theCivil Code. The pendulum appeared toswing back, however, in a recent fraud-ulent bankruptcy case, when the ItalianSupreme Court (without providingadequate reasoning) held that lever-aged buy out structures violate thefinancial assistance provisions and arenot allowed in the Italian legal system.

Given the scarce and conflictingcase law, legal scholars have madesignificant contributions to the debateover LBOs. Some have defended LBOson the grounds that they are compatiblewith the Civil Code because the vehicleis financed long before the acquisitionof the target company and the assets ofthe target company are a generic and

hypothetical security for the financingbank. On the other hand, detractorshave argued that financial assistanceprovisions are triggered because theassets of the target company increasethe likelihood that the acquisition lenderwill be repaid on its credit facility.Therefore, leveraged transactions couldbe viewed as sham transactions circum-venting the financial assistance rules.

Against the uncertain backgroundcreated by these few cases andconflicting opinions of scholars, theReform Project seems to suggest thatthe implementing rules to be passed by the Italian government by Octobershould create a safe harbor for LBOs by making it clear that leveraged mergersof companies do not violate the prohi-bitions against a corporation acquiringits own shares or the financial assistancerules. The text of the Reform Projectseems to unconditionally approve leveraged acquisitions, but gives noguidance to the Italian government asto how this principle should be imple-mented. In light of the conflicting caselaw and of the divergence of scholarlyopinion on this issue, it is likely that theimplementing rules will contain restric-tive terms and conditions limiting theavailability of the safe harbor. While the Reform Project provides powerfulevidence of a positive trend towardsmodernization of Italian corporate law,the full extent of the new legal frameworkfor Italian LBOs will not be clear untilthe implementing rules are released.

Corporate GovernanceThe Reform Project also promisessignificant changes in the corporategovernance arena by introducing signifi-cant changes to the rules governingcorporate organization and directorliability.


Italian Corporate Law Reform Promises Friendlier Deal Environment

Private equity investors

considering investments in

Italy should be aware of two

significant innovations prom-

ised by the Reform Project:

a more favorable treatment

of leveraged acquisitions and

the broader array of choices

of corporate governance

mechanisms that will become

available to Italian companies.


Structural issuesUnder current law, the board of direc-tors (consiglio di amministrazione) of an Italian company is responsible for managing and representing thecompany. In practice, the board ofdirectors delegates many of its powersto one or more managing directors(amministratore delegato) and/or to theexecutive committee (comitato esecu-tivo). The internal board of statutoryauditors (collegio sindacale) is responsiblefor supervising the board of directors.

The Reform Project provides thatItalian companies will be permitted tochoose between the current one-tierboard structure and two alternativeforms of governance: (i) the two-tiermanagement board (consiglio di gestione)/supervisory board (consiglio di sorveg-lianza) structure, and (ii) the board ofdirectors (consiglio di amministrazione)/audit committee (comitato di controllo)structure.

The management board/supervisoryboard structure is based on the Germancorporate governance structure (exceptthat, under the Reform Project, thesupervisory board seems to have a lesserinvolvement in the management, e.g.,does not approve the investmentstrategies of the management board).The duties of the supervisory boarddiffer from the current supervisoryduties of the internal board of statutoryauditors (collegio sindacale) in that thesupervisory board will be granted powerscurrently entrusted to the shareholders.These powers will include the powersto appoint and revoke the members of the executive board, to approve thefinancial statements and to assert claims against the members of themanagement board. In the board ofdirectors/audit committee structure, an ad hoc audit committee, mainlycomposed of non executive and inde-pendent directors, will be formed as apart of the board of directors. This ad

hoc audit committee will be entrustedwith inspecting powers.

Liability issuesAn Italian company’s directors mayface both civil and criminal liability inconnection with the performance oftheir duties. Directors are subject tocivil liability for a breach of (i) the dutyof care, (ii) the duty of loyalty, (iii) dutiescontemplated in ad hoc provisions ofthe Civil Code, for example the duty toprepare the financial statements. Withrespect to the duty of care, directors aresubject to the reasonable person stan-dard of care, according to case law, ahigher than average standard of care by reason of their position. Directorsare subject to criminal liability in certainlimited circumstances such as, forexample, making misrepresentations in the financial statements in the com-pany, divulging confidential informationabout the company or causing thecompany to distribute illegal dividends.

A civil action may be broughtagainst directors by (i) the company(azione sociale), if approved by themajority of the shareholders; (ii) thecreditors (azione dei creditori), if thedirectors’ acts or omissions havedepleted the company’s assets; and (iii) third parties (including minorityshareholders), if they can prove theywere directly affected by directors’ actsor omissions (for example, if minorityshareholders subscribe to a capitalincrease because the directors havemisrepresented the financial statements).In practice, the necessary approval forthe azione sociale is rarely obtained andthe azione dei creditori is filed by thetrustee in bankruptcy proceedings.

Directors are jointly and severallyliable to third parties but, within thecompany, liability is shared amongdirectors and depends on the particulardirector’s degree of negligence. A com-pany may take out insurance policies to cover directors’ liabilities. Such

insurance policies, however, cannotcover directors’ gross negligence,willful misconduct and criminaloffenses. Even in the case where thedirectors delegate their powers, thedirectors maintains supervisory powersand responsibilities.

The Reform Project provides thatcompanies may specify in their by-lawscertain qualifications for their directors(e.g., good standing, relevant skills,independency requirements). Suchqualifications are currently mandatoryonly in certain businesses, such asinsurance and banking. Although caselaw has already developed in thisrespect, directors may be subject to ahigher standard of care if the practicedevelops for Italian companies to requirecertain qualifications for directors.

The new legislation will providecertain qualified minority shareholderaccess to the company’s civil action(azione sociale) against directors.

Under certain circumstances,however, establishing a director’s crim-inal liability will be harder than undercurrent legislation. For example, underthe new legislation directors may becriminally liable for misrepresentationsin the company’s financial statementsonly upon proving the directors’ mis-representations, including by means ofomitting facts, were material and aimedat deceiving shareholders or thirdparties with the intention of makingunlawful profits.

——

The exact ramifications of the ReformProject will be clear only after therelease of the implementing rules. Forthe time being, however, private equityinvestors can take some comfort fromthe fact that the Italian lawmakersappear interested in dealing with someof the perceived difficulties that faceforeign investors in Italy. — Maurizio Levi-Minzi and

Giancarlo Capolino Perlingieri

You are a senior principal of a privateequity fund sponsor about to launchFund IV. The Wall Street Journal calls and wants to interview you. You gladlygrant the interview and extol the virtuesof past fund performance and cheerfullyannounce you are looking forward toclosing your fourth successful fund.Things never looked better. Not so fast!When the article appears the next day,you get an urgent call from counsel whoexplains that your marketing of Fund IVwill have to be delayed to allow for acooling off period. What just happened?You have just come close to losing yourprivate placement exemption. Thisarticle will explain how the exemptionworks, the steps fund sponsors need totake to preserve it and how to avoid thepitfalls of a significant delay in marketingor closing a fund.

Private equity funds are typicallyformed by offering investors partnershipinterests in a limited partnership (a“Fund”) with the fund sponsor as gen-eral partner. Such an offering requiresregistration under the Securities Act of1933 (the “Securities Act”), unless anexemption from registration is available.Private equity funds generally avoid aregistered offering by relying on Section4(2) of the Securities Act, (which exemptsfrom the registration requirements of theSecurities Act all “transactions by anissuer not involving any public offering”)and on Regulation D, the safe harbor forprivate placements promulgated underthe Act by the Securities and ExchangeCommission (the “Commission”).

Counsel will typically provide at theFund’s closing a legal opinion that the

Offering was not required to be regis-tered under the Securities Act, and thatthe Fund will not be required to be regis-tered under the Investment CompanyAct of 1940 (the “Investment CompanyAct”).1 Counsel will not be able toprovide this opinion, which is requiredas a condition to closing the Fund by the Fund’s limited partners, absentrepresentations from the client and the placement agent that the offer wasmade in accordance with the require-ments of Section 4(2) of the SecuritiesAct and Regulation D, including that noform of general solicitation or generaladvertising occurred.

The ExemptionsMost funds qualify for the safe harborunder Regulation D. Rule 506 ofRegulation D requires that the Fund, as issuer of the limited partnershipinterests, “reasonably believe” thatthere are no more than 35 purchaserswho are not “accredited investors.”Therefore, assuming that all the otherrequirements of Regulation D are met,an unlimited number of accreditedinvestors may invest in the limited partnership interests without jeopard-izing the availability of the Regulation D exemption. Accredited investorsinclude natural persons whose individualor joint net worth with their spouse,exceeds $1 million or who had an indi-vidual income in excess of $200,000 or $300,000 with their spouse in eachof the two most recent years, and has areasonable expectation of reaching thesame income level in the current year.

Under both Section 4(2) of theSecurities Act and Regulation D, therequirement that the offering notinvolve “any public offering” meansthat during the course of solicitinginvestors (the “Offering”), no generalsolicitation or general advertising hasoccurred, including, for example, anyadvertisement, article, notice or other

communication published in any news-paper, magazine or similar media, orbroadcast over television or radio; orany seminar or meeting whose atten-dees have been invited by any generalsolicitation or general advertising.

Avoiding the PitfallsSo why was your counsel so perturbed?At the upcoming closing, the Fundsponsor and placement agent will needto make representations to supportcounsel’s opinion as to the privateplacement exemptions. The making of such representations by the Fund’srepresentatives and reliance thereon by counsel would be difficult if the clientis quoted by the press discussing theOffering or the new Fund it is in theprocess of raising. Equally problematicwould be a section of the client’s Web site devoted to the Fund it is in the process of raising – we have seenWeb sites with a link for investors tocontact the fund sponsor for more infor-mation (it might as well say “widows and orphans, send money here!”).

In these situations, counsel will typi-cally propose a cooling-off period priorto continued marketing and/or the firstclosing of the Fund. Additionally, if theCommission believes the conduct of thesponsor has constituted a general solici-tation, the Commission could impose a significant cooling-off period (such assix months) to follow the general solici-tation. We know of at least one instancewhere the Commission has imposed a six-month cooling-off period after anarticle appeared quoting an executivediscussing fund raising. We, have, on occasion, also imposed cooling-offperiods on our own clients (e.g., of 60days) prior to continued marketing or, insome cases, actual closing of the fund.

Most clients ask “but really, how can this be? Our target market consistsof major institutional investors, and the individuals we target are so high net


Marketing Guidelines in Private Placements

1 The requirement that the private placement not involveany public offering is a critical component of the exemptionsfrom registration under Section 3(c)(1) or Section 3(c)(7) ofthe Investment Company Act, on which many private fundsrely to avoid registration. Fortunately, the test under theInvestment Company Act is satisfied by a private offeringunder the Securities Act. In other words, satisfying theprivate offering requirements under the Securities Act willalso satisfy the private offering requirements of the relevantInvestment Company Act exemptions.


worth that they meet the accreditedinvestor test. These investors are sophis-ticated enough to ask detailed questionsabout our track record and engage theirown advisors. They are not going toinvest in our Fund just because we werequoted in the newspaper. The press isreporting our Offering based on infor-mation from third parties and existinglimited partners – and not all of it’saccurate. How can we not at least correctthe misinformation? And the widowsand orphans who logged on to our Website and e-mailed us, well, we certainlyaren’t going to allow them to invest.”

What’s the answer? That may betrue, but it doesn’t matter. Unfortu-nately, this is one of the few areas onwhich the law is clear. And as individualhigh net worth investors comprise anincreasingly significant part of theinvestor base for many private equityfunds, it is becoming more of a possi-bility that advertising and press coveragemay increase awareness and actuallycondition the market for some in thatclass of investor.

Perhaps the most critical advice?When in doubt, consult with counselwho will be providing the private place-ment legal opinion. Of course, if theFund sponsor typically makes publicstatements regarding its business oractivities unrelated to marketing theOffering (for example, an acquisition ordisposition made by a prior Fund, or achange in the Fund sponsor’s invest-ment professionals), it may continue todo so. (A common analogy is that whena company has a stock offering, whetherpublic or private, it continues to adver-tise its products in the same manner as before the offering.) But we advisethat any press release or other publicdocument or statement mentioning theprivate equity business of the Fund’ssponsor should be reviewed by counselto ensure that it does not contain statements that might be construed asan attempt to “hype” or condition themarket for limited partnership interests

(e.g., disclosure of prior fund perform-ance data) or otherwise publicly solicitinterest in investing in the Offering.

GuidelinesSo the stakes are clear: to avoid a poten-tially significant delay in raising yourFund, avoid any form of general solicita-tion during the Fund’s marketing period.

In addition, we recommend thefollowing guidelines:

1. The fund sponsor and placementagent should only contact entities knownby them to be accredited investors onthe basis of previous experience (i.e.,“cold calling” of accredited investors is generally prohibited, as is a broadmailing, even if limited to institutionalinvestors, in the absence of a priorsubstantive relationship).

2. There should be no press releases,press conferences, publicity or adver-tising (in any publication, on radio ortelevision, or over the Internet) men-tioning the Offering.

3. Inquiries from reporters regardingthe Offering should be met with a “nocomment” response.

4. Participation in any panel or con-ferences open to the general public, or at seminars where not all invitees are institutional or accredited investorswith whom the speaker has a priorsubstantive relationship, should notmention the Offering or make state-ments that might be construed as anattempt to “hype” or condition themarket for the partnership interests.

5. There should be no attempts toobtain feature articles or other coverageby U.S. newspapers or other media,either in respect of the Fund, its invest-ment strategy or the Offering.

6. Be even more conscientious in thecase of dual U.S./international offerings.2

The Do’s and Don’ts of Press RelationsHow does the Fund sponsor managecompliance within its organization whendealing with the press and ongoing public

communications about its business andongoing activities? The following “do’sand don’ts” might be helpful:

1. Do limit the persons authorized totalk to the press to a small number ofprofessionals who have been fullybriefed by counsel.

2. Don’t embark on a public relationscampaign during the marketing period,but do continue within the scope of yourcurrent communications without any ref-erence to any specific fund in the market;

3. Don’t mention specific facts aboutexisting funds that might be of interestto prospective investors, such asinvestment returns;

4. Do respond to prior inquiries aboutthe Offering or the Fund in the marketwith “no comment.”

5. Don’t be lured into responding to a reporter’s question which states aninaccuracy about your prospective fund.Do tell the reporter that the facts he orshe has stated are inaccurate but thatyour lawyers have advised you that yourresponse to such comments must be“no comment.”

6. Do limit your communications to thosedesigned to attract deal flow, not investors(e.g., discussing your investment focus,types of portfolio companies in whichyou would be interested in investing).

7. Do maintain a contemporaneousrecord of these inquiries for your protec-tion in the event you are misquoted.

8. And most importantly, don’t forget toconsult counsel before engaging in anyquestionable conversations or activities.— Rebecca F. Silberstein

2 It is possible to offer the partnership interests in the U.S.pursuant to Regulation D and outside the U.S. in reliance onRegulation S, and publicity outside the U.S. is generally notrestricted under Regulation S. However, because of the difficultyof controlling the flow of information from outside the U.S. toinside the U.S., the Commission has been particularly vigilantabout publicity overseas that is picked up by the U.S. media inconnection with international offerings involving a U.S. privateplacement. The fund sponsor must take sufficient precautionsto prevent information ostensibly intended for the overseaspress from appearing in the U.S. Prior clearance from counselshould be obtained before the Fund sponsor engages in offshorepublicity or advertising that might find its way into the U.S.


the ability of Spinco Target to operateas a stand-alone business, therebyallowing Parent to effect the spin-offearlier than it would have otherwisebeen able to do so. In addition, thespin-off may facilitate a more directincentive structure for managementcompensation. Further, the participa-tion of a private equity fund as an“anchor” investor in Spinco Target mayserve to validate Parent management’sdecision to spin off the business andthe choice of the management teamselected to lead Spinco Target.

There are also disadvantages atten-dant to a post-spin-off investment by a private equity fund. Under the Anti-Morris Trust rules, if the investment isagreed to prior to or within six monthsafter the time of the spin-off, the privateequity investor will not be permitted toacquire 50% or more by vote or value of the shares of Spinco Target. As aresult, the private equity investor will notbe able to exercise outright control overSpinco Target or its board of directors.As discussed in greater detail below, asubsequent change of control of eitherParent or Spinco Target within the two-year period following the spin-off couldresult in burdensome taxes beingimposed on Parent. Spin-offs can alsoinvolve significant transaction costs, andParent and its shareholders receive noproceeds from the distribution of shares.Moreover, unlike a privately held port-folio company, Spinco Target will continueto be subject to SEC reporting require-ments, and the value of the shares willcontinue to fluctuate in the market.

Structuring ConsiderationsSeparation Issues. Unless the spin-offbusiness currently operates auto-nomously on both an operating andfinancing basis, a spin-off will raise aseries of separation issues, similar tothose faced in connection with an asset

purchase of a division. Generally, a dis-tribution agreement will allocate assetsand liabilities, including contingent liabilities and debt between Parent andSpinco Target. Parent and Spinco Targetmay also need to enter into transitionalservice arrangements and intercompanylicensing arrangements for shared tech-nology. In connection with a spin-off,Parent and Spinco Target will also enterinto a tax sharing arrangement for allo-cating pre-spin-off tax liabilities and taxbenefits, as well as responsibility for anytaxes that are imposed on Parent if thespin-off fails to qualify as a tax-free trans-action. Although Spinco Target willestablish its own management incentiveplans, there typically will also be a needfor a separate agreement allocating pre-spin-off assets and liabilities relating toemployee benefits between Parent andSpinco Target. The private equity firmwill want to be actively involved in nego-tiating the terms of these separatearrangements and any indemnities thataccompany them.

Control issues. As mentioned above, ifthe private equity fund’s investment isagreed to in connection with the spin-off, under the tax rules the private equityfund generally will not be permitted toacquire 50% or more by vote or value of the shares of Spinco Target. Since, fortax purposes, voting power is generallymeasured by a shareholder’s power toappoint directors, the fund also will notbe able to control Spinco Target’s boardof directors. The fund may neverthelessbe able to obtain practical control if theremaining ownership of Spinco Target ishighly dispersed. In addition, the privateequity firm may be able to negotiateveto rights, both at the shareholder andboard of directors level, although thesemust be carefully tailored to avoid givingthe fund “deemed control” over SpincoTarget for tax purposes. Control arrange-

ments, as well as representationsrelating to the target business and otherarrangements relating to the privateequity fund’s investment, would be setforth in a separate investment agreement.

Debtholder issues. In connection with thespin-off, the existing debt of the groupmust be allocated between Parent andSpinco Target. A significant due dili-gence issue is whether the spin-off willviolate the terms of the indentures orcredit agreements governing the debt of either company. As many indenturesand credit agreements restrict theamount of dividends or distributions toshareholders or the disposition of “all orsubstantially all” or significant portionsof a company’s assets, a spin-off may besubject to the debtholders’ consent.

In order to inject an appropriateamount of leverage into Spinco Target, it may be desirable to allocate a dispro-portionate amount of debt to the targetcompany in connection with the spin-off.One practical limit on pushing debt intoa subsidiary that is to be spun off,however, is the Parent’s tax basis in the subsidiary; any excess amount ofdebt will give rise to corporate tax inconnection with the spin-off.

In order to increase flexibility in allo-cating debt between Parent and SpincoTarget, it may be preferable for Parentto transfer all of its non-target businessto a new subsidiary, leaving behind thetarget business together with an appro-priate amount of debt. Parent wouldthen spin off the new subsidiary and theprivate equity investor would acquireshares in Parent containing only thetarget business. Of course, if the non-target businesses are significantly largerthan the target business, this reversestructure may significantly increasetransaction costs. Also, since anycompany-level taxes resulting from thespin-off ’s failure to qualify as a tax-free

Sponsored Spin-offs (continued)


transaction will be imposed on Parent,the private equity fund’s investment willbe subject to a significant contingentliability. In this situation, a good taxindemnity is critical.

Tax issues. A spin-off must satisfy anumber of technical requirements toqualify as a tax free transaction. If a spin-off does not satisfy these requirements,Parent will be subject to tax on theexcess of the value of Spinco Target overParent’s tax basis in the shares of SpincoTarget. In addition, Parent’s shareholderswill be treated as having received ataxable distribution from Parent equalto the value of Spinco Target.

The principal requirements for a tax-free spin-off are:

• Parent and Spinco Target each musthave been engaged in an active tradeor business during the entire five-yearperiod prior to the spin-off;

• Parent must distribute stock thatconstitutes at least 80% of the SpincoTarget’s voting stock and 80% of eachother class of stock, and generally can-not retain any shares of Spinco Target;

• the spin-off must be undertaken for an IRS-approved “corporate businesspurpose” (including facilitating aninvestment in Spinco Target or Parent);

• the spin-off cannot be principally a“device” for distributing earnings to the shareholders of Parent; and

• the shareholders of Parent mustretain a continuing interest in bothParent and Spinco Target.

As discussed above, a spin-off that is followed by an investment must alsosatisfy the Anti-Morris Trust rules thatgenerally provide that, if an otherwise tax-free spin-off is part of a plan pursuant to which one or more persons acquiresshares constituting 50% or more by voteor value of either the Parent or the spin-off company, the spin-off will be treatedas taxable to the Parent company, but notnecessarily to the shareholders. A planwill be presumed to exist if a change of

control of Parent or the spin-off corpora-tion occurs at any time during the twoyears prior to, or the two years following,the spin-off.

Recently issued Treasury regulationsprovide additional guidance on when a spin-off and a subsequent acquisitionare considered to be part of a plan forpurposes of the Anti-Morris Trust rules.The regulations list a number of factsand circumstances that must be weighedin determining whether the acquisitionis part of the plan, and also provide forseveral safe harbors that, if satisfied,prevent a spin-off and an acquisitionfrom being considered as part of a plan.Unfortunately, a spin-off that is followedby a pre-arranged investment in Parentor the spin-off company will not qualifyfor any of the safe harbors. As a result,such an investment must be limited toless than 50% of the shares of the targetcompany by vote or value. For thispurpose, an option granted in connec-tion with the investment will be treatedas exercised, unless Parent can establishthat, upon the later of the date of thespin-off and the date of the grant, therewas a 50% or smaller possibility that theoption would be exercised. In the eventthe private equity investor approaches a spun off corporation after the spin-offhas been effected and a six-month“cooling-off” period has occurred, and if the spin-off was motivated by a cor-porate business purpose other than tofacilitate an acquisition, a safe harbormay apply that would permit a privateequity investor to acquire 50% or moreof the spin-off company or the Parent.

Shareholder ApprovalShareholder approval is not required for most spin-offs. Section 271 of theDelaware General Corporation Lawrequires shareholder approval only for a sale, lease or exchange of all or sub-stantially all of a company’s assets. Therelevant cases suggest that a spin-off is not a sale, lease or exchange. Further-more, in the majority of spin-offs, the

assets being spun off will not represent“all or substantially all” of the company’sassets. A transaction involving a majorreshuffling of the company’s subsidiariesor assets, followed by the spin-off of sub-stantially all of the company’s assets,may require shareholder approval underDelaware law and other states’ law suchas New York, which require shareholderapproval for a sale, lease, exchange orother disposition of all or substantiallyall assets.

Securities Law IssuesThe federal securities law issues relatingto spin-offs are fairly well settled.

In September 1997, the SEC’s Divisionof Corporate Finance (the “Division”)released a staff legal bulletin setting forththe factors the Division would considerto determine whether a subsidiary beingspun off by its parent company wouldbe required to register the spin-off underthe Securities Act of 1933, as amended(the “33 Act”). The Division stated that itwould not require registration in caseswhere:

• Parent’s shareholders do not provideconsideration for the spun-off shares;

• the spin-off is pro rata to Parent share-holders;

• Parent provides adequate informationabout the spin-off and the subsidiaryto its shareholders and to the tradingmarkets;

• Parent has a valid business purposefor the spin-off; and

• if Parent spins off “restricted securi-ties,” it has held those securities for at least two years.

The Division explained that the firsttwo factors help satisfy the requirementthat the spin-off not involve a “sale” ofthe securities by Parent by ensuring thatshareholders not give up value for thespun off shares. To satisfy the third factor,the subsidiary, if not already a reportingcompany under the Securities ExchangeAct of 1934, as amended (the “34 Act”),continued on page 20


is required to file with the SEC on a Form10 and provide to the shareholders aninformation statement, which containsessentially the same disclosure asrequired for a registration statement onForm S-1 under the 33 Act. The fourthfactor – the need for a valid businesspurpose – also addresses the issue ofwhether the parent company receivesvalue for the spun-off shares. Examplesof a valid business purpose are allowingmanagement of each business to focussolely on that business, providingemployees of each business stock-basedincentives linked solely to his or heremployer or business’ performance,enhancing access to financing byallowing the financial community tofocus separately on each business andenabling the companies to do businesswith each other’s competitors.

For the Division, the fifth factorensures that Parent will not be deemedan underwriter engaged in a publicdistribution of “restricted securities.”The two-year holding period does notapply where Parent formed the sub-sidiary being spun off.

Staff Bulletin No. 4 also confirmsthat the Division will not require 33 Actregistration simply because the parentcompany asks its shareholders to voteon the proposed spin-off. So long asthere is a valid business purpose for thespin-off, the Division declared that avote on the asset transfer that may beinvolved in the spin-off does not changethe overall nature of the transaction.

Form 10 is used to register the spun-off securities under the 34 Act. Much likean S-1 prospectus, the information state-ment included in the Form 10 describesthe spun-off company’s business, prop-

erties and management, and includesinformation on executive compensation,employee benefit plans, financial data,management’s discussion and analysisof results of operations and financialcondition and historical and pro formafinancial statements. SEC review of aForm 10 registration statement issubstantially similar to that for an S-1.

——

Structuring the sale of a non-core business as a spin-off clearly involvessignificant and challenging hurdles and will require close coordination withcounsel and other advisors; yet it canoften be the only good way for a corpo-rate parent and a prospective privateequity investor to tap the pent up valuein an underutilized line of business.— Paul S. Bird and Peter F.G. Schuur

Sponsored Spin-offs (continued)

Many of the major U.S. players such as Clayton, Dubilier & Rice, Inc.; TexasPacific Group; Kohlberg Kravis Roberts& Co.; Providence Equity Partners andThe Carlyle Group have entered theEuropean market. In most cases, initialoffices have been set up in the UK.Some are beginning to venture furtheronto the continent.

Their presence is reflected in theshare of European deal value taken byU.S. investors, which has risen from 4%in 1997 to 13% in 2001, with a further 7%share in 2001 accounted for by syndi-cates which included U.S. players. U.S.private equity investors have beensuccessful with some European invest-ments made from their U.S. operations,such as Texas Pacific Group’s acquisition

of Ducati and Bain Capital’s investmentin SEAT. However, many U.S. playershave found entering Europe on their ownand expanding across the continent chal-lenging. Several, such as Blackstone andBain Capital, have been in Europe forseveral years but have yet to do manydeals from their European operations.

There have been some high-profilesuccesses though, such as KKR’sacquisition and subsequent IPO offinancial services firm Willis Corroon.But other than that, there have beenvery few exits to date by U.S. investors,and so it is too early to judge success.

Is it too late to get in the game?

U.S. private equity investors that havenot yet entered the European marketwill find themselves behind when they

do, particularly give barriers to entrysuch as the need to build local net-works in European markets. U.S.players currently in Europe are trying to build these networks, for example by recruiting senior advisors such asformer UK Prime Minister John Majorat Carlyle, or senior industry figures asinvestment professionals. A thoroughunderstanding of opportunities withineach market and European industrytrends and structures and the strategicissues facing particular acquisitiontargets will be critical to success.— Geoffrey Cullinan, based in London,and Tom Holland, based in San Franciscodirect Bain & Company’s global privateequity practice. Simon Baines, a London-based consultant, assisted with this article.

Guest Column (continued)


Down Rounds (continued)

Contractual Constraints. In the old days (the late 1990s), wheneach subsequent round was higherthan the last, investors did not alwaysfocus on the divergent interests of eachclass of preferred. Now they must.Generally, holders of the preferred stockwill have the right to approve, amongother things, (i) the issuance of securi-ties senior to or on a parity with theexisting preferred stock, (ii) alterationsto the rights of the existing preferredstock and (iii) the sale or merger of theCompany.

Accordingly, the existing preferredstock must approve the financing that will dilute their shares, and the new money investors must not onlynegotiate a deal with the Company, but also with the existing investors.

When a subsequent round ofpreferred stock is sold, it is mostimportant to determine whether theexisting high priced investors will votewith the new lower-priced subsequentround as a single class or whether eachround will vote separately. For example,if the Company proposes a mergernetting the early investors a simplereturn of their investment or less andnetting the new down round investors a return equal to a multiple of theirmoney, it is likely these two classes ofinvestors will have divergent views onthe transaction. If, after giving effect tothe down round, the new money willcontrol a majority of the preferred stockas a class, then the new money willinsist that all the preferred stock votetogether as one class (as opposed toeach series of preferred stock votingseparately) so that the higher pricedinvestors cannot veto a transactionfavorable to the lower-priced preferredstockholders. If the new lower priced

investors do not control the preferredstock as a class, they may require aseparate vote for the new money andthat the special voting rights of thehigher priced preferred stock be elimi-nated. (If the valuation of the downround is dramatically less than theearlier rounds, the new money maysimply insist that the existing preferredstock be converted into common stockin order to eliminate such conflicts.)

In addition to carefully reviewing thelist of matters subject to the separatevote of preferred stockholders, it is crit-ical to review a post-closing pro formacapitalization table in order to determinethe appropriate percentages needed toapprove such matters (the Companywill generally ask for a simple majority)and whether the holders of preferredstock vote as one class or each seriesvotes separately. Similar reviews shouldbe made of existing Stockholder Agree-ments, Registration Rights Agreementsand other ancillary agreements.

Legal Issues.Directors have a duty of care and a duty of loyalty to the Company and itsstockholders and, in certain cases, tothe creditors. (See “Troubling Times for Directors of Portfolio Companies,”The Debevoise & Plimpton Private EquityReport, Winter 2002).

If individual directors (or the fundsthey represent) plan to participate inthe down round, the Board must beparticularly careful that the terms of the round are fair to the Company andthat the process in which the Companyapproved the transaction was itself afair process.

It is important for the Company and the Board to solicit as many bidsas possible in order to obtain the bestpossible deal and to create a record

of a deliberate and fair process. Aninvestor with no pre-existing interest in the Company leading the down round(as opposed to a group of existinginvestors with conflicting interests) isparticularly helpful. Engaging an invest-ment banking firm to solicit bids andassist the Board in exploring options is often helpful should the Board subse-quently need to defend the price of adown round.

Another protection against claimsfrom existing stockholders is to offer allstockholders the right to participate in the dilutive financing. However, anysuch offering must comply with Federaland state securities laws. If the Com-pany’s existing stockholders includenon-accredited investors, an offering of the dilutive securities to all investorsin compliance with applicable securi-ties laws may be expensive and timeconsuming. If timing is an issue, theCompany may sell the dilutive securi-ties to the accredited investors andhold a subsequent closing for the non-accredited investors after it has preparedthe necessary offering materials tocomply with Federal and state securitieslaws. Even if the costs of complyingwith applicable securities laws exceedthe expected proceeds of an offering to non-accredited investors, manyCompanies will make such an offeringin an attempt to protect itself (and the Board) against subsequent claims from such non-accredited investors.

——

Boom times will return, but venturecapital investors will likely rememberthe lessons learned from down roundsfor several years to come.— David J. Schwartz


taxes. A UK branch or subsidiary willnot be subject to withholding andemployment tax obligations in relationto an adviser who is treated as an independent contractor for UK taxpurposes. If, however, the relationshipbetween the adviser and the branch orsubsidiary too closely resembles anemployer-employee relationship, theUK withholding and employment taxrules for employees will apply to thesubsidiary or branch, even if theadviser’s contract specifies that theadviser is an independent contractor.

Special rules apply to the taxation of non-resident employees who areonly present in the UK on a temporarybasis and to UK resident employeeswho are not “domiciled” in the UK forUK tax purposes. Although the defini-tion of “domicile” is very fact-specific, a non-UK national who does not intendto remain in the UK on a permanentbasis generally will not be treated ashaving a UK domicile. Under current UKlaw, a fund manager may be able tostructure compensation arrangementsfor an employee who has responsibili-ties both inside and outside of the UK, but who is not domiciled in theUK, so that compensation relating tothe non-UK services is not subject toUK tax unless it is “remitted” to theUK. Individuals who are resident butnot domiciled in the UK should also be able to shield certain non-UK capitalgains from UK tax unless the gains are remitted to the UK. There has beenrecent speculation in the UK press thatthe UK Treasury will propose to changethe rules described above so that anyindividual residing in the UK for morethan four years will become subject toUK tax on his or her worldwide income.Similar proposals have been rejected in the past, and at present it is notpossible to predict whether, or in what

form, the proposal will be made oradopted. In any event, compensationarrangements in relation to key UK-based employees and arrangementswith respect to any carried interest tobe allocated to UK-based employeesfor private equity funds managed bythe U.S. manager must be closely scru-tinized to ensure they are structured in a tax-efficient manner from both aUK and U.S. tax perspective.

Authorization ProcessThe FSA Application. The informationrequired to be provided for authoriza-tion pursuant to the UK Act is moreintrusive than that required for regis-tration under the U.S. Act.

The FSA application forms requirethe firm to provide extensive informa-tion about its operations and owners,including a business plan describingthe regulated and unregulated activitiesthe firm intends to conduct, details on management and organizationalstructure, anticipated outsourcingarrangements, budgets (includingprojections), compliance procedures,control systems and supporting docu-mentation. In addition, the applicationrequires the individuals who controlthe firm to disclose personal financial

information. Although this informationis kept confidential, many U.S. fundmanagers find this level of scrutinyhighly objectionable.

Furthermore, as “threshold condi-tions” to approving the application, the FSA considers the firm’s affiliaterelationships or “links” (particularlylinks with entities outside the EU, where financial services may be lessregulated), the adequacy of the firm’sfinancial resources, and whether thefirm and its senior personnel are “fit andproper” to perform the functions andactivities proposed in the application.

After the application is submitted,the FSA may demand additional

information, investigate the firm’s com-pliance with other regulatory regimesand agencies, require the firm’s repre-sentatives to appear before the FSAand answer questions, or visit the firm’splace of business. The firm may alsohave to provide, at its own expense, areport by an accountant or actuary on any matters that the FSA chooses,such as the firm’s internal systems and controls.

In general, the FSA authorizationprocess is intended to ensure that onlysuitable firms and individuals engage

Private Equity Funds Abroad (continued)

Subsidiary Branch Office

FSA authorization required FSA authorization required

Investment advisory agreement with U.S. firm exposed to liability for actions

parent required of branch

Able to conduct certain regulated investment Separate authorization required to conduct

activities in other European countries regulated investment activities in other

European countries

Subject to 30% UK corporation tax Subject to 30% UK corporation tax

Subsidiary files UK tax return U.S. firm files UK tax return in respect of

branch operations

Audited reports must comply with the Audited reports may be completed in

Companies Act 1985 accordance with U.S. firm’s reports


in regulated activities. The FSA hasauthority to deny authorization topersons it deems undesirable or other-wise unsuitable to engage in regulatedactivities.

The SEC takes a different regulatoryapproach, requiring registration offirms that provide investment advisoryservices to more than the specifiednumber of clients (or that otherwisehold themselves out to the public asproviding such services) and thensubjecting these firms to regulationunder the U.S. Act. The informationrequired in the application for registra-tion with the SEC is more limited. Amanager registering under the U.S. Act files a Form ADV with the SEC. Thisform requires certain identifying andfinancial information about the firmand its business, including detailsabout the types of clients to which itwill provide advisory services, the basisof compensation, investment policiesand procedures, and educational andemployment background of its ownersand officers and certain employees.Registration usually becomes effectiveby SEC order within 45 days of filing.

Individuals. A UK firm that is itselfauthorized must also ensure that itsindividual employees and outsideservice providers that perform certain“controlled functions” specified by theFSA are also authorized. UK employeeswho undertake investment manage-ment activities, provide investmentadvice, arrange transactions in securi-ties or oversee back-office functionsrelated to managing investments arerequired to pass an examination on therules regulating the particular activity.There is no comparable requirementfor a U.S. private equity firm.

Most Americans who work in theirfirm’s London office consider theexams onerous and do not take them,at least not initially. The London officeis usually staffed with at least one or

two people who have been based in the UK for some time and have alreadypassed the exams. Over the next severalyears the FSA is expected to revise theexamination structure, which currentlyencompasses many overlapping tests,a vestige from the era before the UKAct when several self-regulating organi-zations performed the work of the FSA.

Timing. Applications by firms must be decided upon by the FSA within sixmonths of submission, although theFSA is striving for a turnaround timecloser to three months. For individualsapplying for authorization, the FSA can take up to three months to decide,but generally processes these applica-tions more quickly (usually within a few weeks).

A firm cannot undertake regulatedactivity until FSA approval is received.During the period between submittingan application and receiving FSAauthorization, an applicant may onlyconduct activities that are exempt fromthe general prohibition on carrying outregulated activities in the UK. In contrast,from the date a U.S. firm files the FormADV with the SEC, it operates as aregistered investment adviser and issubject to regulation under the U.S. Act.

Application Fees. Application fees varybased on the complexity of the applica-tion. Fund manager applications arenormally regarded as moderatelycomplex cases and are subject to a feeof £5,000 (about $7,100) per applica-tion. There is no application fee forindividuals applying for FSA authoriza-tion, but there is a small examination fee.

Operating as an Authorized PersonOnce a firm obtains the authorization to conduct investment business, itbecomes an “authorized person.”Authorized persons are subject toseparate FSA rules and disciplinaryprocedures that form an additionallayer of regulation and compliance

requirements on top of the UK Act.Authorized persons must appoint acompliance and anti-money launderingofficer and are subject to detailed rules on the conduct of investmentbusiness, including record keeping,marketing to and advising clients, bestexecution practices, protection of clientassets and other requirements. Anauthorized person should generallyexpect an inspection by the FSA withinits first year of operation and thereafterat least once every three years. There is no client disclosure requirementcomparable to the “brochure” ruleunder the U.S. Act, which requires aregistered investment adviser todistribute a copy of Part II of its FormADV to its limited partners on anannual basis.

Firms may be fined or censured bythe FSA for acting outside the scope oftheir FSA authorization (although actingoutside the scope is not a criminaloffense). Firms can apply to the FSA tobroaden, narrow or cancel their authori-zations as business needs change.

——

Before a manager opens a Londonoffice and begins marketing interests in a private investment fund into or outof the UK, the manager should consultwith counsel on these and other UKregulatory and tax considerations.— Sherri G. Kaplan, Geoffrey Kittredge

and Dale Gabbert

A firm cannot undertake

regulated activity until FSA

approval is received… In

contrast, from the date a U.S.

firm files the Form ADV with

the SEC, it operates as a

registered investment adviser…

June 6 -7 Andrew N. BergTax Planning for Domestic & Foreign Partnerships, LLCs, Joint Ventures and Other Strategic Alliances 2002 New York, NY

Upcoming Speaking Engagement


Alert: Recent Amendments to CERCLA Limit Liability for Purchasersalert

On January 11, 2002, President Bushsigned into law the “Small BusinessLiability Relief and Brownfields Revital-ization Act.” The Act amends theComprehensive EnvironmentalResponse, Compensation and LiabilityAct (“CERCLA” also known as“Superfund”) by, among other things,exempting certain purchasers ofcontaminated property from CERCLAliability, which could be good news for private equity firms refocusing ontraditional old economy businesses. The Act also establishes a program to encourage the redevelopment ofabandoned or underutilized industrialproperties known as “Brownfields.”

Highlights of the Act include thefollowing:

• It exempts from CERCLA liability“bona fide prospective purchasers” of contaminated property even if suchpurchasers were aware of the con-tamination prior to their purchase. To qualify for this exemption, the newowner must, among other things, have(i) conducted an “appropriate inquiry”into environmental conditions at theproperty, (ii) not contributed to thecontamination, (iii) taken reasonablesteps to stop any continuing contami-nation and prevent or limit exposureto the releases, (iv) cooperated withregulators, (v) provided access topersons conducting investigative andremedial activity, and (vi) compliedwith land use restrictions.

• It relieves certain owners of contami-nated property from CERCLA liability

if the contamination resulted solelyfrom contaminants that migratedfrom a contiguous property.

• It clarifies the so-called “innocentlandowner defense” for purchasers of contaminated property who didnot learn of the contamination at thetime of purchase despite undertakingenvironmental due diligence withrespect to the property.

• It establishes federal grants and loansto state and local agencies for investi-gating and remediating Brownfieldssites.

While it remains to be seen whatimpact the Act will have on privateequity transactions, the followingpoints are worth noting:

The Act only impacts liability under CERCLA and has no effect on apurchaser’s liability under state environ-mental laws, which are often the sourceof environmental liability in privateequity investments. In addition, the Actdoes not impact potential obligationsunder other federal environmental laws,such as citizen suits that may bebrought under the Resource Conser-vation and Recovery Act.

Moreover, the Act is not likely to actas a windfall to purchasers of contami-nated property. The Act provides that ifthe property’s market value is enhancedbecause the EPA expends funds reme-diating the property, the EPA mayimpose a “windfall lien” on the prop-erty for the enhanced market value.

The Act may impact how investorsconduct their environmental due dili-

gence. For purchasers to avail them-selves of the new exemptions, the Act generally requires that they haveconducted an “appropriate inquiry” intothe environmental conditions of a prop-erty. Purchasers may need to seek adviceto help determine whether “appropriateinquiry” has been made. (The Act estab-lishes interim due diligence standardsfor “appropriate inquiry” and requiresthe EPA to promulgate regulationswithin two years that establishes finaldue diligence standards.) In addition, in order to avail themselves of the newexemptions, purchasers will want toestablish a reliable record that releases of hazardous materials occurred entirelypre-acquisition.

Similarly, the new exemptionsgenerally require that the purchasersnot take actions post-acquisition thatcontribute to contamination or hindercleanup efforts. Investors will need toensure that their actions do not runafoul of these provisions.

Finally, because of these amend-ments, investors may find it easier toavail themselves of the new CERCLAexemptions if they structure transactionsas asset purchases. As a corollary, sellersmay be more aggressive in trying to shift environmental risks to purchasers.

Future EPA guidance or judicialinterpretation may help provide clarityto the Act. We will be watching closelyas the EPA, state authorities and thecourts begin the process of interpretingthese new provisions.— Stuart Hammer and Harry Zirlin

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