PE Sponsor Fiduciary Duties in Portfolio Company Distress
The record-breaking wave of PE (and VC) backed bankruptcies in 2024 – 110 filings, according to S&P Global Market Intelligence – highlights an important challenge for private equity sponsors: navigating their fiduciary duties when portfolio companies face financial distress.
The Dual Role Dilemma
PE sponsors typically wear multiple hats in their portfolio companies – as controlling shareholders, board members, and sometimes even creditors. This creates inherent tensions when a portfolio company approaches insolvency. While directors traditionally owe fiduciary duties to the corporation and its shareholders, the approach of insolvency triggers a fundamental shift: directors must consider the interests of creditors, who become the primary economic stakeholders.
The Zone of Insolvency: When Does the Shift Occur?
Courts have wrestled with precisely when this duty shift occurs. The "zone of insolvency" concept suggests that as a company approaches insolvency, directors' duties expand to include creditor interests. However, recent Delaware decisions have clarified that while directors may consider creditor interests when a company is in financial distress, their fiduciary duties don't formally shift until actual insolvency occurs.
Key Practices for PE Sponsors to Consider in Times of Portfolio Company Distress
1. Board Composition
- Independent Directors: The presence of truly independent directors on the board becomes even more critical when a portfolio company is facing distress. These directors, without any ties to the PE sponsor or other interested parties, can provide objective oversight and ensure that decisions are made in the best interests of the company. Independent directors should play a leading role in any decisions where there's a potential conflict of interest between the sponsor and the company.
- Special Committees: For particularly significant transactions, such as major asset sales, mergers, or restructuring, the board should consider establishing special committees composed primarily or entirely of independent directors. These committees can provide focused attention and expertise to these complex matters.
2. Decision Documentation
- Detailed Records: It's essential to maintain thorough records of all board deliberations and decision-making processes, especially during times of distress. These records should document the various options considered, the rationale for the chosen course of action, and how the decision aligns with the company's fiduciary duties.
- Stakeholder Considerations: The records should also reflect that the board has considered the interests of all relevant stakeholders, including creditors, employees, and other investors.
- Independent Advisors: Engaging independent financial and legal advisors can provide valuable support to the board and enhance the credibility of the decision-making process. The advisors can provide objective analysis and advice, and their involvement can demonstrate that the board has taken appropriate steps to inform itself.
3. Conflict Management
- Early Identification: Potential conflicts of interest should be identified and addressed as early as possible. This may involve disclosing the conflict to the board, recusing conflicted directors from certain discussions or decisions, or seeking independent advice.
The surge in PE-backed bankruptcies serves as a reminder that understanding and properly managing fiduciary duties isn't just a legal nicety – it's essential for protecting both the portfolio company and the sponsor's interests in challenging times.