Tag: Governance

Double Bottom-Line Investing, In Brief

Posted on by Sandy Liu

The first bottom-line in any investment is obvious: market-rates of return for banks, pension funds, foundations, and other financial investors.1 The second bottom-line consists of social or environmental returns.2 This can be realized in the form of job creation, community revitalization, or energy conservation, among others.3 As a growing number of investors express a desire…

Minority Shareholder Freeze Outs

Posted on by Aaron Schneff

Issues surrounding arbitration are now front and center in the business and legal worlds. In January 2012, news concerning Carlyle Group’s initial public offering surfaced when it proposed “the most shareholder-unfriendly corporate governance structure in modern history.” [1] In its proposal, Carlyle required that public shareholders arbitrate all claims against the company. Moreover, the arbitration must be confidential and precludes class-action lawsuits.[2] With the Supreme Court practically removing all barriers to arbitration in cases like AT&T Mobility v. Concepcion[3] orCompuCredit v. Greenwood, [4] Carlyle’s proposed governance structure seems poised to withstand legal challenge.

But Carlyle goes beyond merely requiring disputes to be arbitrated. Additionally, many Carlyle shareholders will have no ability to elect directors. If public shareholders hold less than ten percent of the company, Carlyle reserves the right to summarily repurchase all of those shares. [5] Perhaps most interestingly, Carlyle has supplanted fiduciary duties with a partnership agreement that grants the board to act in its sole discretion without good faith. A committee of independent directors appointed by Carlyle deals with conflicts of interest.

However, minority shareholder freeze out is not an entirely new concept in the private equity sphere. Other public private equity firms including Apollo Global Management, the Blackstone Group, and Kohlberg Kravis Roberts contain similar corporate governance structures. [6] Some commentators view these provisions as designed to “eliminate any ability of shareholders to sue the board for even the most egregious acts.” [7]

The first challenge the Carlyle Group will face is the approval from the Securities and Exchange Commission. The question will likely center on whether a public company can force arbitration in cases involving federal securities law. In support of its proposed corporate governance structure, Carlyle will find solace in recent Supreme Court decisions like AT&T Mobility and CompuCredit.

Arguments favoring the arbitration clause focus on the division between the company and shareholder interest. Some commentators believe that shareholder interests and incentives tend to be short term, while companies should be run by boards of directors who are incentivized to focus on the company’s long-term interests.[8] By limiting shareholder rights, the board of directors can avoid the pitfall of focusing on short-term profits.

Another advantage is that arbitration clauses reduce transaction costs. When private equity firms primarily operate through acquiring companies, shareholder litigation significantly increases the cost of doing business. According to a report released by Cornerstone Research in cooperation with Stanford Law School, 91% of acquisitions valued over $100 million in 2011 were subject to shareholder litigation. [9] According to the same study, the number of lawsuits per deal averaged 5.1. [10] Of the 565 legal challenges to acquisitions in 2010-2011, 27% were voluntarily dismissed, 4% were dismissed by the court with prejudice, and 69% settled. [11] With the cost of legal representation on the rise, the increase of lawsuits per deal becomes increasingly burdensome for publicly traded private equity firms.

While it is unclear whether firms can require arbitration for claims of federal security violations, the Supreme Court’s decision in CompuCredit seems to support the use of arbitration in any setting not directly prohibiting it. Further, the use of arbitration clauses may be necessary to support the central business model of publicly traded private equity firms. Finally, the market is the best place to regulate corporate governance structures: if investors are not satisfied with shareholder rights, they can simply choose not to invest. As long as adequate disclosure is provided to potential shareholders, arbitration provisions like that proposed by Carlyle Group should be held valid.

[1] Steven Davidoff, Carlyle Readies an Unfriendly I.P.O. for Shareholders, DealBook (Jan. 18, 2012), http://dealbook.nytimes.com/2012/01/18/carlyle-readies-an-unfriendly-i-p-o-for-shareholders/

[2] Id.

[3] AT&T Mobility LLC., v. Concepcion, 131 S.Ct. 1740 (2012) (Under Federal Arbitration Act, California must enforce mandatory arbitration clause that precludes class-action arbitration)

[4] Compucredit Co. v. Greenwood, 132 S.Ct. 665 (2012) (holding where federal statute is silent on arbitration, Federal Arbitration Act requires arbitration agreement to be enforced according to terms)

[5] Id.

[6] Id.

[7] Steven Davidoff, Carlyle Readies an Unfriendly I.P.O. for Shareholders, DealBook (Jan. 18, 2012), http://dealbook.nytimes.com/2012/01/18/carlyle-readies-an-unfriendly-i-p-o-for-shareholders/

[8] Id.

[9] John Gould, Developments in M&A Shareholder Litigation, Harvard Law School Forum on Corporate Governance and Financial Regulation (Mar. 4, 2012), http://blogs.law.harvard.edu/corpgov/2012/03/04/developments-in-ma-shareholder-litigation/

[10] Id.

[11] Id.

Re-defining the Line between Public and Private

Posted on by Zach Paterick

In his new article, Revisiting “Truth in Securities Revisited”: Abolishing IPOs and Harnessing Private Markets in the Public Good, Adam Pritchard argues that the current transition between private and public company status is awkward and inefficient.[1] Pritchard suggests that these inefficiencies can be reduced through the implementation of a two-tier market system for transitioning from private to public status.[2] In this blog, I analyze the implications of Pritchard’s suggested system on the Private Equity Community.

Background

Pritchard argues that the separate enactment of the Securities Act and the Exchange Act created a mismatched dividing line between public and private status.[3] The Securities Act draws the line in a manner that focuses explicitly on investor protection, while the dividing line under the Exchange Act reflects the attempt to balance investor protection, interests in capital formation, and practical ease of application.[4] Congress has shifted the point at which companies must go public through the JOBS Act, which gave the SEC new authority to exempt offerings from the requirements for registered offerings and authorized the SEC to adopt less demanding periodic disclosure from companies who benefit from this new offering exemption.[5] Pritchard contends that the JOBS Act reforms have the potential to create a lower tier of public companies and to blur the line between private and public companies.[6]

The Two-Tier System

Pritchard offers a different solution; one he believes unifies the public/private dividing line under the Securities Act and Exchange Act. Pritchard’s solution involves a two-tier market for both primary and secondary transactions, where the primary market would be limited to accredited investors, while the public market would be accessible to all.[7] Under this regime, all public offerings would be seasoned offerings with a price informed both by full disclosure and a pre-existing trading market. Issuers would be able to choose whether to sell in the primary or secondary market and companies would become eligible for the primary market after reaching a certain quantitative benchmark (he suggests $75 million in market capitalization, the threshold currently used by the SEC for shelf registration).[8]

Under this system, issuers below the quantitative benchmark would be limited to selling their securities to accredited investors. However, contrary to the current system, those securities could not be freely resold after a minimum holding period, but would instead be sold to other accredited investors on an established secondary market (similar to SecondMarket or SharesPost except expanding eligible purchasers from Qualified Institutional Buyers to all accredited investors).[9]

Elevation to the public market would be completely voluntary.[10] Issuers unable or unwilling to meet the obligations associated with access to the public market would be allowed to remain private. Once a company chose to go public, a seasoning period would follow with the filing of requisite 10-Q’s during which the shares would continue to be traded in the private market.[11] This seasoning period would allow the trading price in the public market to be informed by the prior trading in the private market as well as the new information required to initiate the “going public” process.[12] Only after the company graduated to having its shares traded in the public market would the company be free to sell equity to public investors.[13] This two-tier system relies on the pricing efficiency of the markets.

Impact on Private Equity

Pritchard’s suggested model would impact the private equity market in multiple dimensions. First, companies looking for late stage investment to expand their brand could continue to seek private capital, without having to cross the public divide. Consequently, the amount of firms seeking private equity would likely expand, creating more opportunities for private investment.

Additionally, Pritchard’s plan would essentially create a liquid market for private equity investors. While similar markets already exist, see SecondMarket and SharesPost, these markets are limited to “qualified institutional buyers” (investors with more than $100 million under management). Pritchard’s secondary markets would include accredited investors, individuals with at least $200,000 in annual income or $1 million in assets. This increased participation in the secondary market would allow the market to establish a trading price.

Lastly, Pritchard’s plan would eliminate the need for marketers to create demand when a firm decides to go public. Instead, the secondary market, supplemented by the required filings to go public, would establish a trading price. The underpricing dilemma of IPOs would essentially disappear. Thus, private equity holders participating in the company’s transition from private to public would receive greater returns.

In summary, Pritchard’s two-tier market plan would create new opportunities for private equity investment, create a liquid trading platform, and help ensure that investors exiting the market when a firm elects to go public receive proper returns. Such a market system would be advantageous to private equity investors; it should be given serious consideration.

________________________________________
[1] Adam C. Pritchard, Revisiting “Truth in Securities Revisited”: Abolishing IPOs and Harnessing Private Markets in the Public Good (University of Michigan Law & Econ Research, Paper No. 12-010, 2012), available at http://ssrn.com/abstract=2103246 .

[2] See id. at 5.

[3] Id. at 3.

[4] Id.

[5] See Revisiting “Truth in Securities Revisited” at 4.

[6] Id.

[7] See id. at 30.

[8] See id.

[9] See id. at 31.

[10] Id. at 33.

[11] Id.

[12] Id. at 34.

[13] See id.

LLC Fiduciary Duties in Delaware Private Equity and Venture Capital

Posted on by Justin Taylor

In its January 27th decision of Auriga Capital Corp. v. Gatz Properties, LLC, the Delaware Chancery Court put to rest any ambiguity in its reading of the Delaware LLC Act as it applies to establishing default fiduciary duties in the LLC context. (1) Although the topic had been addressed in a number of recent cases, none approached the depth and breadth of analysis exhibited by the Court in Auriga. (2) In his opinion, Chancellor Strine definitively establishes that a manager or member of an LLC owes the default duties of care and loyalty to all other members, unless an LLC agreement effectively expands, limits, or eliminates these duties.

Auriga Capital v. Gatz Properties

The dispute in Auriga centered on Gatz Properties, LLC’s management of property held by Peconic Bay, LLC. William Gatz, as the sole actor for Gatz Properties, formed Peconic Bay with Auriga Capital Corporation in order to develop land held by the Gatz family into a golf course. Peconic Bay then leased the golf course land from Gatz Properties. While the LLC Agreement required dual class majority approval for any “major decision affecting the company,” Gatz was effectively able to approve his own decisions as Manager without interference from minority members due to majority control of both the A and B Peconic share classes by Gatz Properties and the Gatz family.

Gatz made and approved such a “major decision” when he chose to perform a sale of Peconic, which ultimately led to a dispute with Auriga and other minority owners of Peconic Bay. In 2010, after the underperforming golf course operator with a sublease on the property chose to exercise its early termination option, Gatz turned away a serious bidder for Peconic Bay and orchestrated a sham auction. Gatz was the only bidder for the company, and purchased Peconic Bay at an unfairly low price. The minority members, whose invested capital amounted to $725,000, received a paltry $20,985 distribution from the sale. This led them to file suit and claim Gatz breached his fiduciary duties.

At trial, Gatz raised various defenses. However, of particular interest was his assertion that the LLC Agreement of Peconic Bay “displaced any role for the use of equitable principles in constraining the LLC’s manager,” and thus removed his actions from any fiduciary duty analysis. The Court rejected this argument, however, and affirmatively determined the existence of default restrictions on the actions of a managing member of an LLC beyond the requirements of good faith and fair dealing.

Existence of Default Duties

Like the Delaware General Corporation Law (“DGCL”), the LLC Act (the “Act”) does not plainly state the fiduciary duties of care and loyalty apply by default to managers and members of an LLC. However, unlike the DGCL, 6 Del. C. § 18-1104 of the Act provides an explicit default application of the “rules of law and equity.” Do those rules of law and equity include the duties of care and loyalty? Footnote 34 of Auriga explains they do.

That § 18-1101(c) provides for the contracting out or modification of fiduciary duties implies these duties exist by default. The Court goes on to explain that when §§ 1101(c) and 1104 are read together, these sections establish that when a manager or member would traditionally owe fiduciary duties, they are a fiduciary and are subject to the express right of the parties to contract out of those duties. So far as a manager or member would not owe fiduciary duties under traditional equitable principles, they do not owe any in the LLC context. This is not by operation of the Act, but by those same traditional equitable principles. The Act does not create a broader range of duties.

The Court also pointed to the 2004 amendment of the Act (in addition to the amendment of Delaware Revised Uniform Limited Partnership Act (“DRULPA”)) by the Delaware Legislature. The amendments were instigated by a Delaware Supreme Court holding in Gotham Partners L.P. v. Hallwood Realty Partners L.P, which questioned the extent to which default duties could be completely eliminated in the partnership context. (3) Both the Act and DRULPA were reworded to permit the complete elimination of fiduciary duties, as well as full contractual exculpation for breaches (through the introduction of §18-1101(e) for LLCs).

The Court in Auriga reasoned if the “equity backdrop” did not apply to LLCs then: 1) the amendment would have provided that members and managers owed no duties to the LLC other than those set forth by agreement or in the statute; 2) the General Assembly would have eliminated or modified the default application of the rules of law and equity in §18-1104; and 3) the General Assembly would not have provided for the elimination and exculpation of something if that something did not exist. These factors combined with the case law establishing the existence of default duties in the LLC setting and the policy concerns surrounding displacement of a widespread investor belief in the same, firmly established, in the Court’s mind, the alignment of those holdings and the legislature’s intent.

Outcome of Auriga

The Court determined, and Gatz conceded, as an LLC manager without clear and unambiguous elimination or modification in the LLC Agreement, Gatz owed the other members of Peconic Bay the fiduciary duties of care and loyalty. The Court then determined that:

“Gatz breached his fiduciary duty of loyalty and his fiduciary duty of care by: (1) his bad faith and grossly negligent refusal to explore any strategic alternatives for Peconic Bay from the period 2004-2005 forward when he knew that American Golf would terminate its lease; (2) his bad faith refusal to consider RDC’s interest in a purchase of Peconic Bay or a forward lease; (3) his bad faith conduct in presenting the Minority Members with misleading information about RDC‟s interest and his own conduct in connection with his buyout offers in 2008; and (4) his bad faith and grossly negligent conduct in running a sham Auction process that delivered Peconic Bay to himself for $50,000. The results of this conduct left the Gatz family with fee simple ownership of the Property again, a Property that had been improved by millions of dollars of investments and now contained a clubhouse and first-class golf course. The Minority Members got $20,985.” (4)

Chancellor Strine awarded the minority members what they should have received in a fair auction: their initial investment of $725,000 and a 10% return. He deemed this “a modest remedy and the record could support a higher one.” Additionally, because the “record is regrettably replete with behavior by Gatz and his counsel that made this case unduly expensive for the Minority Members to pursue,” Strine required Gatz to pay one half of the minority’s attorneys’ fees and costs. If the manager or a member of an LLC wants a lesson on what not to do, this case is a very instructive read.

Key Takeaways for Private Equity and Venture Capital

In reflecting on Auriga, drafters and parties to LLC Agreements should find some comfort in the relative certainty the holding provides. In drafting their LLC Agreements for Management Company, General Partner, and Portfolio LLCs, parties should ensure their Agreements clearly and unambiguously reflect their intentions as to the types and extent of duties they intend to apply between members and management. Some key takeaways include:
• The traditional duties of loyalty and care apply by default to Delaware LLCs.
• A manager of a Delaware LLC is a fiduciary and subject to those default duties.
• Such duties may be altered or eliminated and liability exculpated by clear and explicit agreement under the LLC Agreement.
• Evaluation of fiduciary duty claims “cannot occur without a close examination of the LLC agreement itself.”
• The duties of good faith and fair dealing, as they exist independently from the duty of loyalty, apply to all LLCs and cannot be contracted around.
• LLC agreements in existing Private Equity and Venture Capital investments should be evaluated for clarity in any desired modification of fiduciary duties, with necessary amendments made to bring them in line with the intentions of the parties to the agreement in light of the Court’s clarifications.

1- Auriga Capital Corp. et al v. Gatz Properties, LLC et al, C.A. 4390-CS (Del. Ch. Jan. 27, 2012).
2- See Kelly v. Blum, 2010 WL 629850 (2010), Bay Ctr. Apartments, 2009 WL 1124451 (2009).
3- Gotham Partners, L.P. v. Hallwood Realty Partners, L.P., 817 A.2d 160 (Del. 2002).
4- Auriga, C.A. 4390-CS at 62.