Free: A New World Order

Beginning with the second quarter of 2007, the financial markets began to change dramatically. Those changes have led to a substantial increase in restructurings and bankruptcies. But this time around, the face of restructuring looks very different than it did in the last cycle. Most companies facing restructuring or bankruptcy today are doing so not because of high legacy costs or because labor is cheaper elsewhere. Instead, the causes for the bulk of current restructurings are highly leveraged balance sheets and very limited available capital. Many companies today find themselves heading toward a restructuring in an uneasy partnership with hedge fund investors who provided this leverage in the first instance.

Hedge fund investors generally sit at various levels of a company's capital structure. By the nature of who they are, hedge fund investors often have substantial influence on the direction of the business. In fact, their investments are often made to support a specific business plan and include checks and balances to make sure that the company executes that business plan. In a restructuring, these hedge funds may also provide a solution for problems facing the company. After all, they have additional capital that could be brought to bear on the situation and, in many cases, they stand to take a loss if the restructuring is not completed successfully. The inclusion of this new type of investor in the capital structure places tremendous pressure on the exercise of traditional fiduciary duties by directors in today's restructurings.

Change in Balance Sheets

Over the last several years, the influx and availability of capital has resulted in a change in the balance sheets of many companies.¹ The typical company today has a balance sheet that was driven off of EBITDA multiples that simply were not justified by the underlying asset value.² As a result, the leverage levels (and related debt service) create substantial challenges for today's typical company. On top of that, the capital structures of a typical company today can be highly complex. Most distressed companies have some combination of first-lien debt, second-lien debt, convertible debt (secured or unsecured), preferred stock and common equity, including warrants. Often, these layers of investment were not all financed at once or involved add-on investments, a fact that serves to even further complicate the interplay between the various investors in the capital structure. When companies begin to experience financial difficulties, the complexity of these instruments becomes part of the issue. In addition, given the multiples that were available when the debt or equity investment was incurred, many of these securities may be out of the money in a restructuring when measured by traditional valuation metrics.

Companies today usually end up with this very complicated balance sheet by obtaining financing from non-traditional lenders such as hedge funds. In fact, in many situations, the hedge fund investor sits at various levels of the capital structure, holding both debt and equity investments in the same debtor at the same time. These same hedge fund investors typically have at least one representative on the board of directors of the company and have had that board seat since they made their investment. When financial trouble starts, these hedge funds are often very active in assisting the fashioning of the company's response. The typical hedge fund investor facing a distressed situation may suggest advisors for the company, involve themselves in the business planning process, interface directly with the financial officers of the company, have discussions with other lenders to the company and generally involve themselves at every level of the business.

The good news in having these hedge fund investors available to the company is that they often bring a lot to the table in the restructuring process. After all, they tend to be financially sophisticated and have extensive experience addressing troubled company issues, often more so than the company's management team. Maybe more importantly, they have access to additional funds that can be brought to bear on a solution to the company's problems and therefore can be a source of both short-term liquidity and longer-term solutions. And, they have "skin in the game" which may motivate them to be helpful in investing in the survival of the company or in avoiding a Chapter 11 process where their investments could be impaired or wiped out. Many will work to fund a solution for the company to avoid being associated with a failed investment.

The bad news is that these same investors likely have very different objectives than the rest of the parties-in-interest. Hedge funds are by definition short-term investors who are return driven.³ As a result, whatever solution they propose is likely to involve a fairly aggressive strategy by the company to achieve a quick return on their investment. This may not be in line with longer-term value-maximizing alternatives preferred by some other creditors. Moreover, because of their involvement in the company, these hedge funds may have better information available to them than the rest of the constituents, such as traditional banks, trade creditors or equity holders. The solution proposed by a hedge fund investor is often a highly dilutive reorganization or refinancing, or a quick sale process, which may result in an acceptable return for them but leave other constituents out in the cold. The price for solutions proposed by hedge fund investors is often high.

Fiduciary Obligations

For today's company considering a restructuring transaction proposed by its hedge fund investor, the problem is exacerbated by the recent trend toward litigation by out-of-the-money constituents. Hedge fund investors (and boards of directors that approve those investments) make attractive litigation targets for constituents that have received recoveries that are not satisfactory. In a few recent cases, the boards of directors of distressed companies have faced litigation (or threats of litigation) over approving deals with existing investors.⁴ As more of these cases come along, boards can expect that risk of litigation to increase.

So, what is a board of directors to do when faced with an over-leveraged balance sheet, a hedge fund investor with a possible solution and unhappy constituents? Before we get there, it is helpful to remind ourselves of the general fiduciary obligations under which boards of directors operate.⁵ In general, members of a board of directors have fiduciary duties of care and loyalty to the corporation and its shareholders.⁶ The duty of care requires that, before making a decision, directors formulate and drive a process that informs themselves of all material information and alternatives that are reasonably available to them in order to ensure an informed decision.⁷ Having educated themselves, directors are then obligated to discharge their duties with requisite care.⁸

The duty of loyalty requires that directors protect a corporation's interests and refrain from self-interested conduct that would be injurious to the corporation or its shareholders or would deprive the corporation or its shareholders of an opportunity or advantage.⁹ The fiduciary duties of officers are generally the same as those of directors except that: (i) a director is generally responsible for all corporate affairs while the duty of care for an officer may be limited to the matters within his or her authority as an officer; and (ii) as one with a more intimate responsibility and a greater knowledge and expertise concerning the corporate affairs within his or her authority, an officer will be held to a higher standard of competence than a non-employee director.

Directors and officers are generally protected by the business judgment rule as they discharge their duties of care and loyalty to the company. The business judgment rule exists to protect a board of directors of a company that, when acting in good faith, decides to pursue potentially risky strategies that promise to generate profit or maximize the value of the corporation - even if the decision does not yield such a result.¹⁰ Even when a company approaches insolvency, the business judgment rule insulates a board in its decision-making processes. To enjoy the benefits of this rule, however, directors are required, among other things, to inform themselves fully and in a deliberate manner with respect to a transaction or other business decision that the directors will make on behalf of the corporation.¹¹

Under Delaware law, a board of directors of a company operating in the vicinity of insolvency must consider the interests of its creditors in addition to those of stockholders.¹²

In certain recent decisions, the Delaware courts seem to have weakened the ability of creditors to bring causes of action against directors for alleged breaches of fiduciary duties when the company is in the "zone of insolvency." However, given the uncertainty of the scope of those decisions, it remains advisable for directors to be cognizant of their fiduciary duties to the corporate enterprise as a whole.¹³

Basic Rules

It is against this backdrop that many boards of directors are being asked to evaluate a transaction with a hedge fund investor in today's restructurings. No question that exercising these fiduciary duties can be challenging in this environment. However, certain basic rules can be helpful to directors in facing these obstacles.

• Slow Down. In a crisis situation, particularly where liquidity is an issue, the tendency will be to push forward at lightning speed. Once they've decided on a path, the hedge fund investors will want to simply get that deal done as quickly as possible in order to maximize their recovery. After all, in restructurings the general rule is that any deal is better than no deal. But, directors exercising fiduciary obligations have a duty of care that requires them to be informed and act prudently in connection with any transaction. It is therefore critical that directors facing this situation take the time to truly understand and evaluate the situation and the available alternatives rather than simply ceding to the demands of one large investor.

• Process, Process, Process. Along with speed, there is often a push in these situations to simply ignore the necessary process to get a deal done. However, process is critical to boards of directors in these situations because it helps ensure an appropriate exercise of fiduciary duties. The board needs to meet regularly and discuss options and alternatives. Moreover, other constituents' ideas should be considered and evaluated. If such ideas have merit, the board should endeavor to make time for those alternatives to be developed before simply pushing forward with a hedge fund sponsored transaction. This focus on process protects both the board and the hedge fund investor from future litigation.

• Fairness Opinion. Where possible, the board should obtain a fairness opinion from an independent adviser. Even where the numbers show that equity (or other constituencies) are out of the money, the fairness opinion provides comfort and protection to the board that the transaction being proposed is indeed fair from a financial point of view. And, to the extent of future litigation, this fairness opinion can be crucial in protecting the board of directors.

• Hire Advisers. Boards of directors facing these types of challenges should hire advisers who are independent to help them evaluate the transactions. The company and its advisers will tend to push to get the deal done at all costs. Large success fees and continued employment for management depend on it. The hedge fund investor will clearly be pushing to get the transaction done, often making noise about fiduciary duties and how not doing the transaction might damage them. After all, a potentially quick recovery rides on it. Having independent advisers can help a board of directors sort through all the competing noise to find the best possible transaction. It provides a buffer against the pressure brought to bear by the various constituents. Furthermore, in exercising their business judgment, boards can feel much more confident if they have relied upon the advice of independent financial and legal advisers.

• Open the Process. Once hedge fund investors have decided to do a deal, they tend not to want the process opened to other possible solutions because those solutions might risk their recovery. However, it is important for the board of directors to push back against this tendency and evaluate all alternatives. Other constituents that have ideas about possible solutions should be brought into the process and invited to develop their ideas. The board obtains substantially more protection from litigation by running an open and fair process, as does the hedge fund investor.

• Limit Access. Just as important as running an open process, limiting the access of the hedge fund investor is important to maintaining fundamental fairness. The investor should not be allowed to direct the company's advisers or interface directly with the financial officers of the company. Controls need to be put into place to insure a fair process and to try to level the playing field for as many alternatives as possible.

• Do not Be Afraid of Chapter 11. Many boards of directors find themselves pressured into accepting whatever deal is on the table because it is purportedly better than a Chapter 11. In some cases, that is true. However, Chapter 11 does not have to be the dire result that companies normally predict. In fact, Chapter 11 can buy a company time to consider other alternatives or even improve operating results to allow for more value to flow to other constituents. Before blindly accepting any deal on the table to avoid Chapter 11, boards of directors should seriously consider the possibility and the effect of that proposed deal on the business.

The fiduciary duties of directors have been relatively well settled for some time. How they get applied, however, changes with the market factors that cause the restructurings. With the advent of hedge funds as active players in the restructuring process, pressure is placed on directors to comply with these duties. Directors need to be cognizant of the process to protect the interests of themselves, the company's investors, and all other constituencies.

Nancy A. Mitchell is a shareholder in Greenberg Traurig's New York office and chair of the New York business reorganization and bankruptcy practice. Jeffrey M. Rosenthal is a shareholder in the firm's New Jersey office and co-chair of its financial institutions practice. John W. Weiss is a shareholder in the firm's New York office and a member of the business reorganization and bankruptcy practice.

Endnotes:

1. See Harvey R. Miller, "Chapter 11 in Transition - From Boom to Bust and Into the Future," 81 Am. Bankr. L.J. 375 (Fall 2007).

2. Id.

3. See Mark Berman & Jo Ann Brighton, "Will the Sunlight of Disclosure Chill Hedge Funds," 26-May Am. Bankr. Inst. J. 24 (May 2007).

4. See, e.g., In re Radnor Holdings Corp., et al., Case No. 06-10894 (Bankr. D. DE 2006) (PJW); In re Fedders North America, Inc., et al., Case No. 07-11176 (Bankr. D. DE 2007) (BLS).

5. The cases referenced in this article were decided under Delaware law. Generally, the law on fiduciary duty in other states tends to follow Delaware although there are some differences between states.

6. See, e.g., Guth v. Loft, 5 A.2d 503, 510 (Del. Ch. 1939); Ryan v. Gifford, 918 A.2d 341, 357 (Del. Ch. 2007).

7. See, e.g., Benihana of Tokyo, Inc. v. Benihana, Inc., 891 A.2d 150, 192 (Del. Ch. 2005).

8. See, e.g., Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984).

9. See, e.g., Guth, 5 A.2d at 510.

10. Id. at 368; see also Trenwick Am. Litig. Trust v. Ernst & Young, L.L.P., 906 A.2d 168, 193-94 (Del. Ch. 2006), aff'd, Trenwick Am. Lit. Trust v. Billett, — - A.2d — — , 2007 WL 2317768 (Del. Aug. 14, 2007).

11. Cede & Co. v. Technicolor, Inc., 634 A.2d 345, 368 (Del. 1993).

12. Credit Lyonnais Bank Nederland N.V. v. Pathe Commc'ns. Corp., Civ. A. No. 12150, 1991 WL 277613, at *34 (Del. Ch. Dec. 30, 1991).

13. See N. Am. Catholic Educ. Programming Found. v. Gheewalla, No. 521,2006, 2007 WL 1453705, at *7 (Del. May 18, 2007); Trenwick, 906 A.2d at 174.