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Private buyout deals produce new D&O risks

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The current trend towards taking public companies private, often by private equity firms, could lead to an increase in claims under directors and officers liability policies, say many observers.

Charges of violating fiduciary responsibility, for instance, could be made against directors and officers in connection with these deals by disgruntled shareholders, say observers.

More than $100 billion in deals taking companies private have taken place so far this year in the United States, "and 2007 might prove to be kind of a record-setting year" for leveraged buyout activity, said Carl Pursiano, a New York-based senior vp with Liberty International Underwriters, a unit of Liberty Mutual Group Inc.

A major driving factor, say observers, is the more costly and time-consuming reporting requirements called for under the Sarbanes-Oxley Act for publicly held companies.

"I would say there's increased claim activity proportionate to the increased private equity takeover activity," said Kevin M. LaCroix, a D&O expert and director at OakBridge Insurance Services L.L.C., a Beachwood, Ohio-based brokerage.

Some observers believe there could also be more claims when many of these privately held companies are eventually brought public again.

Deals taking companies private can be accomplished by buying up the shares of a company, and are often structured through either a merger or a tender offer.

Observers say the trend has not yet lead to a dramatic increase in D&O claims. However, Richard J. Bortnick, an attorney with Cozen O'Connor in West Conshohocken, Penn., said, "Any D&O claim that wasn't there before" constitutes an increase in D&O exposure, "so I would say that companies going private creates a new genre of derivative suits" for plaintiff attorneys.

This trend is a concern to D&O underwriters, say some observers. "Definitely, people are watching" the issue from the perspective of liability under D&O policies, said Stephen Outerbridge, senior vp at Bermuda-based Ariel Reinsurance Ltd. "There are certainly allegations" in connection with these deals that could fall under a D&O contract, said Mr. Outerbridge.

Steve Shappell, Denver-based managing director in the legal and claims practice at Aon Corp.'s Financial Services Group, said, "Absolutely, it's an increase in exposure." The basic issue is, "you're taking this company private and to do that, you've got to buy out all the public shares."

Lawsuits will charge that firms did not get the right valuation, he said. The allegations can range from an inadequate price per share, to charges that there has been lying and stealing at the company's expense. "You have the whole spectrum, from, 'Pay me a little more,' to, 'You're committing fraud and you're self-dealing,"' said Mr. Shappell.

For instance, litigation was filed by shareholders in connection with Weehawken, N.J.-based Hanover Direct Inc. being taken private last month by its major shareholder, New York-based Chelsey Direct L.L.C., a hedge fund affiliate.

According to a filing by Hanover with the Securities and Exchange Commission, shareholders charged that the offering price was inadequate. The shareholders also charged that company directors had conflicts of interest in approving the deal and breached their fiduciary duties. Hanover said in the filing that the complaint had no merit and it plans a vigorous defense. A spokesman could not be reached for comment.

In many cases, these lawsuits are settled by sweetening the deal and increasing the amount paid per share, say observers.

For example, according to statements issued by plaintiff law firm Bernstein Litowitz Berger & Grossman L.L.P. in New York and Bethpage, N.Y-based Cablevision Systems Corp., a lawsuit filed in connection with an offer by the Dolan Family Group to purchase Cablevision's publicly held shares led to an increased offer of $36.26 per share earlier this month--up from an original offer of $27--in a deal valued at about $22 billion. The parties agreed in principle to dismissal of the private litigation, subject to court approval, according to Cablevision.

Such extra payments would not fall under a D&O policy, but defense costs in connection with defending litigation may do so, say observers.

However, if the plaintiff can prove there is a breach of fiduciary duty, "then it becomes a little more complicated" in determining what may fall under the D&O policy's coverage, said Mr. Shappell.

Management's solicitation of a private equity takeover without the board of director's knowledge could result in a D&O claim, said Mr. LaCroix. "That obviously can create a host of problems for owners, board members and management," he said.

Members of management could also be accused of conflicts of interest, leading to a D&O claim, if the private equity firm buying out their company offers them an ownership stake as an inducement to stay with the firm, said Mr. LaCroix.

Christopher Lang, managing director at Marsh Inc. in New York, said to reduce exposure, management must follow a process in which "shareholder interests are put first, and not necessarily management's. I think a lot of time you're seeing management engaged alongside with the private equity firms, and from a D&O perspective that certainly raises the potential for liability," said Mr. Lang.

Michael J. Biles, an attorney with Akin Gump Strauss Hauer & Feld L.L.P. in Austin said, "No two D&O polices are the same, and a lot of D&O polices will have specific exclusions, so my general advice to companies that are considering renewing their policies, especially companies that are considering going private, is that they make sure that such claims would be covered."

Some observers say the current trend could create problems down the road when, as expected, the companies are eventually brought public again by the private equity firms. That is "the bigger issue that we see," said Evan Rosenberg, senior vp of Chubb Specialty Insurance in Warren, N.J.

If the stock does not do well following an initial public offering, "the new shareholders would bring the claim in that situation." Because of the private buyout, these companies may be very heavily saddled with debt, according to Mr. Rosenberg. Claims could also arise from creditors if the company goes bankrupt, said Mr. Rosenberg.

Mr. Pursiano said also, "It is quite possible that we'll see some more claims activity as a result of the additional IPO activity that we see that results from the (leveraged buyout) activity that we see now."

Mr. LaCroix noted, "It's a little bit of uncharted territory because the private equity transactions that are taking place right now are so much larger than we've seen historically."

This means that after going private the acquired company "is going to be saddled with a lot of debt," and whenever that occurs, the "margin for error is slimmer" and could result in any number of moves, including selling assets or significantly downsizing operations. As a result, "the circumstances under which D&O claims could arise are certainly present" after an IPO, said Mr. LaCroix.