Legal Briefs: Double-Sided Liability

Buyout firms that hold both equity and debt securities in a company heading for insolvency need to especially careful about how they proceed.

In late April, the U.S. Bankruptcy Court for the District of Delaware held that a bankruptcy trustee can move ahead with a suit alleging that LBO shop McCown De Leeuw & Co. and directors of a former portfolio company approved financial arrangements that unfairly favored the buyout firm (in its capacity as a creditor) over other creditors.

Here’s the rundown of the case, courtesy of a client alert recently issued by Boston law firm Ropes & Gray, along with our review of the decision. Back in 1997 and 1998, McCown De Leeuw bought a majority equity position in a company called the Brown Schools and later loaned $12.5 in subordinated debt to the company. That debt was junior to $100 million in senior debt owned by Credit Suisse First Boston and $15 million in subordinated debt held by Teachers Insurance Annuity Association.

The Brown Schools in 2000 defaulted on the $100 million in senior debt owned by Credit Suisse. The company subsequently sold off assets and fully repaid Credit Suisse and also paid McCown De Leeuw $1.7 million for its role as a financial adviser to the company. Meanwhile, creditors unnamed in the Delaware court decision were owed $22 million and weren’t paid even as McCown De Leeuw took an advisory fee.

The company later restructured $18 million in debt owed to TIAA and to McCown De Leeuw, with the TIAA portion secured by first liens and the buyout firm’s portion secured by second liens. Brown Schools continued selling off assets to repay the debt and, per an intercreditor agreement, McCown De Leeuw kept $2.9 million of the $18 million in proceeds.

The company’s bankruptcy trustee sued, arguing that McCown De Leeuw engaged in self-dealing by taking in some of the proceeds from assets sales while at the same time slighting other unsecured creditors. The suit also alleges that the Brown Schools’s board of directors were not independent and violated its fiduciary duty to the creditors. The court’s ruling denied McCown De Leeuw’s motion to dismiss the trustee’s allegations.

“The Brown Schools case illustrates risks for equity sponsors and directors of insolvent portfolio companies, if the equity sponsor is deemed to have benefited from asset sales or other transactions while other creditors are left unpaid,” Ropes & Gray attorneys wrote in the client alert.

The attorneys further caution firms to use a court-supervised bankruptcy process because it can “immunize board decisions from after-the-fact criticism,” even if winding down out of court seems like a more painless option. If a court had blessed any of the things that McCown De Leeuw did, there would be no case from the trustee.

Of added interest is that the trustee is seeking an amount greater than McCown De Leeuw pocketed from the allegedly self-dealing transactions. The trustee based its quest for greater damages on the theory of “deepening insolvency.” The Delaware court has previously rejected deepening insolvency as a cause of action.