In this episode of The Professor’s Corner, Mark Freedlander is back to continue the discussion on the ways a sponsor company can find themselves liable if their portfolio companies enter financial distress. 

Having debt recharacterized as equity is the next level of exposure that sponsors need to understand. 

Simply calling something debt doesn’t cut it. Being unclear in the management of debt versus equity can open sponsors up to companion fraudulent conveyance claims if the courts recharacterize a company’s debt. 

The last piece of the liability puzzle focuses on breach of duty claims. If a sponsor is sitting on the board of one of their portfolio companies, they need to stay informed of the company, its financials, and potential liquidity issues. This awareness can be the difference between creating or avoiding liability issues. 

“When a portfolio company runs into trouble [...] it may very well make sense for an independent director to be brought into a company,” explains Mark. “Having an independent director that is truly independent can provide a significant level of protection to the financial sponsor or the equity sponsor.” 

For sponsors concerned about potential liability exposures, Mark offers insight into different situations that a sponsor may encounter, discussing the protection that is available to a sponsor who recognizes problems early and takes a cautious approach. 

This is the second episode in a two-part series. If you haven’t listened to the first half yet, check out the previous episode for an overview of statutes and claims that sponsors need to keep on their radar.  

Featured Guest

Name: Mark E. Freedlander

What he does: As a Partner at McGuireWoods, Mark has been advising clients about creative, business-oriented solutions to matters involving financial distress for the past 25 years. Mark is a goal-driven problem solver whose clients benefit from the creative, pragmatic, and strategic perspective he brings to each engagement.

Organization: McGuireWoods

Words of wisdom: “The more attention to detail you do pay, the better that your records are, the greater the level of deliberation about things that are close calls — the better off a sponsor will be.” 

Connect: LinkedIn

Notes From the Professor’s Corner

Top takeaways from this episode

• Calling something debt doesn’t mean it’s debt in the eyes of the law. According to Mark, recharacterization of debt will occur under common law, and the courts may consider debt instruments to be equity, which can add additional exposure to the sponsor. 
• Sponsors can be liable when you can’t differentiate the sponsor and the portfolio company. Liability is often created when the sponsor has significant control over its troubled portfolio company. The most common instances arise under ERISA for anything from COBRA claims, warrant claims, or pension plans. 
• Sponsors who sit on the board of portfolio companies need to be informed. Board members have a duty of care and a duty of liability that needs to be fulfilled. Awareness of what’s happening with the company, its financials, and any potential liquidity issues can be the difference between creating or avoiding a liability situation.

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This podcast was recorded and is being made available by McGuireWoods for informational purposes only. By accessing this podcast, you acknowledge that McGuireWoods makes no warranty, guarantee, or representation as to the accuracy or sufficiency of the information featured in the podcast. The views, information, or opinions expressed during this podcast series are solely those of the individuals involved and do not necessarily reflect those of McGuireWoods. This podcast should not be used as a substitute for competent legal advice from a licensed professional attorney in your state and should not be construed as an offer to make or consider any investment or course of action.

This is The Professor's Corner, a McGuireWoods series exploring business and legal issues prevalent in today's private equity industry. Tune in with McGuireWoods partner Geoff Cockrell as he and specialists share real world insight to help enhance your knowledge.

Thank you everyone for joining another episode of our Corner Series where we have conversations with deal makers and practitioners in healthcare private equity transactions and try to really dive into some of the more specific elements of investing. One subset of our corner series is called The Professor's Corner, where I have conversations with practitioners and we get into some of the more technical aspects of investing in some of the issues that can arise.

I'm joined for the second installment of discussion on issues that can arise with distressed portfolio companies and some of the ways in which a sponsor can find themselves either with direct liability themselves or claims are being brought by other creditors or fiduciaries. I'm joined by my partner, Mark Freedlander, who chairs our bankruptcy group here at McGuireWoods. Mark, if you could introduce yourself and then we'll jump right back into the next level of exposure, which is having debt recharacterized as equity, but maybe give a brief introduction.

Sure. Thank you again, Geoff. Once again, my name is Mark Freedlander, and I'm a partner at McGuireWoods and the chair of our restructuring group.

Mark, we were talking on the last episode about equitable subordination, where if a sponsor is wearing kind of two different hats, where it's on the equity side, maybe has a board representation, but also has a lender hat that there's a risk that the debt claimed could be subordinated to other creditor claims, but let's keep ratcheting up the nature of that exposure and talk a little bit about recharacterization of debt.

Sure. Recharacterization of debt is something that occurs under common law as opposed to statutorily like equitable subordination. The ultimate result of equitable subordination and the recharacterization of debt to equity is that in each instance the "claims" of an affiliated sponsor wearing lender shoes drops down below creditors so that other creditors have a right of recovery before the sponsor has a right of recovery. With respect to recharacterization, the theory behind it is that just because something is called debt and/or treated as debt by a troubled portfolio company, it doesn't mean that it's actually debt in the eyes of the law.

There are any number of characteristics. Based on developed case law, there's actually 11 different factors, and we won't go into all of them, but there are instances where an instrument that is treated like debt by a portfolio company and its sponsor is ultimately held by a court to really be equity and not debt. Not only does that affect the recovery by the lender/sponsor in a liquidation scenario most often, but it also could add to additional exposure because in an instance where debt is recharacterized as equity, it oftentimes is accompanied by a companion fraudulent conveyance case.

That is because in an instance where debt is recharacterized as equity, the repayment of that debt over time where it's ultimately found to be equity rather than debt really lends itself to fraudulent conveyance claims, which we discussed in our last episode.

Mark, question, would that then apply to even what had been considered ordinary course payments of principle and interest when you are reviewing it as debt? That in the generic preference scenario, you as a lender may have some defenses, even if you are an insider. Do those payments become more imperiled if the debt is entirely recharacterized as equity?

If it's entirely recharacterized as equity and there's a companion fraudulent conveyance claim brought, which is almost always the case, the types of defenses, ordinary course of business, new value defense, those things which are available in preferences are not at all available in fraudulent conveyance. The reason is, again, that fraudulent conveyance is meant to really protect against unfair transactions.

If there is debt that's ultimately classified as equity and you look back, that means that there are repayments which really were repayments of what parties thought were debt and are really repayments or distributions in respect of equity. Therefore, several of the elements of a fraudulent conveyance claim are satisfied, again, when debt is recharacterized as equity.

How often do you see this materializing into an actual kind of winning claim, or is it just another in the pamphlet of things that a creditor could bring?

There are very clear facts which there almost never are. Recharacterization of debt to equity is factually intensive. It does have these 11 elements which are analyzed. It is a very difficult claim to bring and be successful with. A court also has significant discretion because it can weigh the different elements in different ways. There's no set formula where if five of the 11, by way of example, elements were to be satisfied by a plaintiff that suddenly liability is created. A court can, for all intents and purposes, weigh these elements as it sees fit. Again, the factual analysis is quite detailed and it's just not a claim that ordinarily is litigated to fruition where successful in most instances, in fairness, it's also settled.

In this context, if you're going to call it a duck, you need to make sure it looks in a lot of respects like a duck and the instrument should look like a debt instrument, how you're handling the payments, all the things should feel like a real life debt and not a mishmash of other contractual relationships where you've just slapped a debt title on the top of the sheet of paper.

Right. Simply calling it debt and then otherwise really treating it like equity doesn't make it debt alone.

Let's keep ratcheting up the exposure. So far talked about ways in which payments from the troubled platform company can get clawed back. Debt relationships can be recharacterized or subordinated. Now, let's go a step further of direct claims against the sponsor for liabilities of the platform. In what instances can that arise?

There are a group of statutes, primarily federal statutes, where liability is created in each instance as a result of the level of control that a sponsor exercises over its troubled portfolio company. In some instances, those arise under the Securities Act. Those are not very common and primarily a sponsor would be secondarily liable in instances of dishonest statements under the Securities Act. There's circle liability, which is obviously tied to environmental, where for all intents and purposes, the sponsor needs to be deemed an operator as a matter of law. In those instances, again, the level of control that's exercised by the sponsor is very significant.

The most common one, however, arises under ERISA and it's actually in a couple different instances. It could relate to COBRA claims. It could relate to warrant claims. It could also relate to claims under pension plans in certain instances as well and their control is also a very important element of this liability. It's not just control in the ordinary course, but real, real control where it's difficult to differentiate between the sponsor and the portfolio company.

When I'm advising sponsors that have individuals on the board, we always advise to be cognizant of the hat that you're wearing, make a robust record of the way in which you deliberated. It's much easier to explain if the board made an incorrect close call if it's very clear at the time that they realized they were making a close call and were doing their best to make the best call. Making a robust record of the decision making process and being very careful about identifying the hats that you're wearing, but just being careful all along the way.

Right. It's very easy for us as lawyers to say this, when you're living and breathing as a sponsor of a company, you do things at the spur of the moment and you don't always have the time to really pay great attention to detail. But the more attention to detail you do pay, the better that your records are, the greater the level of deliberation about things that are close calls, the better off a sponsor will be, particularly again, where it's serving a role on a board of directors, a board of managers or the like.

It's always remarkable how the communication, whether at the board level or before or after decisions are happening, the part that is in writing through emails or texts or the resolutions themselves may be just a sliver of the actual communication and deliberation and communication that's happening. But you spend a little time removed and you go back and look at it and it's as if the only thing that happened is the stuff that is in the written record. Make that record, written record with an eye towards the fact that, A, everything can be dug up and looked at again.

You want to be careful how you're framing things, but you also want there to be a record of the thought process that you actually did go through to show that it was coherent, it was careful even if there were risks or close calls that are being made that you were at least aware of them in making the best calls you could make.

What you're really leaning into, Geoff, is thoughts and discussion about duties of board members. I would say that the last piece of the liability puzzle for a sponsor that we're going to discuss relates to breach of duty claims. Generally speaking, there is a duty of loyalty and a duty of care on the part of directors to the enterprise. There are questions about when, if ever, duties are owed beyond duties to the enterprise. In an instance of financial insolvency or even being on the verge of insolvency, there's a body of case law that suggests that there may be a duty of care and loyalty that's owed to creditors in those instances.

There's always a duty of directors to an enterprise. Again, there are questions about whether there are duties to creditors in certain circumstances. I would also note that under developing case law in certain jurisdictions, Delaware by way of example, that an operating agreement can eliminate by way of contract the liability of managers to creditors. There is an ability in certain structures to even further limit or eliminate a duty of care and a duty of loyalty to creditors. But even in an instance where a duty is not owed to creditors, there can still be potential liability of a sponsor sitting on a board of a financially troubled company.

That's because in certain instances there is a right to seek derivative standing where a fiduciary of a company or more in frequent circumstances a creditor could seek standing to assert claims derivatively on behalf of the company for breach of duty of loyalty or care. Making certain, frankly, at all times that duties can be satisfied in terms of loyalty and care, that board members are fully informed, that where there are decisions to be made about related party transactions, that certain protections are put in place.

All of those types of things are very important every day for an equity sponsor, but they become even more important and scrutiny is heightened when a portfolio company runs into financial difficulties.

There have also been in the context of healthcare companies some recent troubling cases in which recoveries by the government have been made from private equity sponsors that owned a healthcare company that had reimbursement from the government. That had not been a very commonly occurring thing. It may continue to be uncommon, but it is unsettling that for liability for violation of healthcare law by a platform, the government at some level could seek recourse from the private equity owner. But there's some recent settlements that have that exact color to them.

In thinking through how to manage that risk, Mark, if you could give some thought to some of the things that a sponsor that sits on the board of a company that's in distress, how do they manage some of that risk?

Sure. Without question, being informed is very important. And also recognizing as early as possible that a company is running into or may run into financial difficulties is really important, because liability is created an awful lot, not just by virtue of conduct, but by not being careful and being messy in your approach to things. Really paying attention to a portfolio company, paying attention to its financials, understanding when it may run into liquidity or other financial difficulties is super important because planning to the greatest extent possible could very well mean the difference between creating and avoiding liability.

I'll take it one step further. Many times, particularly in the middle market, sponsors are involved with their companies on a very active basis. There are lenders to those companies. There may be related party transactions. When a portfolio company runs into trouble and it has some of the indices of problems that we started at our discussion about in the last round of discussions, it may very well make sense for an independent director to be brought into a company.

So that where certain decisions are made about the company or its decision tree and where it goes, having an independent director that is truly independent can provide significant level of protection to the financial sponsor or the equity sponsor. Taking it one step further, making certain that the financially troubled portfolio company likewise has its own independent set of advisors where a board can rely upon the advice of financial advisors and turnaround consultants and/or lawyers is also a very important potential protection for a sponsor.

A company can go from mild distress to severe distress to super severe distress in a hurry. Planning in advance for some of the later steps earlier in that process usually makes a ton of sense. Maybe, Mark, talk a little bit about, often comes up the platform is maybe needing to do some restructuring and they usually have complex cap tables. How should they think about value in the context of that? We've talked some about needing there to be kind of straight exchanges on any money going in and out or assets going in and out. How should they think about value in that context?

Yeah, without question, and this is particularly true where there are related party transactions, but not always or exclusively, but having financial reports prepared, having third party valuations done, having fairness opinions done, those are all types of things, although they cause delay and they are expensive, there frankly is almost no better way to create or undertake a transaction that either won't be subject to liability or has very good defenses where the sponsor is able to rely upon fairness opinions in third party valuation reports.

Those are some of the best protections that can occur where there are questions about value or where there are questions about the solvency of the entity with which a transaction is being undertaken.

I had a handful of scenarios with portfolio companies at varying degrees of size and sophistication where when things got sticky, there was a concern that the directors and fiduciaries, everybody's going to run for the door. They felt that the best way to protect themselves is to get out of that spot, whether that's an independent director or an appointee for a group of investors or the founder. How should the directors think about continuing in that role when the company's in distress?

Sure. In my experience, it's a red flag when board members of a sponsor leave the board on the eve of financial difficulties or during the pendency of financial difficulties. That doesn't mean that a representative of a sponsor should never leave a board. I do have to say though, it does raise any number of red flags and things are always reviewed in hindsight, as we've previously discussed.

It makes the most sense as a general proposition, but not always for representatives of the sponsor to remain on the board to heighten their sense of awareness, again to potentially involve one or more outside directors, to involve counsel and other professionals where board members can rely upon their advice. Likewise, it makes sense to abstain in certain circumstances from voting on certain issues in particular where affiliates are involved or related parties are involved, but just simply walking away from the board because a portfolio company is experiencing problems as a general proposition is not the best approach.

Maybe to close with a couple topics, there are a few areas where the things you do along the way can either make things better or worse, and two that come up very specifically are insurance and privilege with respect to communications. It's easy to mess things up in that regard in ways that you can't later fix. But maybe taking those two topics as a sponsor's looking at a accompanying distress, how should they be thinking about insurance, and then also how should they be thinking about privilege of communications, recognizing that there's a higher possibility that people are going to be recalling through everything that's said and done?

Those are both scary topics that not enough attention is paid to regularly enough, and you don't start to think about it until it's almost too late. In many instances where things melt down, claims may very well be broad or threatened. In both instances, D&O coverage becomes important. Where there are common deductibles, by way of example for the enterprise and for individual Ds and Os, you sometimes run into issues as a director or an officer of a financially troubled company, particularly one that files for bankruptcy protection, obtaining coverage because the coverage is deemed to be property of a bankruptcy estate, by way example, as a result of either shared coverage or a common bucket for deductible and things of that nature.

Working with a broker and analyzing the coverage and analyzing how the coverage works as early as possible is very important to assure that there are protections available for an officer or director who stays involved with a company that does have financial difficulties. Likewise, understanding that coverage in an instance where there could be insured versus insured issues, what I mean by that is where the company and its officers or directors, a company brings claims against, by way example, its officers or directors or parties do it derivatively on behalf of the company, that could very well raise insured versus insured exclusions to a policy that would cause a carrier to the deny coverage.

Again, I think the bottom line is that when you have a financially troubled portfolio company, it's very important to work with your broker as early as possible to really understand what could happen to that coverage in the event that the portfolio company were to visit bankruptcy protection. By the same token, privilege likewise becomes very important. In many instances, a financial sponsor and its portfolio company will share counsel. In any number of circumstances, that would be perfectly fine. But where there is shared counsel and there are later issues with the portfolio company, it could be the case that there are fights over who actually owns privilege of communications that have occurred.

It is important as early as possible when a portfolio company runs into financial distress to see to it again that there is a separation of council and that the portfolio company and the sponsor are each separately represented so that communications with one council or the other become very clearly delineated and there aren't issues about whom actually owns privilege by way of example with council.

As a company becomes more and more in distress, the topics and issues become quickly higher stakes and more complicated in every direction. To Mark's point, a significant amount of care as you're entering into that timeline is super important and it covers a whole host of topics and there are often some choices that you won't be able to unmake later, and so you should do them with a lot of care and attention on the front end.

Without question. I would just add, Geoff, that similarly speaking, planning is very important. An awful lot of liability, an awful lot of questions can be answered. There's a level of protection available to a sponsor when it recognizes problems early and is very cautious as in its approach and prepares as much as possible for the potential problems that a portfolio company will face.

Frankly, those preparations almost never occur too early. In a worst case scenario, there may be money that's unnecessarily spent on professionals to make sure that things are done properly, but that cost and that expense shies in comparison to the potential liability or even the cost of defense that's associated with things not being done in a proper manner and then later being reviewed and questioned in potentially significant manner.

With that, Mark, I think we'll bring this episode to a close. Distress and bankruptcy and all the issues that come with it are not anyone's favorite topic, but when you're in the midst of it, a little bit of care and planning on the front end can go a long way. Mark, thanks for joining this episode and thanks everyone else for joining. We'll see you all soon.

Thank you.

Thank you for joining us on this installment of The Professor's Corner. To learn more about today's discussion, please email host Geoff Cockrell at gcockrell@mcguirewoods.com. We look forward to hearing from you.

This series was recorded and is being made available by McGuireWoods for informational purposes only. By accessing this series, you acknowledge that McGuireWoods makes no warranty, guarantee, or representation as to the accuracy or sufficiency of the information featured in this installment. The views, information, or opinions expressed are solely those of the individuals involved and do not necessarily reflect those of McGuireWoods. This series should not be used as a substitute for competent legal advice from a licensed professional attorney in your state and should not be construed as an offer to make or consider any investment or course of action.