D&O Insurance and Private Equity
Panelists:
John Failla, Proskauer Machua Millett, Marsh Michael Morales, Everest Specialty
October 22, 2013 D&O INSURANCE AND PRIVATE EQUITY
• The Panelists: - John Failla . Partner, Insurance Recovery and Counseling Group, Proskauer Rose LLP - Machua Millett . Claims Advocate and General Partner Liability Product Leader, Marsh USA, Inc. - Michael Morales . Vice-President, Claims Everest Specialty Underwriters D&O INSURANCE AND PRIVATE EQUITY
• The Agenda:
- Investment Model for Private Equity/Venture Capital • Structure of Private Equity/Venture Capital Funds • Typical Private Equity/Venture Capital Transactions
- Private Equity/Venture Capital Insurance Coverage
- Hot Topics in Private Equity/Venture Capital Risks and Insurance Coverage PRIVATE EQUITY – UNIQUE MODEL, UNIQUE RISK
• Typical Transactions - Venture Capital: . Seed-money financing of a potential business . Early stage financing of entrepreneur
- Private Equity/Venture Capital: . Growth Equity Transactions – existing business needs capital to grow
- Private Equity: . Troubled company turnaround transactions . Leveraged or management buyout transactions . Industry consolidation
PRIVATE EQUITY – UNIQUE MODEL, UNIQUE RISK
Private Equity Investment model: • Acquire investment interest in portfolio companies • Active in advising and guiding portfolio company • Private Equity professionals appointed to portfolio company board of directors • Investment term intended to be finite – funds invested over first 5- 7 years; close out fund 10-13 years STRUCTURE OF PRIVATE EQUITY FUND
• Fund is usually LP but can be LLC. • Raises capital from a limited number of sophisticated investors in a private placement. • LPs make an unfunded commitment to LP, which is drawn down over term of fund. • Typical LPs are pension plans, insurance companies, university endowments, high net worth individuals. • Private Equity professional is GP of LP fund or MM of LLC fund. • Fund is sponsored by Private Equity professionals who then split the profits of the fund with the capital providers. • In addition to receiving a share of the profits, Private Equity professionals also earn a management fee for managing and advising the fund.
STRUCTURE OF FUND
• At direction of PE professional, fund invests in number of portfolio companies.
PE Professional is GP or MM of LP #1 LP #2 LP #3 Fund
GP LPs Fund
Portfolio Co. #1 Portfolio Co. #2 Portfolio Co. #3 PRIVATE EQUITY/VENTURE CAPITAL INSURANCE COVERAGE
• General Partner Liability Insurance - Primary insurance vehicle for private investment funds - Typical coverage includes: . Management Liability • Individual Non-Indemnified • Indemnified Individual • Entity coverage . Professional Liability (“E&O”) . Outside Director Liability . Employment Practices Liability . Fiduciary Liability
PRIVATE EQUITY/VENTURE CAPITAL INSURANCE COVERAGE
• Fidelity Bond - Covers insured company against employee dishonesty (theft, forgery, computer fraud, on-premises and in transit) . May include third-party coverage PRIVATE EQUITY/VENTURE CAPITAL INSURANCE COVERAGE
Additional Insurance Coverage Matters to Consider When Structuring a Private Equity/Venture Capital Program
• Transactional Risk
• Cyber Liability
• Portfolio Company D&O Programs
• Indemnification/Subrogation/Insurance Priority
PORTFOLIO COMPANY D&O PROGRAMS
- Rationales . Leverage on price, policy language, and claims . Consistency - Insurance Lines . D&O . Other Traditional Insurance Lines . FCPA / RCO / W&H / Reps and Warranties - Structure . Blended . Separate . Separate Primary with Blended Excess . Co-Defendant Language - Negative Characteristics . Premium allocation and reallocation among insureds . Shared revenues, loss-based or other basis . Can complicate sales
11 INDEMNIFICATION/INSURANCE PRIORITY
• Where Private Equity Professional Acts As Outside Director Of Portfolio Company, Private Equity Firm And Portfolio Company May Have Co-extensive Indemnification Obligations • Levy v. HLI Operating Company (2007)
-Sponsor Contractually Obligated to Indemnify • Schoon v. Troy Corporation (2008)
- Sponsor Voluntarily Indemnifies
12 HOT TOPICS IN PRIVATE EQUITY/VENTURE CAPITAL RISK AND INSURANCE COVERAGE
. Portfolio Company Fiduciary Liability – Scott Brass
. Club Deal/Anti-Trust Liability – Dahl
. Regulatory Scrutiny
. Portfolio Company Bankruptcy Liability – Mervyn’s
. Public Shareholder, Third Party and Outside Director Liability HOT TOPICS IN PRIVATE EQUITY/VENTURE CAPITAL RISK AND INSURANCE COVERAGE
.Portfolio Company Fiduciary Liability – Scott Brass PE/VC RISK EXPOSURE – FIDUCIARY LIABILITY
Scott Brass Decision: Sun Capital Partners III, L.P. v. New England Teamsters & Trucking Industry Pension Fund (1st Cir. July 24, 2013): • Private equity firm is potentially liable for underfunding of portfolio company’s pension plan • Private equity funds were sufficiently involved in the management and operation of the portfolio company for their activities to qualify as being involved in a trade or business.
PE/VC RISK EXPOSURE – FIDUCIARY LIABILITY
Scott Brass Decision (continued) • PE funds’ limited partnership agreements and private placement memoranda explicitly described the funds as actively involved in their portfolio companies’ management • PE partnership agreement gave the general partner the authority to make decisions about hiring, firing and compensation for agents and employees of portfolio companies. • The funds’ controlling stake gave them the ability to place two of their employees on the portfolio company’s board thus giving the funds effective control of the board according to the court.
PE/VC RISK EXPOSURE – FIDUCIARY LIABILITY
• GPL policy is routinely amended by endorsement to add fiduciary, employment practices liability and other coverage agreements to provide coverage for defense costs, settlements and judgments. Fidelity coverage can also be purchased to protect against theft by employees and third parties.
HOT TOPICS IN PRIVATE EQUITY/VENTURE CAPITAL RISK AND INSURANCE COVERAGE
.Club Deal/Anti-Trust Liability – Dahl, et al. v. Bain Capital Partners, LLC, et al., US District Court (Massachusetts)
Dahl, et al. v. Bain Capital Partners, LLC, et al.— the Parties
• Plaintiffs—former • Defendants—Ten shareholders of Large Private Equity several large Firms who purchased companies subject to plaintiffs’ respective leverage buyout holdings from 2003 transactions between to 2007, plus JP 2003 and 2007 Morgan, which provided financing.
19 Dahl – Plaintiffs’ Allegations
• “Beginning as early as mid-2003 and continuing until 2007…Defendants and their co-conspirators engaged in a continuing agreement, understanding, and conspiracy in restraint of trade to allocate the market for and artificially fix, maintain, or stabilize prices of securities in club LBOs in violation of §1 of the Sherman Act…”
20 DAHL – HOW THE “CLUB” ALLEGEDLY WORKED
1) Defendants banded together to form bidding clubs to bid for Target Company. 2) Defendants worked together on various deals with “quid pro quo” arrangements. To the extent a defendant violated arrangement, retaliatory action would be taken (i.e. “if you bid on my deal, I’ll bid on yours.”) 3) If Target Company set up auction, even losing defendants were given stake in that company. 4) During “go shop period”, defendants refused to “jump” each other’s deals.
21 DAHL – THE E-MAIL TRAIL
• “KKR has agreed not to jump our deal since no one in private equity ever jumps an announced deal.” -Executive of PE firm TPG Capital, L.P., on verge of the company’s joint acquisition of Freescale. • “Henry Kravis [of KKR] just called to say congratulations and that they were standing down because he had told me before they would not jump a signed deal of ours.” -Executive of Blackstone, on verge of same acquisition.
22 DAHL – LEGAL STANDARDS
• Section 1 of the Sherman Act prohibits “every contract, combination…or conspiracy, in restraint of trade or commerce amongst the several states.”
• Plaintiffs must produce evidence that is not only consistent with conspiracy, but “tends to exclude the possibility of independent action.”
23 DAHL COURT DECISION
• “The Defendants’ alleged motivations to maintain friendly relationships with other Defendants in the industry further fail to suggest the existence of a market-wide conspiracy. A Defendant who is acting independently would have the same motivation. Each Defendant may simultaneously, but independently, institute a policy of not inciting retaliation from other Defendants.” • However, action allowed to proceed on “alleged overarching agreement between the Defendants to refrain from “jumping” each other’s announced proprietary deals; separate, narrower count based solely on one consortium’s withdrawal from HCA bidding also survives.
24 HOT TOPICS IN PRIVATE EQUITY/VENTURE CAPITAL RISK AND INSURANCE COVERAGE
.Regulatory Scrutiny
PE/VC RISK EXPOSURE – REGULATORY SCRUTINY
• Regulators are increasing their investigations of private investment funds - Recent SEC comments . [I]t’s not unreasonable to think that the number of cases involving private equity will increase. . [P]rivate equity has … unique characteristics that may make the industry more susceptible to fraud. • Bruce Karpati, Chief, SEC Enforcement Division’s Asset Mgmt. Unit, January 23, 2013 (available at http://www.sec.gov/news/speech/2013/spch012313bk.htm#P33_8420) PE/VC RISK EXPOSURE – REGULATORY SCRUTINY
- Categories of recent high-profile investigations by regulators . Insider trading . Asset valuation . Compensation/Taxation
COVERAGE FOR REGULATORY AND OTHER INVESTIGATIONS: WHAT’S THE RISK?
• The SEC Process - Matter Under Investigation (MUI) - Formal investigations and subpoenas - Wells notice - Regulatory proceedings, lawsuits, indictments . Piggyback civil plaintiffs . Other regulators • Other Regulatory and Governmental Investigations
28 COVERAGE FOR REGULATORY AND OTHER INVESTIGATIONS: IS THERE COVERAGE?
• Important issues for coverage - Has a claim been made? - Type of relief sought - Formality trigger - Wrongful act by insured - What costs are covered? - Coverage for disgorgement, restitutions, penalties, etc.
• Important to consider when buying policy – not just after the SEC calls
29 COVERAGE FOR REGULATORY AND OTHER INVESTIGATIONS: IS THERE COVERAGE?
• Is there a claim? • Typical / traditional insurance definition of claim: 1. a written demand for monetary damages 2. a proceeding commenced by the service of a complaint or similar pleading 3. a criminal proceeding commenced by a return of indictment 4. a formal administrative or regulatory proceeding commenced by the filing of a notice of charges, formal investigative order or similar document (or by entry of a formal order of investigation or similar document) against any Insured Person for a Wrongful Act
30 COVERAGE FOR REGULATORY AND OTHER INVESTIGATIONS: IS THERE COVERAGE?
• Is it a wrongful act by insured? - Who is covered by the insurance? . Organization or individual - Who is being investigated? • Wide variation of endorsements in marketplace to deal with these issues - Most versions have their own issues - Does there have to be a written subpoena? - Does the investigation need to be initiated by SEC order? - Does Insured or Insured Organization need to be targeted in writing? . What if a business partner or third party?
31 HOT TOPICS IN PRIVATE EQUITY/VENTURE CAPITAL RISK AND INSURANCE COVERAGE
.Portfolio Company Bankruptcy Liability – Mervyn’s
PORTFOLIO COMPANY BANKRUPTCY LIABILITY
• Portfolio entity files for bankruptcy. • Debt creditors assert claims against PE firm
- Mervyn’s LLC v. Cerberus
. Bankrupt portfolio company alleged that PE firm’s structuring of buyout and subsequent transactions drove company into bankruptcy. HOT TOPICS IN PRIVATE EQUITY/VENTURE CAPITAL RISK AND INSURANCE COVERAGE
.Public Shareholder, Third Party Liability and Outside Director Liability PE/VC RISK EXPOSURE – SUITS BY INVESTORS
• Fund investors disgruntled with investment strategy and/or performance of fund bring suit alleging misrepresentation and/or breach of duty. • Examples: . I-Enterprise Co. LLC v. Draper Fisher: $150 million dispute concerning alleged misrepresentations in fund marketing materials . State v. Forstmann Little: $2.5 billion dispute concerning alleged deviation from fund investment guidelines • GPL policy provides broad coverage to individual general partners and private equity firm for defense costs, settlements and judgments relating to wrongful acts in the course of private equity professional services activities.
PRIVATE EQUITY/VENTURE CAPITAL RISK EXPOSURE – THIRD PARTY SUITS
• Potential acquisition targets, rival private equity firms and other third party commercial actors bring suit alleging misrepresentation, unfair business practices and/or other tort claims arising from the private equity firm’s business. - Examples: . Huntsman v. Apollo Management: $1 billion dispute between private equity firm and target company concerning failed buyout. . ABRY Partners v. F&W Acquisition LLC: $100 million dispute between private equity firms alleging misrepresentations in portfolio company's financial statements. PRIVATE EQUITY/VENTURE CAPITAL RISK EXPOSURE – OUTSIDE DIRECTOR LIABILITY
• As part of investment model, Private Equity firm places general partners on boards of directors of portfolio companies. • Shareholders, bondholders, bankruptcy trustees and/or other portfolio company stakeholders target GPs for fiduciary duty suits due to perceived deep pockets of Private Equity firms. • Portfolio company D&O insurance sometimes proves inadequate to fund defense and resolution of suit. PRIVATE EQUITY/VENTURE CAPITAL RISK EXPOSURE – OUTSIDE DIRECTOR LIABILITY
- Examples: . In re: Just for Feet: $550 million suit by bankruptcy trustee against outside directors/fund general partners; portfolio company D&O already exhausted. . Refco Litigation Trusts v. T.H. Lee: Litigation trusts of portfolio company sought in excess of $1 billion from Private Equity firm and its GPs that sat on portfolio company board of directors. • GPL policy provides coverage for defense, settlement and judgment of suits against such general partners on an excess basis to the portfolio company D&O, thereby protecting GP’s personal assets and fund assets from potential losses for and clawback of investment return from investors.
PRIVATE EQUITY/VENTURE CAPITAL RISK EXPOSURE -- MISCELLANEOUS
• Private Equity firms face all of the same miscellaneous risks as other large companies, as well as some unique to the Private Equity industry, including potential employee malfeasance and employment disputes. - Examples: . Austin v. Archway Cookies LLC: Former portfolio company employee sued Private Equity firm alleging that firm controlled portfolio company as to wrongful termination without sufficient notice. . Foster v. Churchill: Former portfolio company founders and CEOs alleged that Private Equity firm wrongfully forced them out by fabricating “cause.” JOHN FAILLA PARTNER, INSURANCE RECOVERY & COUNSELING GROUP
Mr. Failla has more than twenty years of experience focusing on insurance recovery for business policyholders. In the past few years alone, he has helped clients recover more than a billion dollars from their insurers through litigation, alternative dispute resolution or negotiation in a wide range of issues, including directors and officers’ liability, mutual fund market timing and sales practices claims, t: 212.969.3141 [email protected] complex financial fraud recoveries, losses related to the global economic crisis, property and business interruption claims, secondary life insurance transactions and privacy, cyber-risk, and data security claims. Mr. Failla is a graduate of New York School of Law. MACHUA MILLETT CLAIMS ADVOCATE, GENERAL PARTNER LIABILITY PRODUCT LEADER, MARSH USA, INC.
Mr. Millett is a Claims Advocate and the General Partner Liability Product Leader at international insurance brokerage firm Marsh USA, Inc. He specializes in advising private equity, venture capital and hedge fund firms and private and public companies regarding management and professional liability issues and insurance products. t: 617.385.0308 Before coming to Marsh, Mr. Millett spent ten years in private practice [email protected] defending companies against government investigations, securities class action and derivative suits and insurance coverage lawsuits. Mr. Millett is a graduate of Harvard Law School and Tufts University.
MICHAEL MORALES Vice-President, Claims Everest Specialty Underwriters [email protected]
• Mike is a Vice President of Everest National Insurance Company and leads the Everest Specialty Underwriters (ESU) Claims organization. The ESU focus is on the professional lines markets, specifically directors and officers and errors and omissions products for the primary insurance market. • Prior to appointment to his current position in 2009, Mr. Morales was Vice President of Claims for the Financial Institutions Group of AIG Domestic Claims, a member company of American International Group, Inc (AIG). He also served as a Divisional Vice President and Product Manager for the Professional Liability Underwriting Division of AIG member company National Union Fire Insurance Company of Pittsburgh Pa. • Mr. Morales has over 24 years of insurance experience in the underwriting and claims disciplines and has served the insurance needs of professional service providers nationwide.
D&O INSURANCE AND PRIVATE EQUITY
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