Conflicts of Interest in LBOs -- a Case Study

 

Vice Chancellor J. Travis Laster, a member of the Delaware Chancery Court, handed down a recent decision highlighting the substantial conflicts of interest that bedevil the investment banking industry in leveraged buyout transactions, and how one board of directors mishandled these conflicts.  Steven Davidoff in his NY Times DealBook blog gives a fine account of the matter. 

The case concerns the buyout of Del Monte by PE firms Kohlberg Kravis Roberts, Centerview Partners and Vestar Capital Partners, for $5.3 billion including debt.

Barclays Capital was hired by Del Monte to run a sale process for the company. Barclays made sure that its long time client, KKR, would be the winner of the bid, subject to a “go shop” provision. In return, Barclays received a commitment from KKR that it would represent KKR and the other buyers in placing the debt financing for the deal. Vice Chancellor Laster excoriates the Del Monte board for letting this conflict of interest play out under its nose. He painstakingly laid out the time table and steps taken by Barclays to put together a deal that served the interests of KKR and Barclays.

From the court’s opinion: 

“Barclays secretly and selfishly manipulated the sale process to engineer a transaction that would permit Barclays to obtain lucrative buy-side financing fees.  On multiple occasions, Barclays protected its own interests by withholding information from the Board that could have led Del Monte to retain a different bank, pursue a different alternative, or deny Barclays a buy-side role.  Barclays did not disclose the behind-the-scenes efforts of its Del Monte coverage officer to put Del Monte into play.  Barclays did not disclose its explicit goal, harbored from the outset, of providing buy-side financing to the acquirer.  Barclays did not disclose that in September 2010, without Del Monte’s authorization or approval, Barclays steered Vestar into a club bid with KKR, the potential bidder with whom Barclays had the strongest relationship, in violation of confidentiality agreements that prohibited Vestar and KKR from discussing a joint bid without written permission from Del Monte.”

 

After months of behind the scenes steps,  Barclays finally informed Del Monte’s board that Barclays also planed to be a major participant in the distribution of debt securities for the buying group. It was a tricky moment because the board was relying on Barclays’ opinion saying that the KKR bid is fair from a financial standpoint. How could that opinion be trusted when the giver of the opinion had lined up a lucrative engagement to distribute debt securities for the buyers? In fact, the fees Barclays would earn on the debt distribution were higher than the fees it would earn from representing Del Monte in the sale. The solution was pretty simple. Barclays had the board hire a second firm -- Perella Weinberg -- to give a second investment banking fairness opinion.  The fee for that opinion - $3 million – was paid by Del Monte with the approval of its board. 

Adding to the intrigue, in an earlier round of bidding, Vestar Capital Partners, a PE firm with loads of experience in the canned food business, made the highest offer. In the second round, Barclays paired Vestar with KKR, in violation of the “no teaming” provisions of earlier agreements the firms had entered into with Del Monte, and had them submit a joint bid. Problem was, Barclays didn’t let the Del Monte board know it had taken this step, leading the board to believe that Vestar had dropped out. Vice Chancellor Laster found that this shady business alone “materially reduced the prospect of price competition for Del Monte”.     

Here is a copy of the opinion

One reason for the board’s inertia may have to do with the fact that the CEO of Del Monte presented the board with little option but to sell the company. Despite being pressed by the board for a succession plan to deal with his planned retirement in 2012, the CEO dallied, and in the end recommended a sale of the company. Personally, he stood to gain $24 million if Del Monte were sold before his retirement in 2012.    

The initial proxy materials filed by Del Monte omitted to describe the true story behind Barclays’ activities. In response to this litigation, an extensive proxy supplement was mailed to shareholders describing all the goings on. The mailing of those materials eliminated one of the two remedies sought in the litigation. The other remedy -- to delay the meeting and give Del Monte time to solicit other offers – was granted by the court.

Of course, due to the ironclad protections under Delaware law absolving board members from financial liability where they have acted “reasonably”, this injunctive relief was the only remedy against directors available to the plaintiffs. From the court’s opinion:

“Unless further discovery reveals different facts, the one-two punch of exculpation under Section 102(b)(7) and full protection under Section 141(e) makes the chances of a judgment for money damages vanishingly small.”

 

 

LPs Push to Reinforce Fiduciary Duty of Sponsors

As we previously noted, the ILPA (International Limited Partners Association) recently published a wide-ranging set of “best practices” that it hopes will shape the practices of the private equity sponsor community. In this piece, we’d like to focus on ILPA’s recommended changes to the fiduciary duty provisions of investment partnership agreements. First, we’ll summarize ILPA’s wish list in the area of fiduciary duties. Then, we’ll examine the investor documents of a well-known sponsor (KKR) to see how far apart current practice is from ILPA's wish list.

First, a little background. A fiduciary duty is a relationship of confidence or trust between two parties. A fiduciary must be loyal to the person to whom he owes the duty. He must not put his personal interests before that duty, and must not profit from his position as a fiduciary, unless the principal consents. Under common law rules, the general partner of an investment partnership owes a fiduciary duty to the limited partners. 

In Delaware, where most investment partnerships are formed, the fiduciary duty include an obligation to act in good faith and with due care and loyalty. The duty of care requires a general partner to act for the partnership in the same manner as a prudent person would act on his own behalf.  The duty of loyalty prohibits a general partner from taking any action or engaging in any transaction that is not in the best interests of the partnership where a conflict of interest is present. However, Delaware law also says say that these duties can be “restricted or eliminated” in the partnership agreement. Most sponsors take advantage of the opportunity to both restrict and eliminate fiduciary duties.

ILPA hopes to push back against the erosion of fiduciary duties and “reinforce” the fiduciary duties of the sponsor community. Specifically, it wants to delete:

  • Provisions that reduce fiduciary duties “to the fullest extent allowed by law”.
  • Provisions that allow general partner to use its sole discretion and weigh its own self-interest against the interest of the fund.
  • Provisions where limited partners waive broad categories of conflicts or affiliated transactions.
  • Provisions that allow general partner and its affiliates to be exculpated or indemnified for conduct constituting a material breach of the partnership agreement, breach of fiduciary duties, or other “for cause” events.

So, how far back do LPs have to push on fiduciary duties? To answer that, we looked at the prospectus filed by KKR & Co. LP last year when it tried to go public. The prospectus summarizes the lengths to which KKR has gone to restrict or eliminate any fiduciary duty to investors. In short, KKR has fully eliminated the core fiduciary obligation to put the interests of investors ahead of its own interests, and to act solely in the best interests of investors where a conflict is present. In making any discretionary decision, the KKR general partner is allowed to take into account whatever factors it wishes, including its own interests, and does not have any duty or obligation to consider any factors affecting investors.

Moreover, the KKR general partner cannot be liable to investors for any act unless there has been a final and non-appealable judgment by a court determining that it has acted in bad faith or engaged in fraud or willful misconduct. That's a pretty high hurdle.

As the prospectus itself informs us, in language only a lawyer could love: “These modifications are detrimental to our unitholders because they restrict the remedies available to our unitholders for actions that without those limitations might constitute breaches of duty, including a fiduciary duty, and they permit our Managing Partner to take into account the interests of third parties in addition to our interests when resolving conflicts of interest.”

It looks like ILPA and its members have a ways to go.