How to avoid PE-backed bankruptcy troubles

PE-backed bankruptcies are on the rise, which means that firms should pay particular attention to a preliminary ruling handed down last week in Delaware. It related to the manner in which McCown De Leeuw & Co. handled the wind-down of portfolio company The Brown Schools. Specifically, certain Brown Schools creditors believed that McCown De Leeuw had engaged in self-serving transactions via its control of the company’s board of directors.

The court found that McCown De Leeuw could indeed be held liable under a legal term called “deepening insolvency.” This means that the firm, if found guilty, not only could be requited to pay out for damages related to a breach of fiduciary duty, but also for the entire amount the Brown Schools balance sheet deteriorated under McCown De Leeuw’s watch.

Mark Bane, an attorney at Ropes & Gray, says that this state ruling stands in contrast to past Delaware rulings that deepening insolvency would not apply in such situations. He also has a couple of suggestions for PE firms, so that they don’t wind up facing such potential liabilities:

1. Take particular care in deciding to wind down a portfolio company outside of court supervision. Firms often reflexively want to go this route to both secure the firm’s reputation and the portfolio company’s customer and vendor contracts. Such a move, however, can open you up to deepening insolvency claims. If you instead operate under court supervision, such claims cannot apply – even if you follow the exact same set of liquidation transactions.

2. If you do choose to go the out-of-court route, make sure that the board is constantly aware of the fiduciary duty owned the company’s other creditors. This is particular true of equity sponsor representatives on the board. If it comes time to vote on a transaction that could affect the PE firm as a credit, have the firm’s representatives abstain from the vote (i.e., let independent directors handle it).