EXECUTIVE SUMMARY: Earlier this summer, Chief Judge Walrath of the United States Bankruptcy Court for the District of Delaware issued a ruling in The Brown Schools bankruptcy proceeding permitting a bankruptcy trustee to pursue affiliates of private equity firm McCown De Leeuw & Co. ("McCown") and directors of its portfolio company, The Brown Schools, as a result of McCown's pre-sale and post-bankruptcy relationship with its portfolio company.

The Delaware bankruptcy court reaffirmed an important exception to rulings that business decisions made when a company is in a state of "deepening insolvency" are not independently actionable (the so-called claim for "deepening insolvency" was rejected as an independent cause of action by the Delaware Supreme Court in 2007 in Trenwick Am. Litigat. Trust v. Billet, 931 A.2d 438 (Del. 2007)). In Trenwick, the court held that decisions by directors of companies in such circumstances are presumed to be in accordance with their duties of loyalty and care. However, in this case the court held that directors are not entitled to such presumptions when the appearance of a conflict of interest exists.

In this instance, The Brown Schools held two asset sales prior to filing for bankruptcy under Chapter 7. Other trade debt accumulated as a result of continued operations while the sales were pending. While The Brown Schools fully repaid its obligations to its senior secured lender and partially repaid an unsecured junior lender, it was unable to pay all of its unsecured debts. During the process of making the sales, The Brown Schools granted liens to secure the remaining debt obligations to its unsecured junior lender and to McCown (which had even more deeply subordinated unsecured debt). Judge Walrath found that the trustee for The Brown Schools sufficiently pled facts to pursue a breach of fiduciary duty claim against McCown and certain McCown-affiliated directors who also sat on the board of directors of The Brown Schools and approved the liens to McCown as well as certain pre-bankruptcy "transaction fees."

YOUR TAKE-AWAY: Judge Walrath's opinion highlights the need for independent director approval of interested party transactions between private equity sponsors and an underperforming portfolio company. Powerful creditors such as the equity sponsor and lenders may decide to continue operations in hope of generating revenue to repay existing obligations to creditors. However, by granting liens and approving transaction fees to the equity sponsor, the directors affiliated with McCown stood to gain from delaying The Brown Schools' shut down. Hence, they were not entitled to the presumption that they did not breach their fiduciary duty of care in making that decision.

In light of Judge Walrath's opinion and as a general rule when facing a distressed transaction, Schiff Hardin LLP's Private Equity and Restructuring, Bankruptcy and Creditors' Rights Practice Groups, recommend the following safeguards:

• Understand fiduciary duties when addressing financial issues relating to a portfolio company that is either insolvent or in the "zone of insolvency" and how fiduciary duties may shift in light of the financial viability of the portfolio company;
• To the extent possible, affiliated board members and officers (i.e., board members who sit on the boards of the distressed portfolio company and the private equity sponsor) should abstain from voting on any matter relating to or benefiting the private equity sponsor; such decisions should be left, to the extent possible, to disinterested directors;
• Take added precaution to document (i.e., as reflected in board minutes) the abstention of the equity sponsor's designees from all decisions that create a conflict of interest. The minutes should reflect the directors' reliance on professionals and their analysis of all financial considerations and the impact those considerations may have not only on shareholders but on all the company's stakeholders (i.e., the enterprise itself, private equity sponsor, secured lender and general unsecured creditors). The documentation process might not address specifics, but rather that the board considered various alternatives, and impact on different constituencies;
• Consider engaging an independent financial advisor or consultant specializing in distressed-company scenarios to serve as a disinterested director (if no others exist on the board) and to assist the board and its officers in decision making and planning efforts;
• Document efforts to market the assets to be sold and thereby help establish reasonableness of those efforts and market demand for the assets ultimately sold;
• To the extent financially possible, consider obtaining a fairness opinion as to the contemplated transaction where marketing efforts were limited; and
• Consult with your counsel during the initial period when a portfolio company's enterprise is in question.

For your convenience, linked is a copy of the Brown Schools opinion discussed in this Update.

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