Wind down woes

This April the US Bankruptcy Court of Delaware found that private equity firm McCown De Leeuw & Co. could potentially be held liable in a lawsuit brought by a bankruptcy trustee for one of its portfolio companies, The Brown Schools. The ruling could be a warning for private equity firms that find themselves both owner of and creditor to a portfolio company.

McCown owns 65 percent of The Brown Schools, which operates education and treatment centers for troubled youths. McCown had also provided the company with $12.5 million in subordinated loans. In December 2000 The Brown Schools became insolvent, and began the process of an out of court wind down. After a series of liquidations and debt restructurings, the company wound up in bankruptcy anyhow. During the proceedings, the bankruptcy trustee filed suit against McCown, accusing the firm of a breach in fiduciary duty, corporate waste and civil conspiracy.

After The Brown Schools defaulted on $100 million of secured debt owed to Credit Suisse First Boston in 2000, it began the out of court wind down, eventually selling enough assets to repay Credit Suisse First Boston in full and repay $1.7 million of its debt to McCown. Then in 2004 The Brown Schools restructured $18 million in debt owed to the Teacher's Insurance and Annuity Association and the rest of the debt owed to McCown. The debt owed to the Teacher's Insurance and Annuity Association was secured by first liens on The Brown Schools' assets, and the debt owed to McCown was secured by second liens. McCown then entered into a side agreement with the Teacher's Insurance and Annuity Association to share proceeds from the sale of $18 million in assets.

The suit claims that the conduct of the McCown constituted selfdealing and a breach of their fiduciary duties resulting in damages to The Brown Schools. Specifically, the trustee accuses McCown of wrongfully prolonging the existence of The Brown Schools so that McCown could profit at the expense of the company, and of putting its own interests ahead of the company's other creditors. The charge has its basis in Delaware case law that says if a company is insolvent, directors may owe fiduciary duties to unsecured creditors.

There are several notable aspects of the suit, according to James Wilton, a partner in Ropes & Gray's bankruptcy and restructuring practice. The amount of damages sought exceeds the amount McCown took out of the company during liquidation, for one. The trustee is also suing the law firm The Brown Schools hired during the wind down, Winstead Sechrest & Minick, a relatively unprecedented occurrence.

As it is fairly common for a private equity firm to be on the board of a company of which it is a creditor, the McCown case is a ?graphic illustration? of the risk inherent in liquidation, when there is a conflict between a director's responsibilities to the private equity firm and to the other creditors of the portfolio company, Wilton says. The finding that damages are apparently open-ended should also be a wake-up call to the industry, he says.

?An interesting lesson for other private equity firms is to understand that there is a tension between the desire to generate a return on the investment and to protect the interests of unsecured creditors or other constituencies to whom the board may owe fiduciary duties,? he says.?

The best way to safeguard against this type of suit, he says, may be to file for bankruptcy early on. A bankruptcy filing is obviously undesirable to private equity firms for a number of reasons, but every transaction during the process is subject to the approval of the court and the creditors' committee, so the owner is insulated from risk.

At this point, the case is slated to go forward to discovery and trial.

?Obviously when you're a defendant you'd love to be able to knock the lawsuit out at the pleading stage, which they were not able to do in this case,? Wilton says. ?So now the case will go forward to discovery, and that means that the creditors' committee will be able to depose principals of the private equity firm to ask about their investment in this company, look into all the emails, all the files that have to do with the investment decisions that were made here, something that's not a very pleasant process for a private equity firm to have to go through.?