Share Dilution

The Portfolio Company Playbook – Chapter 3: Navigating the Risks and Claims of Company Employees

Claims by employees of holding companies are another source of litigation risk for fund promoters. Promoters should be aware of these risks, especially when the portfolio company is in difficulty or is considering a sale or other transaction affecting the disposal of shares in the company. We have presented below some examples of litigation that can be brought against the fund, sponsor and board representatives by employees of the holding company, likely triggering at least indemnification considerations (which should be assessed in the portfolio insurance and indemnification framework (at company level), and could also affect the value of the portfolio company and, therefore, the value of the fund’s assets.

Complaints from employee shareholders

As noted in previous articles, a fund promoter’s appointment of its own partners as directors of the board of directors of a holding company provides some measure of control over the company, but also creates potential exposure. for the sponsor. For example, in a major corporate transaction, there may be a divergence of interests of the fund (as a shareholder) compared to some of its other shareholders (such as employees who hold a different category of holdings) and even to the company itself. This divergence of interests can be particularly acute between common shareholders and preferred shareholders, whose preferred stock may give them priority in the distribution of any proceeds from a sale. Often times, a fund will hold a combination of preferred stock and common stock, especially if the investment was made at a later stage in the life of the portfolio company, when employees often own common stocks.

Examples of unequal rights and restrictions between share classes include voting preferences, liquidation preferences, and anti-dilution preferences. These preferences can produce extremely divergent results among shareholders, leading to disputes. Employees holding common stock may claim that a director – and in particular a representative of the fund – has breached their obligations to the company and shareholders by voting for a transaction that produced a disproportionately favorable outcome for the fund.

In this context, fund promoters should take into account the risk of a lawsuit by employee shareholders against the company, its directors and even the promoter entities, when dissolving or selling a portfolio company. Employees holding common stock may be inclined to sue if they believe that the value of their stock has been disproportionately and unfairly depreciated relative to other classes of stock upon dissolution or sale. Additionally, if a director is also a representative of a fund that owns preferred stock, employees may allege that the director was in conflict and favored preferred shareholders over common shareholders in the sale in order to maximize profitability. fund investment. With increasing frequency, fund promoters (as well as the equity fund (s)) are directly named as defendants and accused of contributing to these alleged breaches of fiduciary duty. At a minimum, the fund is indirectly at risk due to its indemnification obligations to the appointed agent and financial risk.

Conflicts can also arise when employee shareholders feel aggrieved (whether justified or not) by the different treatment of their common shares compared to the shares of preferred shareholders. For example, preferred shareholders of a holding company may be able to sell as part of a secondary market stock transaction, while common shareholders of employees are often locked into these transactions. Likewise, when a holding company is facing liquidity issues, it may seek out convertible debt or equity financing. Downward financing can disproportionately dilute the value of employee common stock and cause employees to seek to recoup their lost value through litigation.

WARN complaints

Delaware courts have permitted WARN Act class actions against fund promoters in addition to the management of the holding company. Again, this is a situation where increased control by a fund promoter equates to increased exposure to litigation. Federal and state WARN laws require companies to notify employees if the company can reasonably predict that it will not be able to meet payroll. The key factor in determining the potential direct liability of a fund sponsor is the degree of control the sponsor has over the decisions and operations of the business. Even if the fund promoter is not sufficiently involved to be named as a defendant himself, he may still face an indirect risk in a Warn Act case due to his indemnification obligations to the board delegates. administration who are often named as defendants in WARN Act lawsuits.

Complaints by whistleblowers

We have seen greater whistleblower activity, in increasingly high profile cases with high rewards, where whistleblowers expose financial inconsistencies and irregularities related to valuations, including valuations of 409A options and goodwill impairment, in particular for acquiring portfolio companies. Additionally, a flag raised over how a holding company values ​​itself could spark interest in how the fund promoter values ​​the company for the purposes of its own accounting and reporting purposes, especially when the promoter has l ” one of its own members of the board of directors of the holding company.

ERISA out of stock complaints

Boards of directors and committees of the board of directors responsible for administering employee pension plans that contain the option to purchase shares of the company are required to ensure that the maintenance of the equity fund option is prudent, that is, to the benefit of employees participating in the plan. Directors with fiduciary responsibility for the plan run the risk of litigation under ERISA if an employee chooses to invest some of their holdings in the plan when the board knows something about the health of the business that would make it unwise for the stock to be available for the investment plan. In these cases, claimants face a high standard of advocacy, but history shows that employees will continue to pursue claims when there has been a depreciation in the value of the business affecting their retirement.

For more information on how to mitigate risks, such as those above, contact us regarding The Portfolio Company Playbook: A Fund Promoter’s Guide to Risk and Liability.

Keep an eye out for Chapter 4 of the manual, which will cover navigating additional sources of direct liability risk to the fund.

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