Private equity firms have turned to dividend recapitalizations in recent years to enhance returns and obtain liquidity from their portfolio companies without altering the relative ownership interests. In a dividend recap, a company borrows money - increasingly through high-yield bonds, syndicated loans or other debt structures - to finance dividends to owners or stockholders of the company. According to Standard & Poor’s, dividend recaps resulted in more than $18 billion in payouts to investors last year. The general availability of credit, relatively low interests rates, and the desire of many institutional investors for higher-yield vehicles all fuel the practice.
Lately, a number of companies owned by private equity funds end up in the bankruptcy courts or are left in questionable states of solvency after a dividend recap. Dividend recaps have drawn fire from institutional investors, analysts, the media and legislators who charge that private equity funds are piling too much debt on the backs of portfolio companies without considering the companies’ financial well-being. Also increasing is litigation charging private equity sponsors with breach of fiduciary duty, fraud, self-dealing, acting to deepen the insolvency of a portfolio company, fraudulent conveyance and other fiscal malfeasance following the bankruptcy of a portfolio company involved in a dividend recap.
Recent high-profile public offerings that were preceded by large dividend recaps have amplified that concern. Headlines have not been favorable for private equity funds - the August 7, 2006 issue of Businessweek, for example, blared “Buy It, Strip It, Then Flip It: The quick IPO at Hertz makes buyout firms more like fast buck artists than turnaround pros. Investors beware.” (Available online at http://www.businessweek.com/magazine/content/06_32/b3996042.htm.) The headline refers to Hertz Corporation, which was purchased in September 2005 in a multi-billion-dollar leveraged buyout from Ford Motor Company. In June 2006, Hertz took out substantial loans to fund $1 billion in special dividends to the buyout group. Three weeks later, Hertz filed a registration statement for the company, stating that the funds to be raised would pay down the loans that funded the dividends. Since the buyout, Standard & Poor’s has downgraded Hertz from investment-grade to junk status, citing the heavily leveraged position of the company as a prominent reason.
A similar scenario involves Burger King Holdings, Inc. (Burger King). Since a buyout in 2002, Burger King’s investor group has been paid significant fees and dividends - the most recent a $367 million special dividend, which was paid within three months of the company’s initial public offering (IPO). In its first earnings report since going public, Burger King announced a $9 million quarterly loss for the fourth quarter of 2005, which it attributed to one-time fees associated with the company’s IPO. However, Burger King indicated that it anticipates losses in the current year due to a $30 million management termination fee paid to its investor-management group and financing costs from the $367 million special dividend.
Although properly effected dividend recaps are entirely legal, directors of companies that undertake them without exercising due care to act for the interests of the company alone expose themselves to liability for a variety of legal claims should the company subsequently fall on hard times financially. In such cases, litigation is all but guaranteed. Allegations typically arise against the private equity firms who control the company, and the directors and executives who act under their control. The controversy surrounding the recapitalization of KB Toys, Inc. (KB Toys), once one of the largest toy merchandisers in the United States, illustrates the litigious harm the practice can cause.
The KB Toys Recapitalization
In 2000, Bain Capital, LLC and other investors (collectively Bain) acquired KB Toys from Big Lots Stores, Inc. (Big Lots) through a stock purchase transaction. As partial consideration for the acquisition, Big Lots received a $45 million 10-year promissory note (the Note) from KB Toys. In 2002, KB Toys was recapitalized by issuing significant secured and unsecured debt. The proceeds were used to pay executive bonuses and dividends exceeding $120 million that ultimately flowed through the corporate structure and back to Bain. By January 2004, KB Toys was insolvent and filed for bankruptcy protection under Chapter 11, leaving Big Lots and other creditors largely unpaid.
After KB Toys filed for bankruptcy, its creditors and the Residual Trust of KB Toys, Inc. (the Trust) - which was formed under its plan of reorganization - claimed that the company was never truly solvent after the recapitalization. Bain and KB Toys’ other investors countered that the company was fully solvent at the time of the dividend recap, as evidenced by a solvency opinion the company had received from its financial advisor. Bain alleged that the company’s suppliers, many of whom also were creditors, contributed to the insolvency by supplying deeply discounted toys to KB Toys’ competitors (such as Wal-Mart and Target) for sale during the critical holiday season in the fourth quarter of 2003. According to Bain, this significantly eroded the company’s sales and caused it to discount prices beyond what it could bear - resulting in huge losses for the company.
Creditors blamed insolvency on the dividend recap, which occurred almost two years earlier. Big Lots turned to the Chancery Court in Delaware and brought suit against Bain, seeking to recoup some of its $45 million in losses on the Note. Big Lots alleged that Bain and the other investors never intended to repay the Note, that they committed outright fraud and self-dealing, and that they breached their fiduciary duties in a number of respects. In Massachusetts, where KB Toys was headquartered, the Trust also brought suit against Bain on similar grounds.
The Delaware Chancery Court issued an opinion regarding Big Lots’ claims in March 2006. Although the ruling was favorable to Bain and its co-defendants, it was based on procedural grounds and the merits of the claims have not been decided. Bain has requested a finding that it is entitled to retain the dividends and that it did not breach any fiduciary duties, violate the Delaware General Corporation Law, Uniform Fraudulent Transfer Act or any other laws.
Similar claims are at issue in Massachusetts, where the Trust has filed a laundry list of allegations against Bain and certain former executives and directors. The Trust claims that the defendants are guilty of actual and constructive fraud, unlawful redemption of stock, breaches of fiduciary duty, aiding and abetting such breaches, and unjust enrichment. In addition to seeking direct damages in the form of a return of the dividends, the Trust is seeking consequential, incidental and punitive damages - which puts the defendants at risk for well in excess of $120 million paid out as dividends. Despite apparent adherence to sound practices on the part of the directors and their advisors, the outcome of each case on the merits is uncertain and the defendant’s exposure to liability is significant, particularly since the costs of the protracted litigation itself and the business disruption are not factored in.
Despite public criticism of dividend recaps, they are not inherently improper, and they continue to afford investors a means of enhancing returns. The “billion-dollar question” for private equity firms considering a dividend recap is how to best effect the transaction while shielding themselves and their directors and officer representatives from liability. Unfortunately, no absolute safe harbor is available. Because dividends generally benefit just the investors in the case of private companies, the decision to engage in one can be fraught with legal and fiduciary conflicts. Should a company subsequently become insolvent, creditors and bankruptcy trustees alike undoubtedly will look to the investors’ deep pockets to recover some of the losses. However, equity investors and directors may reduce their risk of liability by using best practices for the dividend approval process. During this process, the company’s directors must fulfill their fiduciary duty to all stakeholders before approving the transaction.
First, the company should take steps to verify that it is solvent and will continue to be solvent after a proposed dividend recap. Once a company is insolvent or is in the so-called “zone of insolvency” (when it is not yet insolvent, but is well on its way), a fiduciary duty to its creditors arises under Delaware law. Rather than maximizing stockholder value, directors then must work to protect the assets of the company so that they are available to pay its debts. This requires the company to forego effecting a dividend recap or face liability to the creditors for the directors’ failure in duty if the incurrence of debt or paying of the dividend cracks the foundation of the balance sheet.
The company’s directors also must take care to fully exercise their individual duties of care and loyalty to the company, and not to their funds or the investors in their funds. In practice, this means that the directors (1) will make reasonable efforts to gather and examine all relevant information that is reasonably available to them to determine whether it is in the company stockholders’ best interests to effect the recap, and (2) will not put their own interest or that of a third party above that of the company. By exercising these duties fully and faithfully, the directors will have the benefit of the business judgment rule - which provides that the company itself was in the best situation to examine the merits of the proposed action at the time that it did so and prevents the courts from re-examining the decision after the fact. The court defers to the company’s business judgment, and the decision to effect a dividend recap will stand. If the process of approving a dividend recap implicates a director’s duty both to his fund and to the company, that director must find a means to isolate that conflict and insulate the company from its effect.
To combat any subsequent claims in connection with a dividend recap gone awry, prudent directors will engage in certain “best practices,” including:
- creating a board of directors committee composed of independent individuals who will scrutinize the proposed transaction and all reasonably available information to determine the transaction’s advisability given the company’s financial position
- empowering the independent committee with access to recognized, competent outside legal and financial advisors to guide them through the necessary analysis
- arranging for an independent financial advisor to provide the company with a solvency opinion that determines whether the company will continue to be solvent immediately after giving given effect to a proposed recap
- forbidding the equity investors or other interested parties from exerting actual or apparent pressure on the independent directors or on the independent committee’s advisors to influence the solvency opinion or the independent committee’s determination as to the advisability of the transaction.
By setting up a committee of truly independent directors early in the process to evaluate the advisability of the proposed transaction, by allowing it to access separate financial and legal counsel not under the influence of the equity investors, and by avoiding any appearance of any control of the process, the board can better defend itself from accusations of self-dealing.
In the KB Toys scenario, no independent committee was created. Although a financial advisor was retained to perform diligence and provide a solvency opinion, the Trust alleges that Bain was heavily involved in the process, and that the final outcome was a foregone conclusion due to Bain’s integral involvement and influence. While such a determination requires a review of the facts and circumstances of the case, by not following best practices, Bain and its codefendant’s have opened themselves to scrutiny, accusations of breach of the duty of loyalty through self-dealing and possible corresponding legal liability. As such, the intrinsic fairness of the transaction itself, including an analysis of the process used in determining whether the dividend recap was in the best interests of the company and the substantive outcome itself, are under scrutiny by a court.
In fulfilling their duty of care, directors should consider all reasonably available information relevant to evaluating the proposed transaction, and should retain competent advisors to assist in the diligence process and financial analysis. Directors can be attacked for failure to fulfill this duty if they either ignore materially relevant information that is available or do not seek out information that would be reasonably available. In particular, if directors focus solely on information that supports a particular desired result to the exclusion of negative information, they can fail in the performance of this duty. In the KB Toys cases, the Trust asserts that by ignoring negative information and by focusing on supportive information that was based on obviously incorrect data, the directors further breached their duty - and gave the decision that was already made by the Bain-controlled directors a “rubber stamp” of approval.
By adhering to the best practices outlined in this article and assisting directors with meeting their fiduciary duties, a company provides an additional layer of protection for the company and its directors that also shields their private equity investors from claims. If confronted with allegations of fraud or self-dealing, equity investors can stand confidently behind the integrity of the approval process. While the outcome of litigation is almost never guaranteed, following these best practices should result in the courts applying the business judgment rule, which goes a long way toward protecting private equity funds and directors from adverse claims by creditors and bankruptcy trustees looking for a pocket to pick after a recapitalized company goes bust.
James D. Rosener and Shawn P. McAveney