Many investors take on an operating thesis that, by law, the obligations of investment companies are not the obligations of the investor. They apply this whether their fund has invested in the securities of a limited partnership, a limited liability company, or a corporation. 

In this episode of The Professor’s Corner, McGuireWoods’ Mark Freedlander joins host Geoff Cockrell to explore the limits of this idea. 

As chair of the bankruptcy group, Mark has seen a host of real-world examples where sponsors of private equity funds get themselves in trouble when their portfolio companies are experiencing financial challenges. 

“If you're a sponsor that owns a distressed company, you need to be careful with money and things leaving that company — both in terms of the timing of when that's happening, the nature in which it's happening, and the value,” Geoff explains. “Recognize that all of those transfers will be looked at after the fact with different eyes.”

It’s within normal course of business for sponsors to be overseeing aspects of the day-to-day management of their portfolio companies. However, if you’re a sponsor that owns a distressed company, you need to be careful about monetary decisions and money leaving that company. 

On this first of two episodes on this topic, both Mark and Geoff review examples of potential issues drawn from real-life situations they have lived through and experienced, along with their experience on the litigation side of these issues. The next episode will continue the discussion where they left off, looking deeper into the nature of these claims and reviewing proper board management. 

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

Connect: LinkedIn

Notes From the Professor’s Corner

Top takeaways from this episode

• Patterns emerge in troubled portfolios. According to Mark, it’s common for sponsors to see potential claims asserted against them.
• It’s important to understand preference statutes when it comes to payments. A preference statute exists to ensure creditors are treated fairly. Often this will come into play when reviewing payments and antecedent debt with a transferee.
• Fraudulent conveyance is designed to protect creditors from fraud. Compared to preference statutes, fraudulent conveyance exposure doesn’t have the same defenses as a preference action.

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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's partner, Geoff Cockrell, as he and specialists share real world insight to help enhance your knowledge.

Hello. This is Geoff Cockrell. Thank you everyone for joining us for another episode of our Corner series where we bring together deal makers, practitioners and investors, in particular in healthcare investing, and explore some of the more nuanced elements of healthcare investing.

Today I'm thrilled to be joined by my partner, Mark Freedlander. He's the chair of our bankruptcy group here at McGuireWoods. And I spend a lot of time with Mark looking at distressed assets for investment, or at times dealing with distressed portfolio companies and private equity fund investors as issues do come up.

Mark, if you could introduce yourself a little bit? And then what we're going to be talking about is some of the pitfalls to avoid if you're with a company that is experiencing some distress.

Sure. Thank you, Geoff. And, again, my name is Mark Freedlander and I'm a partner with Geoff at McGuireWoods. What we're going to do today in large part is review in the first instance a variety of ways that private equity funds as sponsors can get themselves in trouble where there are financially troubled portfolio companies.

And what we'll discuss is a whole list of items where bad things have happened to sponsors in the past. That doesn't mean that every time a portfolio company runs into trouble that a sponsor should expect to have this list of issues, but they all are potential issues, and they're all real life situations and not hypothetical what ifs and maybes. We've lived through each and every one of the items that we're going to discuss today.

And Mark, this will be helpful. Because the operating thesis for most investors is, "My fund has made an investment into the securities of a limited partnership, or a limited liability company, or a corporation. And by law, the obligations of that company are not the obligations of me." But there are limits to that idea that we'd like to explore.

Right. So there are both statutory and common law approaches by parties involved... Let me just say creditors, of a financially troubled portfolio company where they or a fiduciary, a bankruptcy trustee, a state or a federal court receiver all have the ability to pursue claims potentially against a sponsor.

So they sound in both statute in some instances, and in other instances in common law. It doesn't mean that they are common, but things are talked about all the time, and in the right set of circumstances can actually create liability on the part of a sponsor.

So Mark, against that backdrop, maybe we could walk through some of the fact patterns that create the most sources of potential liability?

Sure. And obviously every set of circumstances is somewhat different. But nevertheless, there is a common theme that we see in troubled portfolio companies, where sponsors could end up having potential claims asserted against them or difficulties and pretty strong inquiries made of them.

And among those are a whole co-OpCo structure, where the HoldCo doesn't have assets and it's just purely a HoldCo. Also, most often in circumstances where troubles really arise, the OpCo is highly leveraged. In many instances, at least some of the debt of the Opco is held by the sponsor or an affiliate of the sponsor.

Likewise, in many of these situations there are management agreements or other forms of arrangements, where the sponsor or an affiliate is involved in some form of managerial rule with respect to the OpCo. And likewise, most often there's balance sheet management on an active level by the sponsor of its operating company.

Then I would say another indication of potential problems is when the window of the hold for the sponsor really helps drive the strategies of the OpCo.

And finally... And again, these are by no means an exhaustive list, it's just a common set of circumstances where the sponsor is actively involved in the governance of the OpCo. And active involvement for many of these items will be key, not occasionally, not oversight, those are clearly within parameters that don't create issues. But the more active a sponsor becomes in the day in day out management and activities of the OpCo, the more potential liability that could be created when the Opco runs into financial problems.

So Mark, those the things that can be the basic fact pattern where exposure of the sponsor can be contemplated, those are basically present in every deal. That kind of control, that kind of structure, kind of the operational decision making falling into significantly the hands of the sponsor, an identifiable timeframe for entry and exit of the platform. Those are present pretty much every time. So what are some of the more specific elements that can create some harder liability?

Sure. And some of these are tied to intent and others really don't have anything to do with intent. And among the most common are exposure by way of example to preference.

And we'll talk briefly about each of these, but in preference situation, preference most often occurs when an OpCo ends up subject to bankruptcy protection. But there are, likewise, some states that also have preference statutes. But the bankruptcy code has a very specific statute that for, all intents and purposes, the purpose of a preference statute is to see to it that similarly situated creditors are treated in a similar and fair manner, and that one or more don't take advantage of a situation.

So the general framework for preference exposure is where there's antecedent debt and a transferee. Meaning in this particular instance the sponsor receives an account of that antecedent debt prior to a bankruptcy filing more than it would receive had there been a hypothetical chapter seven bankruptcy filing.

And many times it relates to payments. In some instances it relates to the taking of collateral where it didn't otherwise exist. And in a bankruptcy scenario, there's a one year look back period. Where if these transfers occurred within a year prior to a bankruptcy filing, the sponsor could be subject to liability.

That differs than other types of creditors who aren't what are referred to as insiders or closely related parties to the OpCo. The one year period relates to those and only those who are considered insiders or parties that are very close to the OpCo by way of relationship.

The private equity fund who's got a running management fee needs to be careful that dollars that they've received through that fee arrangement, or basically otherwise the dollars that they've received during that look back period, are potentially subject to recall for the benefit of the other creditors. That being one scenario.

And then another one that we encounter in middle market deals fairly regularly is there might be capital providers for a deal that are wearing both debt and equity hats. So they're a significant equity investor, maybe they're a [inaudible 00:08:29]. But also are a significant participant in, say, the mezzanine or other debt apparatus of the company.

Right. So in these situations, secure debt and unsecured debt have different profiles for preference actions. So in large part, but not entirely, we're talking about unsecured claims. Claims that are not collateralized, management fees, unsecured mezzanine loans. Those types of repayments in a one year period prior to a bankruptcy filing could be subject to preference claw back in a bankruptcy case.

And we're not talking about untoward activities, where the sponsor or the lender is kind of shoveling available assets into their own pockets, but payments that are made fairly in the ordinary course, pursuant to scheduled payments, scheduled debt service. But all of those just falling within that one year period can be a significant source of exposure to those parties.

In part, that's correct, yes. So there are certain defenses to preference actions. So payments that really and truly are ordinary course type payments are subject to a defense as it relates to a preference action.

But where payments are typically made, and as a company runs into more and more problems, those payments are slow paid, and they accumulate for a period of time and then are caught up, by way of example. Those are the instances where preference exposure really is at its greatest.

Mark, what are some of the other categories of exposure that a sponsor could experience?

Sure. Similarly, and they get kind of go hand in hand, there's preference exposure, as I just mentioned, and likewise, fraudulent conveyance exposure. That exposure is exposure that's statutory under the bankruptcy code. And likewise, just about every state in the country also has fraudulent conveyance statutes as well.

So fraudulent conveyance is a way of protecting creditors from two real instances. In the first instance where fraudulent conduct, truly fraudulent conduct has occurred, there's a way to claw back money in those instances.

But likewise, even where there's no intent, if there's basically unequal value that has been transferred, so that the value of services doesn't equate to that of the payments that are received, or by way of example, a guarantee where this guarantor gets no real value at all for providing the guarantee, or other different types of payments in a variety of different instances, not withstanding intent, there can still be fraudulent conveyance exposure in the event that there isn't a transfer of reasonably equivalent value. And likewise, the transferor was either insolvent or had unreasonably small capital at the time the transfer was made. And again, that can occur either in a bankruptcy context or outside of a bankruptcy context.

The other thing that I would just note is that in many instances, if a sponsor were subject to claims for a preference, or potentially claims for fraudulent conveyance, it's not uncommon for breach of duty claims, which we'll also discuss, to be brought at the same time.

So that in any number of instances that we've seen, most often claims against insiders or sponsors relating to a financially troubled portfolio company come in sets. It's not just a single claim, it's a multitude of different claims essentially relating to the same conduct, though, so that there are alternative theories of recovery. Preference may be more limited, fraudulent conveyance exposure could be much greater.

By way of example, fraudulent conveyance exposure does not have the same types of defenses that a preference action may have. So an ordinary course of business, which I mentioned to you, Geoff, is not a defense to a fraudulent conveyance action.

And even more scary for a sponsor is that a look back period for fraudulent conveyance can be anywhere from two to potentially four years, as opposed to one year in the instance of a preference. So transactions between a sponsor and its affiliated portfolio company really are subject to potentially far look back if the portfolio company becomes financially troubled.

And I would think that the whole idea of whether or not the transfer was of equivalent value could look different with the benefit of hindsight. If you've got a troubled company that has an asset, that they would greatly appreciate the liquidity that that asset could bring. You have a purchaser, maybe an affiliated purchaser or somehow connected to the company.

And what feels equivalent at the moment of the transaction, given unforeseen future in both the existing company and maybe even the asset that's being purchased, that can all look very different if the purchased asset is immediately very valuable or very quickly becomes valuable. I think there's a healthy amount of exposure that you have to be cognizant of in that context.

Yeah, Geoff, without question, that's the case. And when litigation relating to these types of claims arises, the litigant, the plaintiff always really has the benefit of hindsight and looking in the rear view mirror.

So that it's super important for a fund to make sure that what it's doing at a point in time of a transaction or a transfer is well documented. That valuation work is done then, that we rely upon the opinions of experts, by way of example.

And I know that that can become expensive, but if there are concerns about survivability and about potential exposure, the more that we can rely upon outside third party valuation, and document what we're doing in very significant manner, the better our defenses would be in the future.

And I think some of the takeaway on that is if you're a sponsor that owns a distressed company, you need to be careful with money and things leaving that company. Both in terms of the timing of when that's happening, the nature in which it's happening, and the value. And recognize that all of those transfers out will be looked at after the fact with perhaps different eyes.

Without question, that's the case. And I would also say there is some differentiation between transfers and payments that are made to the sponsor or entities affiliated with the sponsor, and there are completely and totally independent third parties.

So the level of scrutiny and the period of investigation or look back period, the scrutiny is more intense. And likewise, the look back period is longer when these things occur with affiliated parties.

We've talked a little bit about the timing of payments on account of debt, that you have to be careful as it relates to preference exposure. But what about the broader topic, of if there's a sponsor that is a lender to this company, the risk that the rights and preferences that they as a lender in general could be subordinated to other creditors?

Sure. So under the bankruptcy code, just like there are provisions for recovery under preference and fraudulent conveyance, there likewise is a much shorter and less detailed provision relating to equitable subordination of debt. And it only relates to debt, it doesn't relate to equity.

But ostensibly a court at its discretion has the ability to subordinate the debt of a sponsor, or a sponsor's affiliate, to recoveries of others where there's inequitable conduct of that sponsor or its affiliated lender that results in harm to creditors or the underlying enterprise. And again, this is very much discretionary on the part of the court.

It's absolutely positively an extraordinary remedy. You hear people talk about equitable subordination a lot in my world when there is a financially troubled portfolio company and the sponsor is a lender. But it really does take a pretty extraordinary set of circumstances before the debt of that insider will be, or a sponsor, would actually be equitably subordinated.

You talk about an equitable conduct, that that's the catalyst for that exposure. Can you describe some of the fact patterns that realistically could kind of create that exposure?

Sure. The more control that a sponsor exercises over a financially troubled portfolio company, the worst things get. And likewise, where, by way of example, the sponsor influences decisions about how their debt or their affiliates debt is treated vis-a-vis other creditors, the more likely it is that equitable subordination claims could come about.

So in large part, but not entirely, it really and truly does relate to the exercise of control by the sponsor or its affiliate over its financially troubled portfolio company in terms of how that debt is traded.

But I have to assume that mere levers of control don't immediately generate that. Because a lot of sponsors that are wearing kind of both of those hats, that take a middle market or lower middle market healthcare transaction where the capital is being provided by, say, one or more SBIC investors that are investing collectively all of the equity and also maybe providing all of the debt, they're still going to have that kind of control. So control would seem like a catalyst, but does it require more kind of specific conduct that generates the harm?

Sure. So I'll give you an example, and this is something of an extreme example. But where the sponsor were to cause its portfolio company to default on a loan, so that the sponsor has the ability to accelerate its loan and accelerate collection activities, where otherwise not declaring that default or creating a default that didn't otherwise exist would allow the company to continue. That would be an example of conduct that would be inequitable, which would almost certainly give rise to potential equitable subordination claims.

Where the sponsor is really pushing its portfolio company not to pay certain things so that instead debt payments can be made, that could be another example. Depending upon how actively involved that sponsor is in the day in day out management of what gets paid and what doesn't get paid.

Another time that I've heard it kind of kicked around, I'm not sure how viable the theory would be. But when you have lenders that are saying no to different pathways that they have veto rights over and foreclosing potential kind of escape or betterment pathways, it's often asserted by other investors that the lender needs to be careful in how they're exerting that control through kind of negative veto rights. If they're foreclosing possible escape routes, they do so at their peril.

So very fact intensive. And it becomes difficult for a sponsor because they're wearing different hats. So, by way of example, where a sponsor or a sponsor's affiliate is a lender, and likewise the sponsor sits on the board of directors, it's sometimes difficult to differentiate between when that lender is wearing its lender's hat. And in those instances, a lender certainly has a veto right over things that it doesn't believe are in its best interest.

But likewise, that becomes increasingly difficult if that same lender also has representatives on the board. When it wears the board hat it has an obligation to the enterprise, and where it's wearing its lender hat it only needs to be concerned about its own interests and exclusively its own interests. So those situations become very difficult.

I often hear these theories in the heat of a moment tossed around, with the idea of a warning to the different participants to be careful how they conduct themselves, to be careful about what kind of leverage they put on different parties. How often do you see these types of claims actually materialize into point blank legal claims?

Most often it happens when a portfolio company melts down. It's talked about a lot. It's actually a great point of leverage for creditors to talk about and maybe even to file a complaint initially. Because when a sponsor has a portfolio company that runs into issues, there's always some level of vulnerability. People can always look back, people can always question certain decisions, so there's a level of vulnerability that exists in almost every instance where there is a financially troubled portfolio company.

But where that exposure really and truly exists is not very often. And you almost know it when you see it, unless that exposure purely relates to very technical, statutory type of potential recoveries. But when we start to talk about inequitable conduct, or likewise, if we talk about the re-characterization of debt, which we'll talk about in a moment, or a breach of duty claims, any of those types of things are all very fact intensive. And while those issues can be raised in a multitude of circumstances, their underlying success is not very common.

The litigation is threatened on a regular basis, it's brought on a less frequent basis because obviously there's a cost to litigation. But where recoveries occur is not very often. And in fairness, in almost every one of these circumstances where litigation is brought, they're ultimately settled. Sometimes they're settled for a lot of money, other times they're settled for very nominal amounts. But it's a rare instance where these matters are litigated to fruition.

Mark, we usually try to keep these podcast sessions to about 20 minutes. I know we have some more topics to cover. We've been slowly ratcheting up the nature of the claims, and the next ones we're going to talk about are going to be increasing from where we started. But why don't we call it a break for there, and we'll pick this up with the next episode. But thank you everyone for joining.

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.