Private Equity Report - Debevoise & Plimpton/media/files/insights... · process has become as real and perhaps as troubling for them as it is for public ... chute excise taxes in

What’s Inside

Presented for Your Approval: Parachute Payments Enter the Twilight Zone

The Internal Revenue Service has finalizedregulations in respect of the so-called“golden parachute excise tax” provisionsthat have placed substantial constraintson the ability of private companies to relyon the shareholder approval exemptionfrom the application of this tax. Theserestrictions make it virtually impossible for a privately held company to commit, priorto the occurrence of an actual change of control, to provide its employees withadditional compensation related to achange of control without risking the loss of the tax deduction associated with thesepayments and the imposition of an addi-tional 20% excise tax on the individualsreceiving such payments. Worse, in fact, is that shareholder approval of arrange-ments that were entered into before therevision to these regulations must satisfythese more stringent standards to qualify for the exemption from the application of these excise tax provisions.

The bottom line is that an issue that a private equity firm and its portfoliocompany executives thought they couldeliminate by following a careful approvalprocess has become as real and perhapsas troubling for them as it is for publiccompanies, where the majority practicehas become for the company to bear thefull burden of the tax through gross-up

arrangements. But private equity fundshave not calculated this added cost intotheir existing compensation arrangements(and indeed may have agreed to gross-upprovisions believing that their approval of the relevant change-of-control arrange-ments would assure that no tax would beimposed and no gross-up required).

What the Statute DoesSince the mid-1980s, because of perceivedabuses in the context of payments madein connection with a change of control,special additional excise taxes have beenimposed on certain employees, and a taxdeduction is denied to the employer ofsuch employees, with respect to amountstreated as “excess parachute payments.” A parachute payment is generally anypayment, the amount of which is increased, or timing of pay-ment of which is accelerated,on account of a change of con-trol. A payment will not betreated as an excess parachutepayment, however, to the extent that the total amount of payments that are made oraccelerated on account of achange of control do not equalor exceed an amount equal tothe product of three times the

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Volume 4 Number 1 Fal l 2003

P r i v a t e E q u i t y Re p o r t

“I guess they just don’t give out parachutes the way they used to.”

Private equity firms controlling private portfolio companies rarely worried about golden para-chute excise taxes in the event that executives they hired received significant change of controlpayments when the business was sold. Executives were, after all, entitled to “get rich” if thebusiness was successful and appreciated the certainty of knowing that their employment agree-ments and change of control payments would not be subject to excise taxes because thepackage had been approved by shareholders. Those days are over.

continued on page 20

3 H0w “Independent” isIndependent Enough?

4 Fund Terms and Conditions:Beware of “Solving theValuation Conundrum”

6 Guest Column Public to Private: Few Companies Have Shown Up for the Party

8 Making Sense of the CashBalance Plan Brouhaha

10 TrendwatchAdvisory Committees in U.S. and European PrivateEquity Funds

12 Sign on the Dotted Line?

14 An Introduction to Private Equity Firm D&OInsurance Coverage

16 Alert SEC Staff RecommendsRegistration of Hedge FundAdvisers – Private EquityAdvisers Likely to Be Unaffected

17 UK Provides Relief for Carried Interest Holders fromApplication of New Tax Rules

18 Is It Time for a Power Play?

19 AlertGermany to Modernize Fund Laws

28 AlertFrance: Private Placement of Foreign Closed-End FundsNow Easier

letter from the editor

Private Equity Partner/ Counsel Practice Group Members

The Debevoise & Plimpton Private Equity Report l Fall 2003 l page 2

Franci J. Blassberg Editor-in-Chief

Ann Heilman Murphy Managing Editor

William D. Regner Cartoon Editor

Please address inquiries regardingtopics covered in this publication to the authors or the members of the Practice Group.

All contents © 2003 Debevoise & Plimpton. All rights reserved.

The articles appearing in thispublication provide summaryinformation only and are notintended as legal advice.Readers should seek specificlegal advice before taking anyaction with respect to thematters discussed herein.

The Private Equity Practice GroupAll lawyers based in New York, except where noted.

Private Equity FundsMarwan Al-Turki – LondonAnn G. Baker – Paris

Kenneth J. Berman–Washington, D.C.Jennifer J. BurleighWoodrow W. Campbell, Jr.Sherri G. CaplanMichael P. HarrellGeoffrey Kittredge – LondonMarcia L. MacHarg – FrankfurtAndrew M. Ostrognai – Hong KongDavid J. SchwartzRebecca F. Silberstein

Mergers and Acquisitions/ Venture CapitalAndrew L. BabHans Bertram-Nothnagel – FrankfurtE. Raman Bet-Mansour

Paul S. BirdFranci J. BlassbergColin W. Bogie – LondonRichard D. BohmGeoffrey P. Burgess – LondonMargaret A. DavenportMichael J. GillespieGregory V. GoodingStephen R. HertzDavid F. Hickok – FrankfurtJames A. Kiernan, III – LondonAntoine F. Kirry – ParisMarc A. KushnerLi Li – ShanghaiRobert F. QuaintanceKevin M. Schmidt

The Debevoise & Plimpton Private Equity Report is a publication ofDebevoise & Plimpton919 Third AvenueNew York, New York 10022(212) 909-6000

www.debevoise.com

Washington, D.C.LondonParisFrankfurtMoscowHong KongShanghai

Private equity firms think of themselves as cham-

pions of management teams and generally advocate

significant stock ownership by management as

a way to enhance the returns on portfolio invest-

ments. While this strategy is still basically sound,

we highlight some new regulations that change

the rules for private company executives and their

private equity investors.

On our cover, Larry Cagney discusses the unex-

pected results that new regulations taxing payments

that were previously exempt from the golden para-

chute excise tax may have on executive compensation

packages in private equity transactions. Also on a

benefits topic, Dave Mason reports on two surprising

decisions impacting cash balance plans and warns

both buyers and companies considering converting

their plans to cash balance plans to do so with care.

Also in this issue, we review several recent legal

developments that impact the private equity industry.

We describe a recent Delaware case that has nar-

rowed the potential pool of independent directors

that may serve on committees where potential

conflicts of interest may occur. From the UK, we

report on action by the UK Inland Revenue creating

a safe harbor for carried interest holders from

application of the adverse tax treatment generally

applicable to restricted securities.

In our Trendwatch piece, we focus on the role

of Advisory Boards in U.S. and European private

equity funds and explain that U.S. Advisory Boards

generally have more significant approval rights than

their European counterparts. In our Guest Column,

David Lobel of Sentinel Capital Partners notes

that while the volume of public-to-private deals by

private equity firms will likely not be as significant as

anticipated, such transactions, especially involving

small-cap companies with complex capital structures

or difficult operational issues, can be opportunistic

for private equity firms. John Allen also explores

whether, and under what circumstances, the power

industry might present opportunities for private

equity investment.

We also provide the second installment in our

series on directors and officers insurance, exploring

how to analyze whether private equity firms should

consider D&O policies for themselves as well as for

their portfolio companies.

We welcome your thoughts on our publication and

on how we can make it more helpful to you. Please

feel free to contact any of us if you have questions on

any of the articles or the topics they discuss.

Franci J. Blassberg

Editor-in-Chief

When private equity firms invest in publicly held companies, they often negotiate special governance arrange-ments, including as to composition of the board of directors. Sometimesthe private equity firm will get the right to nominate one or more directors,and often there will also be an agree-ment to nominate a specified number of “independent” directors, mutuallyacceptable to the company and theprivate equity firm.

What happens when the privateequity firm is asked to suggest an“independent” director? Often, it turnsto a trusted businessperson who, whilehaving no economic ties to the firm orits portfolio companies, is well knownto the firm’s principals through priorbusiness dealings or social ties – some-times ungraciously called a “houseindependent,” if the relationship is cozy enough.

A recent Delaware case, involving a special litigation committee formedby Oracle Corporation, suggests thatsome independent directors– even thoseconsidered “independent” for purposesof stock exchange rules – may not beindependent enough to deal with seriousconflict issues.

A special litigation committee (SLC) is a group of independent directors

formed to consider whether a share-holder derivative action – a lawsuitbrought by shareholders assertingclaims on behalf of the corporation –should proceed. If the SLC is inde-pendent and concludes after carefulreview not to proceed with the litiga-tion, the SLC’s motion to terminate the action is likely to be granted.

The Oracle SLC was formed to con-sider shareholder derivative litigationclaiming that Oracle CEO Larry Ellisonand several other Oracle directors hadbreached their duties to the companyby engaging in insider trading – sellingOracle shares before an earnings shortfall became public. Oracle’s SLCconsisted of two directors, both ofwhom had joined the board well afterthe alleged insider trading.

Counsel for the SLC interviewed 70witnesses, with SLC members partici-pating in several of the key interviews.The SLC produced an 1,100-page report,concluding that the defendants did nothave any material nonpublic informationabout the earnings shortfall and thatOracle should not pursue the claimsagainst the defendants. The SLC movedto terminate the derivative litigation.

The Delaware Chancery Court deniedthe motion, finding that the SLC hadfailed to demonstrate that no material

factual questionexisted regarding itsindependence. Thecourt noted that: bothSLC members wereboth professors atStanford; one of thedefendants was aprofessor at Stanford

who had taught one of the SLCmembers; another defendant was a big donor to Stanford (one of his gifts was $50,000, made after an SLCmember gave a speech at the defen-dant’s request); and Ellison himselfwas reported to be considering giving$170 million to Stanford. The courtfound “a social atmosphere painted in too much vivid Stanford Cardinal red for the SLC members to havereasonably ignored it.” To the court, the connections suggested that “material considerations other than the best interests of Oracle could have influenced the SLC’s inquiry and judgments.”

The court reached its conclusioneven though the two SLC members had tenure at Stanford and so weren’tvulnerable to being fired, had no fund-raising responsibilities at Stanford andweren’t shown to be controlled by any of the defendants. Although priorDelaware cases had held that personalfriendship, absent a showing of controlor a material economic relationship,was not enough to show a lack of direc-tor independence, the court noted thateconomic interest is not the only humanmotivation: “homo sapiens is not merelyhomo economicus.”

Will private equity firms now pro-pose complete strangers to the boards of portfolio companies? That’s unlikely:private equity firms will probably want to have some first-hand basis forbelieving in the trustworthiness of even an “independent” candidate –which requires some kind of relation-ship. What private equity firms must

How “Independent” is Independent Enough?

Thomas Schürrle – FrankfurtAndrew L. Sommer – LondonJames C. Swank – ParisJohn M. Vasily Philipp von Holst – Frankfurt

Acquisition/High Yield FinancingWilliam B. BeekmanCraig A. Bowman –LondonDavid A. BrittenhamPaul D. Brusiloff Peter Hockless – LondonA. David Reynolds

TaxAndrew N. BergRobert J. Cubitto

Gary M. FriedmanPeter A. FurciFriedrich Hey – FrankfurtAdele M. KarigDavid H. SchnabelPeter F. G. Schuur–LondonElizabeth Pagel Serebransky

Employee Compensation & BenefitsLawrence K. CagneyDavid P. Mason

Estate & Trust \PlanningJonathan J. Rikoon



With the economy slow, fund realizations below expectations and private equity funds making news for their lack of transparency,investors have naturally started asking more questions about how fund sponsors value their investments. It’s a critical question, sincethere are currently no standardized methods of valuation for the privately held companies in which most LBO funds invest. Given thelack of standards, and the economic risks posed by over-valuation, some investors have attempted to take matters into their own handsby pressing for terms they think will keep fund general partners in line. As they are discovering, it’s more complicated than it may seem.


The Risk of Over-ValuationMost U.S. buyout funds, and manyEuropean ones, permit the generalpartner to begin to share in profits onrealized deals before returning thelimited partners’ invested capital inunrealized deals (See, “Are the Termsof U.S. and European Private EquityFunds Converging?” in the Summer2003 issue of this Report) The theory is that, over time, investors will receive a return of their capital in all deals, plus a preferred return (generally 8% annu-ally), and that all profits will be split80% to the limited partners and 20%to the general partner as its carriedinterest. However, it’s not hard toimagine a scenario where a fund’s trou-bled investments remain unrealizeduntil the end of the fund’s life, whilethe successful ones are sold. When the duds are finally sold, they may notgenerate enough cash to return capitalplus 8% to the limited partners on thosedeals. In that situation, the general part-ner has received more than 20% of theoverall profits and needs to return (or“claw back”) the overdistributed amount,subject to certain caps. Nobody wantsthis situation – limited partners don’twant to have to chase the general part-ner, and general partners don’t want to suffer the reputational damage ofhaving a clawback in their fund.

To avoid clawbacks, most fundagreements treat a write-down or write-off of an investment as a “realization”for purposes of returning capital to

investors – meaning that the next timethe fund sells an investment, in additionto returning capital on the investmentsold, a portion of the proceeds will gotoward returning capital to the extentof the write-down or write-off. Thisreduces the amount of “profit” fromthe successful deal and accordinglyreduces the amount of carry the generalpartner receives. Assuming invest-ments are valued appropriately, thismechanism should help keep thegeneral partner from being overdistrib-uted over the life of the fund. (Ofcourse, there is always the risk that oneor more portfolio companies willdecline dramatically in value long afterthe general partner has received carriedinterest, at a point when subsequentrealizations won’t produce enoughcash to make up the amount of thewrite-down – the classic “end of theday” clawback scenario.) However, if the general partner does not writedown the value of troubled investmentssufficiently (or at all), or otherwise overvalues unrealized investments, therisk of clawback is greatly increased.

The Call for StandardsSo why not just force general partners to value their investments correctly?That’s easier said than done. Oneoddity of the current private equityscene is that investors who invested in a single portfolio company throughmore than one fund – an increasinglycommon phenomenon in this era ofclub deals – may find that different

funds assign the company very differ-ent valuations. This odd result occursbecause each fund has its own valuationmethodology and procedures – none ofthem “right” or “wrong,” just different.

Unfortunately, there is no uniformmeasure of “value” that can be appliedto all privately held companies, and thereis no industry-wide accepted valuationpractice. Even where a fund uses GAAPreporting methods, which require thatsponsors assign a “fair value” to theirinvestments on a periodic basis, thereis no uniform method for assigningthat value. A value can be inferred fromsources such as cost, P/E multiples,revenue streams, or the value of thecompany’s assets, but one or more ofthese may not be representative of actual“value” in any real sense for a particularcompany. What’s more, valuations basedon these indicators are still inherentlysubjective: different (well-informed)investors in the same company couldinterpret the same economic indicatordifferently and assign the company adifferent value. Several industry groups,including the National Venture CapitalAssociation and the Association forInvestment Management and Research,are actively pursuing valuation guide-lines that might be adopted across theindustry, but to date these efforts havenot borne fruit.

Interim Solutions – Fund TermsConcern over this state of affairs hascaused some investors to press spon-sors for fund terms that require general

Fund Terms and Conditions: Beware of “Solving the Valuation Conundrum”


partners to value their portfoliosfrequently, or that tie the general part-ner’s economics more closely to thevalue of the portfolio. While this mayseem at first blush a reasonable way to address performance-related fears,these terms don’t necessarily addressthe underlying problem, and may actu-ally end up creating an incentive forgeneral partners to overvalue their port-folios, thereby increasing rather thandecreasing the risks they are meant tomitigate. Any term that rewards the GPfor a high valuation can lead to a riskthat investments are aggressivelyvalued and could create a greater riskfor a GP clawback at the end of thefund’s life.

Management FeesFor example, when investors requestthat the management fee base followingthe investment period – often describedas “dollars at work” – be adjusted toreflect write-downs and write-offs, theyshould bear in mind that it may givethe manager a perverse incentive. Thesponsor may be slow to write down thevalue of an ailing investment if it knowsthat doing so will reduce its manage-ment fee – and most sponsors will tellyou that a troubled company takes moremanagement time and attention than amore robust portfolio company, so thefee reduction can become a sore issue.

ClawbacksOther proposals address the clawbackmore directly. The clawback calculationfor a fund is typically made after thefund’s last investment is sold, since it is only then that one can accuratelydetermine what, if anything, is owed.Since fund returns in general haveslowed and clawbacks are no longer a purely theoretical concern in somesectors, some investors have proposedvalue-based protections that applybefore the end of the fund. None ofthese proposals has gained much trac-

tion in the industry, in part becausethey address the symptom, rather thanthe problem, of the difficulty inherentin valuing these kinds of investments.

One such proposal is requiring allor a portion of the general partner’scarried interest to be deposited into anescrow account until such time as itcan be determined (based on a valua-tion of the portfolio) that the moneywill not be needed to fund a clawback.Aside from the obvious economicdownside of locking up a portion offund profits for years, depriving thegeneral partner of its use and earning a paltry return, the escrow contains an insidious incentive for sponsors toovervalue their investments in order torelease the funds as soon as possible.

Another proposal would requireinterim clawback calculations, so thatat some specified interval, the generalpartner determines whether, as of thatdate, a clawback would exist if the fundwere to be liquidated. This approachdoesn’t really add anything to the normalend-of-fund calculation, however, since it depends on the same valuationmethodology the general partner woulduse for write-downs and write-offs. Inother words, assuming the generalpartner is able to return capital on a cur-rent basis for write-downs and write-offs(as described above), the “clawback”calculation will be made every time thereis a realization.

Yet another, much more drastic,proposal is simply to make the generalpartner return all invested capital andthe preferred return before it begins toshare in profits. In most cases this is asurefire way to avoid having a clawback,but it is also a major economic disin-centive for the general partner. It cankeep the general partner from sharingin profits for the first several years of a fund’s life – and given the compen-sation structure of most fund sponsors,this is usually simply unacceptable.

Third-Party “Checks” on ValuationMany funds provide that certain trans-actions (e.g., purchases or sales ofinvestments where an affiliated party isinvolved and in-kind distributions ofportfolio company securities) requirean independent third party to value theinvestment in question. This is a healthypractice where there is a potential forconflict of interest, but investors shouldbeware of trying to apply this approachto ordinary course valuations. Not onlywill the cost of the valuations decreaseall partners’ fund returns, but thirdparties suffer just as much as the gen-eral partners from the basic problem of lack of a standardized approach tovaluations. Add to this the fact that theappraiser will not know the companynearly as well as the fund sponsor, whois actively involved in the company’smanagement, and the likelihood thatthe appraiser’s value will be more accu-rate than the sponsor’s is small indeed.

Some investors try to take comforton valuation issues by requesting a seaton the fund’s advisory committee andrequesting that the advisory committeeapprove valuation determinations. Aword of caution: there are risks associ-ated with playing that role. The concernis that there may be liability associatedwith approving or failing to object to a particular valuation. For this reason,some limited partners will not sit on an advisory committee that plays a role in valuation. Investors that sit on advisory committees that participate in valuation should be sure that theyare appropriately indemnified for allactions they may take as a member ofthe advisory committee.

What is to be Done?There is no easy answer to the conun-drum posed by valuation. Private equityfunds invest in every industry, each oneof which has specialized characteristicsthat imply certain valuation assumptions.



Public to Private: Few Companies Have Shown Up for the Partyguest column

As Wall Street redirects most of itsshrinking research coverage on thelarger, better-known companies, andSarbanes-Oxley adds another layer of risk and liability for CEOs of publiccompanies, it would be logical to con-clude, as many commentators havesuggested, that going-private transac-tions would mushroom. Right?

Wrong. The much-anticipated going-private party so far has failed toswing into high gear. In fact, the trendseems to be going in reverse, much to the dismay of many private equitysponsors with an abundance of capital to deploy. According to ThomsonFinancial, only 29 public-to-privatedeals were announced in the first sixmonths of 2003, mostly involvingsmall-cap companies, compared with 71 for all of 2002.

So what’s going on? While thereasons most commonly cited for theslow pace of going-private deals – pro-cedural headaches associated with theprocess and increased board scrutinyfor anything perceived to be a potentialconflict of interest – are certainly valid,there are other formidable factors atplay, not the least of which is the reboundin stock valuations.

Through August of this year, forexample, the Russell 2000 is up over30%, and the other indices have shownstrong year-to-date performance. Therun-up is being supported by investorexpectations of a recovery six to 12months down the road. And manage-ment teams, especially of smallcompanies, tend to believe what thestock market is saying when their stock prices move northward. This, ofcourse, makes it much more difficult

for private equity firms to purchase apublic business at an attractive price.

In the world of small caps, where thegoing-private action has been widelyanticipated, however, the most signifi-cant impediment is management andboard entrenchment. While entrench-ment and related governance issuesare well documented in larger compa-nies, these same issues are far morepronounced in small companies andare frequently coupled with a sense of entitlement – that the company istheirs, not the shareholders’.

Small businesses that are publicdon’t always act like it. Public owner-ship, particularly for OTC- and PinkSheet-listed companies, is often inci-dental. With management and theboard in complete control of strategy,compensation and perks, the publicshareholder is at best a distant abstrac-tion. It’s a comfortable and predictablelife for those who run the business andsit on the board. The truth is that smallcompany leadership will not give awaycontrol, unless they are compelled todo so. No wonder no one answers thephone at small publicly traded compa-nies when private equity firms call –that is at small companies performingreasonably well, which brings me to myreal point.

What kinds of small public com-panies are likely to show up for thegoing-private party? For starters, theymay not be from the “A” guest list.Most will have a lot of “hair” on them –ugly balance sheets, overly complicatedbusiness models or failed strategies.For these walking wounded, doingnothing is not a viable option.

The most fertile areas for going-private transactions are those situationswhere private equity capital is capital of last resort. The good news is thatsmall-cap companies with complexprofiles are not likely to attract a bigcrowd of suitors. In that sense, thesesituations may represent the closestthing to a quasi-exclusive deal that aprivate equity firm can see today. Thebad news is that there is likely a verygood reason why others will not gonear them. Assuming, however, thatthe company’s capital structure can becleaned up, its strategy clarified andmanagement refocused on execution,our experience teaches us that there is a good chance that taking a companyprivate can generate superior returnsfor private equity investors.

A couple of recent examples illus-trate the potential that small-cap “hairy”public companies hold for private equityinvestors. Take Edison Schools. Startedby Chris Whittle in 1992 on the promisethat it could improve public schools in the U.S. and generate profits in theprocess, Edison made its debut on Wall Street in 1999 amid a lot of fanfare.

Unfortunately, the company’s fouryears as a publicly held company weremarked by political controversies,strategic setbacks and a string of losses,all reflected in the stock price decliningfrom its IPO price of $18 a share to as low as $1.63 a share on July 14, 2003.Last year, in particular, was one of compounding horrors for Edison, itsshareholders and Mr. Whittle. The company settled a regulatory complaintover its accounting, was sued by itsshareholders, restated earnings andlost a very public battle in Philadelphia

by which it lost half the schools it wasoriginally hired to manage.

Wall Street soon lost confidence. By July of this year, Edison’s marketcapitalization was just $81.4 million,even though its cash and other currentassets amounted to close to $150million. News of a management buyoutproduced little reaction in Edison’sstock price. Faced with the very realprospect of extinction, Edison decidedto go private in a management-ledbuyout in the hopes of stabilizing itsaccess to funding, diminishing theadded scrutiny that comes with being a public company, and securing afriendlier, more committed long-termshareholder. The complexity of theEdison story has made this deal a quasi-exclusive transaction – no other bidderhas come out of the woodwork andEdison’s stock price has remained relatively dormant since the announce-ment to go private was made.

Another example of the potentialvalue embedded in small public com-panies that fall below Wall Street’sradar screen in terms of size is CastleDental Centers. With sales of approx-imately $100 million, Castle had abusiness model to roll up dental prac-tice groups into one large integratednetwork. While Castle has been aroundsince the early 1980s, its roll-up stra-tegy proved to be more expensive andchallenging to manage.

Starting with a small footprint ofdental clinics in Houston, Castle wentpublic in 1997 and raised considerablecapital to pursue its roll-up strategy. Inthe succeeding few years, Castle acquiredmany new dental centers over a largegeographic area stretching from Cali-fornia to Florida. Castle depleted its cashand incurred considerable debt to fund

the acquisition strategy. The companyalso used stock to pay for acquisitions.

Ultimately, Castle was unable tomanage and execute the integration ofthe acquired businesses and the wheelscame off. Castle entered 2002 saddledwith approximately $65 million of debt and little or no cash flow. Auditorsquestioned its future viability and thecompany’s stock sank to a low of $0.02a share, down from its IPO price of$13.00 a share. A crisis-managementfirm was retained to assist the company,and by the end of 2002, Castle’s debthad been pared down to $52 millionand its operations stabilized.

Despite the progress, Castle had fewviable options to go forward as a goingconcern. Castle’s board therefore deter-mined that a comprehensive financialrestructuring led by a private equity firmwas its best option for survival. Thenew capital would address Castle’s over-leveraged balance sheet, provide greatercertainty to its executives and networkof dentists and allow management torefocus on running the business.

In May of this year, our firm led aninvestor group that invested $13 millionin Castle, $7 million in subordinateddebt and $6 million in Series B preferredstock for a controlling 62% ownershipstake in the still publicly traded company.Following the $66.2 million recapitaliz-ation and Sentinel’s investment, Castle’stotal debt fell from $52 million to $21million of which $7 million was held bySentinel. The balance sheet, which atone time was strangling the company,is now in good shape and Castle is well-positioned for growth.

Both Edison and Castle fit the profileof suitable going-private candidates.Both businesses serve a basic andfundamental economic need, yet their

respective strategies proved moreexpensive to execute than managementexpected. Operational issues all tooquickly swelled into financial structureissues, leaving the companies littleroom to maneuver.

The decisions to relinquish control to private equity investors made byEdison and Castle were not easy onesto make. However, partnering with aprivate equity firm holds the promise of immediate balance sheet repair andthe freedom to adjust their businessplans without the distractions of beingin the public limelight.

Both companies’ situations alsoaffirm the notion that, despite all of theirchallenges, public-to-private deals can bebeneficial to all parties involved. Publicshareholders get immediate liquidityand management teams, in many cases,can retain significant equity stakes in theongoing success of their companies.

While the volume of public-to-privatedeals will probably never live up to thehype, they merit careful consideration,particularly by small companies con-fronting capital structure and operatingissues and private equity firms willingto tackle complex challenges. Boardsand outside shareholders of such com-panies should urge management toconsider going-private transactions asa transitional strategy to address theirchallenges away from public scrutinyand the increasing demands that accom-pany public ownership. Beleagueredmanagement teams might be recep-tive, even though they will often havedifficulty relinquishing their “controlentitlement.” — David S. LobelFounder and Managing Partner, Sentinel Capital Partners


Gone are the days when potential buyers of businesses were thrilled to see cash balance plans rather than their older cousins – final average pay defined benefit plans – as the key benefit plans at acquisition candidates. Cash balance plans were front-pagenews this summer. In one widely reported court decision, lump-sum payments made under Xerox’s cash balance plan were found to have been miscalculated (in Xerox’s favor) to the tune of about $300 million. On top of that, a different court decided that IBM’s cash balance plan (and by extension practically all other cash balance plans) fundamentally violated one of ERISA’s rules –and a politically sensitive rule about age discrimination at that. The decision in the Xerox case came as no real surprise. The IBMcase, on the other hand, shocked many benefits gurus, and gave pause to companies considering converting their pension plans to a cash balance plan formula. Both buyers and sellers of businesses should understand the uncertainty surrounding cash balanceplans in negotiating acquisition transactions.


What is a “Cash Balance Plan” Anyway?A cash balance plan is a particular type of ERISA-governed tax-qualifiedpension plan. Under ERISA, a qualifiedpension plan is either a “defined benefitplan” (a traditional pension plan) or a “defined contribution plan” (such as a 401(k) plan).

A traditional defined benefit planmight have a formula for determining an annual pension benefit that is something along the lines of “for eachyear of service, 1.5% of average finalfive years’ compensation.” For anemployee with 30 years of service andan average pay over the first five yearsof $60,000, this would translate into$27,000 a year. A participant’s benefitis determined under the plan formula,without reference to the plan’s assets.If we total up all the plan participant’saccrued benefits, that total might behigher or lower than the value of theplans assets. Thus, a defined benefitplan may be underfunded or over-funded depending on how its assets

compare with its liabilities (accruedbenefits).

A defined contribution plan – again, think 401(k) plan – is very dif-ferent. Each participant has a separate“account” that is invested in invest-ments usually chosen by the participantfrom a menu of available alternatives(e.g., mutual funds). The account iscredited with contributions, and cred-ited with earnings and charged withlosses on the investments. A particularparticipant’s benefit under the plan isdetermined directly by reference to hisor her account balance (and is usuallydelivered as a lump-sum payment ofthat amount). The assets of the planalways total up to the sum of the par-ticipants’ account balances, which inturn equal the total accrued benefitsunder the plan, and hence there is nounder- or over-funding in the case ofdefined contribution plans.

A cash balance plan is a definedbenefit plan that is designed to walk andtalk (as it were) like a defined contribu-tion plan. And therein lie many of theproblems.

A cash balance plan has accountsfor each participant – but they are onlynotional accounts, merely bookkeepingentries. That notional account typicallyearns a “yield” or “interest” of one sortor another, and is credited with additionalcontributions each year. A cash balanceplan might, for example, credit each

participant’s account with 5% of his orher compensation paid for that year,and then provide for additional accrualsin the form of interest credits on thataccount at a rate established as part ofthe plan design. Often, this rate is somefloating rate determined by reference to Treasury securities or high-ratedcorporate notes of a particular maturity.(Embedded in this benign and quiteage-neutral sentence is the key to theersatz age-discrimination issue that is the heart of the IBM case, but moreabout that later.) Because the interestcredits are actually part of the accrualfor the services already performed,when someone ceases employment,unless a distribution of the account ismade, his or her account continues tobe credited with interest (but of coursethere would be no more accruals withrespect to the individual’s compensa-tion). Although most participants dotake a lump-sum payment equal to hisor her account balance when they leavethe company, some do not and calcu-lating the “accruals” that would haverelated to the additional “interest” creditsis the hard question, and one that leadto the $300 million Xerox issue, but moreabout that later, too.)

Because cash balance plans have“accounts” and a participant might evenreceive a monthly or quarterly state-ment that shows an “account balance”– cash balance plans were meant to

Making Sense of the Cash Balance Plan Brouhaha

A cash balance plan is a

defined benefit plan that is

designed to walk and talk

(as it were) like a defined con-

tribution plan. And therein

lie many of the problems.


act like defined contribution plans.There is, however, no direct correlationbetween participants’ benefits and theamount of the plan’s assets. It is just anotional account notionally invested ina hypothetical investment, not reality. Acash balance plan may be underfundedor overfunded, and a review of the com-pany’s financial statements shouldreveal the plan status. It is a definedbenefit plan.

Before turning to the real (or imag-ined) problems with cash balanceplans, it is worth noting one more ratherimportant difference between cashbalance plans and traditional pensionplan formulas that may create perceivedage-discrimination issues. The way atraditional pension plan formula works– in our earlier example, “1.5% of finalfive years’ average pay per year ofservice,” employees with more exper-ience (older employees) actually accruemore of their total benefit toward theend of their career. This is because anemployee’s pay usually increases overhis or her career so that the final averagepay is higher than, say, a career-averagepay, and that increasing average pay getsthe added bang of an increased multi-plier because years of service is alsogoing up. Thus, this class of employeesis always disadvantaged when a tradi-tional plan is converted into a cashbalance plan, and the class can oftenbecome a unified force for an employerto contend with.

The Trouble With Cash Balance Plans: Round 1When companies first started convertingtheir traditional pension plans to cashbalance plans in the mid- to late-1980s,there was a flurry of controversy. Thisearly wave of controversy, however, largelyrelated to the way traditional definedbenefit plans were converted to a cashbalance plan formula rather than to thevery nature of the formula itself.

One of ERISA’s fundamental protec-tions is that an employee’s accruedpension benefit cannot be taken awayor reduced. Therefore, when a companyconverts from one formula to another,it cannot do so in a way that reducesthe accrued benefit of a participant.When companies converted their pen-sion plans to cash balance plans, theywould calculate an amount equal to theemployee’s accrued benefit under thepre-conversion formula. Some compa-nies may have gotten this wrong, whichled to some disputes, but companiesseem to be getting it right these days(although it is worth having actuariesdouble check this in due diligence foran acquisition if there is a large cashbalance plan involved.)

The requirement that the prior bene-fit be preserved, however, led to the so-called wearaway problem. Wearawayis ultimately a human relations/publicrelations/political problem, but becausethe issue has so tainted cash balanceplans, it may be informing what mightotherwise be dispassioned legal analysisas well.

As we mentioned above, when plans converted from a traditional pen-sion plan formula to a cash balanceplan, they would calculate each individ-ual’s protected accrued benefit, calculatedin accordance with legal requirements.They would also calculate a startingbalance for each employee’s account,and this starting balance often differedfrom the protected accrued benefitbecause it could be calculated usingdifferent factors from those used tocalculate the protected benefit. (Thediscount rate might, for example, bedifferent.) Where the protected benefitwas higher than the starting accountbalance – as might often be the case for older workers– the employee wouldoften not enjoy any true additionalbenefits under the cash balance plan

formula until he or she caught up withthe protected benefit. For example, ifthe protected benefit at normal retire-ment age had a present value of $80xand the starting balance were only $70x,the employee would actually not beaccruing any additional benefits eventhough the plan was growing the accountbalance until that balance exceeded$80x (the value of the protected benefit).The wearaway problem was very contro-versial. Some thought that the very factof wearaway was evidence of age discrim-ination, but the First Circuit Court ofAppeals has held otherwise. Even moreproblematic, however, was the perceivedunfairness to older workers. Manycompanies resolved this issue by grand-fathering older individuals into thetraditional plan formula, or by providingthat the additional credits to the accountfor additional service would be addedto the protected benefit.

The Trouble With Cash Balance Plans: Round 2In the next wave of cash balance plandisputes was the Xerox case, the thirddecision of a U.S. Appeals Court toaddress how cash balance plans mustcalculate lump-sum payments made to individuals who take a lump-sumpayment before normal retirement age.These blue-chip decisions – in additionto Xerox, one case involved Georgia-Pacific and another a company acquiredby Bank of Boston – show some of the problems raised by trying to designa so-called “hybrid” pension plan tocomply with ERISA legislation designedbefore these plans existed.

A traditional defined benefit plan mayprovide that people who leave beforenormal retirement can elect to take alump-sum payment from their pension.In calculating that lump-sum payment,the rules essentially say to look at whatthe benefit would be at normal retire-continued on page 24


Sign on the Dotted Line?

BackgroundYou are a buyer in an M&A transactionon the eve of signing a definitive purchaseagreement. You and your advisors haveworked hard to draft and negotiate theagreement and, at long last, you believe itis in final form. Signature pages havebeen exchanged and you are starting toplan ahead for the closing. Then, muchto your unpleasant surprise, the seller’scontrolling shareholder simply refuses tosign the agreement. The deal is off, right?

Hard to believe, but maybe not. In a July 2003 case (AIH Acquisition Corp.LLC v. Alaska Industrial Hardware, Inc.),a court in the Southern District of NewYork was presented with a similar factpattern. In its opinion, the court denieda motion to dismiss by the seller, indi-cating that, unless the parties presentedfactual support for a different outcome,1

it would grant the buyer’s summaryjudgment motion to enforce the agree-ment – even though it was never signedby the controlling shareholder of theseller. In addition, the court enjoinedthe seller from selling the business to athird party prior to the final determin-ation of the summary judgment claim.2

In reaching these conclusions, the courtcited a 1979 decision of the New YorkCourt of Appeals (Municipal Consultants& Publishers, Inc. v. Town of Ramapo),which held that “when the parties haveagreed on all contractual terms andhave only to commit them to writing…

the contract is effective at the time theoral agreement is made, although thecontract is never reduced to writingand signed... in the absence of a positiveagreement that it should not be bindinguntil so reduced to writing and formallyexecuted.” (Emphasis added.)

ConsequencesEven if the court ultimately enforcesthe purchase agreement against theseller, prior case law suggests that thisdecision should not affect most M&Atransactions between sophisticatedparties, in which the letter of intent orterm sheet (if any) and the purchaseagreement would generally be inter-preted to give effect to customarylanguage requiring that the definitiveagreement between the parties must bereduced to writing. (Examples of suchprovisions are included below under“Recommendations.”) However, theAIH Acquisition case introduces anunexpected degree of uncertainty intothe acquisition process. Rather thanoperating on the traditional assump-tion that “it ain’t over ’til it’s over” –that there is no deal until the papers aresigned by all of the parties – if the caseis not overruled on appeal, parties toM&A transactions would be required todetermine whether, at any time prior tosigning, there exists an oral agreement“on all contractual terms.”

The Court’s AnalysisThe discussion of the court’s reasoningin the AIH Acquisition case is very briefand the facts provided are scant. Thecourt’s preliminary conclusion was thatthere was a “complete written agree-ment containing all material terms infinal form” solely on the basis of an

email from the buyer’s counsel, whichstated, in relevant part: “Attached is the final SPA. Everyone, including the lawyers, has stated that it is finalwithout qualification.” However, theopinion does not otherwise demon-strate that the seller had concurred thatthe agreement was final. The decisionsuggests that the buyer raised issuesrelating to the controlling shareholder’smental condition and capacity, but the court does not attempt to explainthe seller’s failure to sign the agree-ment. Did the seller in fact lack capacityor was it instead a classic case of“seller’s remorse?” Or, perhaps, did the “final” draft simply not address allof the seller’s concerns in a satisfactorymanner? Did the e-mail message cor-rectly reflect a meeting of the mindsbetween the parties, or was it merely aself-serving exercise in wish fulfillmentby a frustrated lawyer, anxious to avoidanother round of edits? Is this case just a bad dream?

The PrecedentsThe background of the MunicipalConsultants case cited by the court wasquite different from the M&A context of the AIH Acquisition case. In MunicipalConsultants, the town board of Ramapo,New York approved a contract with a publishing company and passed aresolution authorizing the town super-visor to sign the contract on the town’sbehalf. Although the resolution did not specifically direct the town super-visor to execute the contract, local lawprovided the town board with the soleauthority to award contracts andgranted no discretion to the town super-visor with respect to contracts previouslyauthorized by the board. The AIH

1 As of the date this article went to print, the parties hadsubmitted additional information to the court in connectionwith the motion to dismiss the plaintiff ’s claim for specificperformance, but no further decision on this motion hadbeen issued by the court.

2 As of the date this article went to print, an appeal withrespect to this injunction had been filed in the Second CircuitCourt of Appeals, but had not yet been briefed for argument.


Acquisition opinion cites this case insupport of the proposition that the“mere lack of signatures is but a minis-terial formality.” However, in MunicipalConsultants, it was the lack of discretionon the part of the signatory that ren-dered the execution of the contract amere formality, not, as AIH Acquisitionsuggests, the fact that the agreementwas in allegedly final form. By contrast,it is difficult to argue that the control-ling shareholder in AIH Acquisition doesnot have full discretion over his deci-sion to sign or not sign an agreementrelating to the disposition of his shares.

The AIH Acquisition opinion alsocites the 1984 decision of the SecondCircuit Court of Appeals in R.G. Group,Inc. v. Horn & Hardart Company, butfails to indicate that the R.G. Groupdecision in fact reached a contrary con-clusion. In R.G. Group, the plaintiffssought injunctive relief to enforce anunexecuted franchise agreement andprevent a restaurant chain from grantingfranchises to third parties within theterritorial scope covered by the agree-ment. Despite uncontroverted evidencethat the parties agreed on at least oneoccasion that they had a “handshakedeal,” the Second Circuit held that, “ifparties do not intend to be bound byan agreement until it is in writing andsigned, then there is no contract untilthat event occurs.” In determining theintent of the parties, the court reliedprimarily on the presence in the stan-dard form franchise agreement of aboilerplate “merger clause” (i.e., thatthe contract “contain[s] the entire agree-ment and understanding between the parties hereto with respect to thesubject matter hereof”) – to be sure,not a provision that likely attracted

much attention during the negotia-tions. Nevertheless, the Second Circuitin R.G. Group was satisfied that thisprovision sufficiently demonstrated theparties’ intent to be bound only by awritten agreement, which intent thecourt would not frustrate, “handshakedeal” or not.

RecommendationsTo avoid any traps for the unwary thatmight arise in the wake of the AIHAcquisition case, private equity firmsand others involved in bids or M&Aprocedures, and M&A practitionersshould remember:

• If you will be using a bid letter, letterof intent or term sheet in your trans-action, include explicit disclaimerlanguage to the effect that the bidletter, letter of intent or term sheet ismerely an expression of interest toproceed with the proposed transac-tion outlined therein, and that nobinding agreement will exist betweenthe parties until definitive writtenagreements have been executed anddelivered.

• Make sure that your purchase agree-ment adequately manifests yourintent only to be bound by a writtenagreement. In addition to the cus-tomary “merger clause” mentionedabove, the court in R.G. Groupsuggested that such intent would be demonstrated by provisions suchas standard amendments language(i.e., that the agreement could not be “modified, waived, discharged orterminated… except by a writing signedby the parties”) and enforceabilityrepresentations (i.e., that the agree-ment, “when executed and delivered,…will be a valid and binding agreement”).(Emphasis added.)

• Create the appropriate paper trail. Ifyou receive a distribution of transactiondocuments that purports to be “final,”but you have not yet signed off on theirterms, be sure to reserve your right toright to further comment.

Stay tuned to find out the final judg-ment in the AIH Acquisition case. — Joshua J. G. [email protected]

— Franci J. [email protected]

Even if the court ultimately

enforces the purchase agree-

ment against the seller, prior

case law suggests that this

decision should not affect most

M&A transactions between

sophisticated parties, in which

the letter of intent or term

sheet (if any) and the purchase

agreement would generally

be interpreted to give effect to

customary language requiring

that the definitive agreement

between the parties must be

reduced to writing.


An Introduction to Private Equity Firm D&O Insurance Coverage

Why Get CoverageThe principals of many firms, notsurprisingly, are concerned about theirliability as a fund manager. The con-cern is, in particular, whether the D&Oinsurance and indemnities received at the portfolio company level will besufficient to protect the private equityfund, the general partners or man-aging members, and the managementcompany. Principals could be exposedto lawsuits for breach of fiduciary duty,claims for wrongful acts or omissions,or could be the subject of regulatory or securities investigations. A portfoliocompany’s D&O insurance will covera principal only to the extent that theprincipal is a director of the portfoliocompany and a claim is made againstthat principal for a wrongful act com-mitted in his or her capacity as adirector for that portfolio company.Stated another way, the portfoliocompany’s D&O insurance does not(and most likely cannot be modifiedto) extend to the private equity fund,the general partners or managingmembers, and/or the managementcompany. Thus, the fund manager andits principals are not covered by theportfolio company’s D&O insurancewhen they are acting in any capacityother than their capacity as directorsor officers of that portfolio company.Furthermore, a principal with aminority interest in a portfolio com-pany will probably not be in a positionto dictate and negotiate the terms of

that portfolio company’s D&O insur-ance. Inadequacy of coverage andrestrictive terms and conditions, whichare common problems with D&Oinsurance today, could lead to uncov-ered claims.

Still, not every private equity firmpurchases firm D&O insurance. Manyfirms rely on contractual indemnitiesfrom the funds they manage and fromthe portfolio companies in which thefunds invest. The typical fund indem-nity covers the fund manager andgeneral partner and their respectiveofficers, directors, employees, partnersand agents. This indemnity wouldbe funded by the liquid assets of thefund, or by calling capital contribu-tions (or a return of distributions, ifthe fund terms incorporate a limitedpartner clawback provision). Ofcourse, indemnification typically doesnot apply to the extent the loss aroseprimarily from the gross negligence orwillful malfeasance of the indemnitee,and limited partner clawback obliga-tions are often subject to limitationson the amount that can be clawed backand/or the time during which the claw-back can be required. Moreover, it canbe difficult (and unpopular) to enforcea limited partner clawback obligation.

Although limited partners of alimited partnership have limited liabilityin most circumstances, limited partnerswanting to protect their investments(and the distributions they have alreadyreceived) may approve the fund man-

ager’s obtaining firm D&O insurance.The limited partnership agreements of many funds often allow the generalpartner to treat firm D&O insurance as a fund expense. In fact, many fundinvestors have expressed concern abouttheir contractual indemnification obliga-tions to the fund and its managers, and have suggested – strongly, in manycases – that the fund manager insurethose obligations as a fund expense.

Who is Covered? Private equity firms should rememberthat the terms and conditions in D&Oinsurance designed for an operatingcompany won’t work for them. Forexample, a portfolio company’s D&Oinsurance is typically written to coverthe parent company and its majority-owned subsidiaries. This coveragestructure, however, will not work for a private equity fund and fund man-agers. While the manager acts for the fund pursuant to a managementagreement, it generally has no directownership interest in the fund or itsgeneral partner. A private equity firmwith several funds may have a sepa-rate general partner for each fund,each with different ownership, thatalso do not fall within the parent/subsidiary relationship with either themanager or with the other generalpartners and funds.

When securing firm D&O insur-ance, it is extremely important toidentify to the insurance broker and

In our Fall 2002 issue, we discussed indemnification and directors and officers (D&O) liability insurance generally, and how to applythose mechanisms to directors and officers of portfolio companies. We promised a future article that would focus on D&O insurancefor private equity funds, their general partners or managing members, and the management company (referred to hereinafter as“firm D&O insurance”).

In this article, we summarize some of the issues that a private equity firm thinking about purchasing firm D&O insurance mightface in answering the questions: Why get coverage? How do you know you are getting appropriate coverage? What issues shouldyou look for? In other words: Is the policy worth the premium?

underwriters each entity to be covered,to explain the relationships of thoseentities among one another and to theportfolio companies, and to discusswho the individual insureds must be.The various defined terms in any D&Opolicy should respond to the correctterms applicable to the entity. Thedefinition of “insured” can be modifiedto cover the private equity fund and itsgeneral partner, and partners of thoseentities as well as the manager of theprivate equity fund. If there are co-investment entities, which are used tofacilitate, among other things, the prin-cipals’ estate planning, those entitieswill not be covered unless they arespecifically included in the policy (someof which may not even require an additional premium if the commitmentamounts are small). Coverage mayalso be extended to non-principal pro-fessional employees, to the extentspecifically identified.

How Do You Know You are GettingAppropriate Coverage? Of course, potential purchasers of firm D&O insurance will look at priceand coverage limits. The D&O insur-ance market is currently very difficult to navigate. Premiums are high andterms are more restrictive than ever.Careful review of the proposed firmD&O insurance and all of the endorse-ments is warranted, including thedefinitions, requirements for coverageand exclusions as they apply to thecontractual arrangements for themanager, general partner and fund.Insurers generally offer several stan-dard D&O insurance forms and, uponthe insured’s request, will modifylanguage to address particular risks.The manager should negotiate anyprovisions that don’t fit the firm’sparticular needs, should make clari-fying amendments to the language of ambiguous provisions and should

obtain specific comfort from theinsurer regarding the interpretationsthat will be applied in this context toensure that coverage will be providedwhen it is needed.

In addition, new policy forms arenow available to cover directors andofficers for claims if the private equityfirm (or, for that matter, the portfoliocompany) rightly or wrongfully refusesor is financially unable to indemnify the directors and officers. These poli-cies are referred to in the insurancemarket as “Side A excess policies.” AllSide A excess policies, however, arenot created equal. Some Side A excesspolicies contain a “drop-down differ-ence-in-conditions” (DIC) term. Side A policies with DIC terms frequentlyhave limited or narrowed exclusionsrelating to personal profit or advantageand dishonesty. Some Side A policieswith DIC terms cannot be rescindedbased on the restatement of any finan-cial statements included within theapplication. These broad coveragefeatures (which are not typically offeredin a primary D&O policy) becomecrucial when a claim is made, inasmuchas a Side A policy with DIC terms willact as a primary policy (subject to its own terms and conditions) in theevent the primary D&O insurance willnot cover a particular claim. A Side Apolicy will also act as an excess policy,protecting the directors and officers(not the corporation) in the event theprimary policy limits are exhausted.

Does the Coverage Protect AgainstSuits by the Fund’s Limited Partners? D&O policies generally exclude claimsbrought by or on behalf of one insuredperson against another insured person,subject to certain exceptions (such asshareholder derivative actions.) This iscommonly referred to as the “insuredvs. insured” exclusion. Since the limitedpartners are, of course, partners of the

fund and could, therefore, be deemedan “insured” under firm D&O insurance,this may exclude from coverage claimsby the limited partners against the gen-eral partner or manager, particularly ifthe suit is brought as a derivative actionin the name of the fund. In someinstances, the insured vs. insured exclu-sion can be modified to cover theserisks in whole or in part.

Are the Innocent Protected?Many D&O policies now being offeredby insurers void coverage for all directorsand officers if one insured committedfraudulent acts or withheld materialinformation on the D&O insuranceapplication. Thus, those “innocent”directors sitting alongside a waywarddirector could find themselves unpro-tected and exposed, even though theyacted in good faith and are withoutfault. In addition, knowledge of pastevents known by one board memberthat may give rise to a claim may beattributed to other board members,making it difficult or impossible for theprivate equity firm to add a new princi-pal. Further, some insurers have addedbroadly worded exclusions wherebyany “statement made in or out of acourt” could be used as evidence offraud and, therefore, to void coverage.Informed insureds and their lawyers,finding such provisions unacceptable,have been aggressively negotiatingthese terms and exclusions with poten-tial insurers, with various degrees ofsuccess. Despite the tight D&O insur-ance market, insurers are willing, incertain cases, to modify these provi-sions, keeping the innocent directorsprotected in the event of a claim.

Other Issues to Look For Coverage under firm D&O insuranceoften does not extend to a principal’smembership on a portfolio company’sboard (public or private) on the basis




SEC Staff Recommends Registration of Hedge Fund Advisers –Private Equity Advisers Likely to Be Unaffected

alert

As we went to press, the SEC Staff issuedits report and recommendations onhedge funds, culminating after a year-long study and investigation. The keyrecommendation made by the Staffwas that hedge fund advisers of a certainsize be required to register with theSEC by amending a rule to the AdvisersAct. The Staff noted that registrationwould have at least one significant effectbeyond increased SEC oversight: itwould effectively increase the minimuminvestment requirement for investors

in some hedge funds because registeredadvisers are generally prohibited fromcharging performance fees unlessinvestors have at least $750,000 investedwith the adviser or have a net worthover $1.5 million.

The Staff recommended that spon-sors of private equity and venture capitalfunds not be subject to the new regis-tration requirement. Rather, they wouldcontinue to be subject to the currentregime, which exempts advisers withfewer than 15 clients. Finally, the Staff

requested the Commission to considereliminating the general solicitationrestriction for hedge fund offeringslimited to highly sophisticated investors(i.e., individuals owning $5 million ormore of investments and institutionsowning or managing $24 million ormore of investments).

We will update you with a fullerdescription of the report in our Winter2004 issue. — Jennifer A. [email protected]

Recent and Upcoming Speaking Engagements

October 9 Andrew N. BergCorporate Debt RestructuringsNew York, NY

October 20 David H. SchnabelThe Use of Partnerships & Disregarded Entities in Corporate PlanningInstitute on Federal TaxationNew York, NY

October 30-31 Woodrow W. Campbell, Jr., ChairPrivate Equity Funds: Current Issues in Structuring and Fund Terms

Paul S. BirdFundamentals of Private Equity Investing: Parts I and IIEthical Issues: “Noisy Withdrawal” Under Sarbanes-Oxley

Private Equity Forum: Legal & Financial Strategies for Dealmaking in a New Regulatory RegimeNew York, NY

November 13-14 Franci J. BlassbergNegotiating Corporate AcquisitionsNew York, NY

January 13-14 Franci J. BlassbergCorporate Governance: Managing Risk for the GP

Michael P. HarrellPartnership Strategies and Structures for GPs and LPs

The 2004 North American Private Equity COOs and CFOs ForumNew York, NY


The UK’s Finance Act 2003 changessignificantly the UK tax treatment ofequity-based compensation plans. The new rules, in Schedule 22 of theFinance Act, apply to grants of“restricted securities” after April 16,2003 to employees who are both “resi-dent and ordinarily resident” in theUK.1 Grants of carried interest in aprivate equity fund to UK-based execu-tives are within the scope of Schedule22 and therefore are potentially sub-ject to adverse UK tax treatment. In asignificant concession to the privateequity industry, however, the UK InlandRevenue recently published a safeharbor that limits substantially theapplication of Schedule 22 to carriedinterest holders.

New Tax Treatment of Restricted SecuritiesIf Schedule 22 applies to a grant ofrestricted securities to an employee, heor she will be subject to a tax regimethat is similar to the rules applicable toU.S. “section 83(b) elections:”

• If the employee and his or her employermake a joint election within 14 days ofthe grant, the employee will be subjectto UK income tax up front on theexcess of the fair market value of thesecurities at the time of grant, ignoringthe negative impact of any vesting,transfer or other restrictions on the

securities, over the amount that theemployee pays for the securities. Theemployee, however, will not be subjectto additional tax charges underSchedule 22.

• If the employee and his or heremployer do not make the election,the employee will still be subject toUK tax on the excess of the fair marketvalue of the securities at the time of grant over the amount that theemployee pays for the securities, but in this case fair market value will bedetermined taking into account thenegative impact of any vesting,transfer and other restrictions. Theemployee, however, will be subject to additional UK income tax on theearlier of the date that the vesting orother restrictions lapse and the datethat the executive sells the securities,based on the gross value of the sharesat the later date multiplied by the per-centage discount, determined at thetime of grant, attributable the vesting,transfer and other restrictions.

Whenever the employee is subject to income tax under Schedule 22, the employer and the employee willalso be subject to a corresponding UKemployment tax charge.

The significance of Schedule 22 to a private equity fund executive who isresident and ordinarily resident in theUK is that, if Schedule 22 applies to agrant of carried interest, the executivemay be subject to a significant incomeand employment tax charge at the timeof the grant of carried interest and each time the executive’s share of thecarried interest increases (if the execu-tive and his or her employer make theelection), or at the time that the vesting

restrictions lapse or the fund makescarried interest distributions (if theexecutive and the employer do not makethe election). In either case, the impactof Schedule 22 would be of particularsignificance to an executive who is notdomiciled in the UK and who, in theabsence of Schedule 22, would not besubject to UK tax on all or part of his orher carried interest distributions underthe UK’s remittance-based tax system.

Safe Harbor for Carried InterestThe Inland Revenue recently provided a safe harbor from the application of Schedule 22 in relation to carriedinterest holders. Under the safe harbor,the issuance to an executive of secur-ities representing a share of the carriedinterest in a private equity fund, andsubsequent increases in the executive’sshare of the carried interest, will not be subject to tax under Schedule 22 ifthe issuance occurs at the time thefund is formed, or if the issuance orincrease occurs at a time when theaggregate value of the fund’s portfolioinvestments does not exceed the aggregate acquisition price of the port-folio investments. The safe harbor does not address specifically the grantof carried interest that relates to somebut not all of the portfolio investmentsof a fund (for example, the issuance toan executive of securities representingcarried interest that relates only toprofits from future portfolio invest-ments), however, under the principlesarticulated in the safe harbor, this type of grant would not be subject to tax under Schedule 22.

To qualify for the safe harbor, thefund and the executive must satisfy a

UK Provides Relief for Carried Interest Holders from Application of New Tax Rules

1 Generally, an individual will be treated as resident andordinarily resident in the UK upon arrival if he or shearrives in the UK with an intention to remain in the UKfor at least three years. An individual who does not arrivein the UK with this intention will become resident andordinarily resident if he or she subsequently develops anintention to remain in the UK for more than 3 years fromarrival. Also, if an individual remains in the UK for anaverage of 91 days or more each tax year, the individualwill become resident and ordinarily resident in the UK atthe beginning of the fifth UK tax year during which he orshe is present in the UK. continued on page 26

As the blackout of this past August brought close to home, the last few years have not been good ones for the power-generationsector. Challenging times for the power-generation sector may create powerful opportunities for private equity players. The combi-nation of headline-grabbing reports of manipulative energy trading (and whopping penalties), overbuilding, the recession andregulatory uncertainties have caused values reached in 2000 to plummet, offering potentially attractive investment opportunities to those who continue to have access to capital and the requisite knowledge base to evaluate this complex market sector. Notsurprisingly, private equity players are showing increased interest in this field.


Is It Time for a Power Play?

How Did Things Get This Bad?The recent downward spiral in the powersector is the result of a combination offactors. Not so long ago, independentwholesale power producers (IPPs) wereviewed as the lean-and-mean players in the industry, unencumbered by rateregulation and the overhead andbureaucracies seen as the hallmarks of integrated investor-owned utilities.In the post-Enron era, the volatility ofenergy prices, the collapse of energytraders and the threat of overcapacityposed by recent construction, have leftmost IPPs and companies operating in the merchant energy market, tradingat a small fraction of their values ofonly two years ago.

The decline in the equity market has been accompanied by significantnegative impact on the credit profile of power-sector companies. Rating-agency downgrades were commonplacethroughout 2001 and 2002. Virtually allpure-merchant IPPs had ratings belowinvestment grade by the end of 2002 –a function of declining coverage andincreased leverage ratios. Deterioratingcredit ratings have, in turn, triggeredsignificant collateral calls under power-trading contracts, while at the sametime making access to capital a muchmore expensive proposition. Thecrunch has been particularly acute forthose companies that relied uponshort- or medium-term debt, as theprospect of refinancing has becomemore tenuous. Facing spiking credit

spreads, buyers have turned into sellers.Some owners have simply handed overthe keys to their banks.

Prevailing energy prices have con-tributed to the slump. The combinationof a weakened economy and perceivedovercapacity has translated into decliningprices (or so-called forward sparkspreads) for the near to medium term.Bankruptcy seems not too far off forthose deepest into the downward spiral.

Where Does It Go From Here?It should come as no surprise that one outgrowth of these developmentshas been an increasing number ofgeneration assets being put up for saleby strapped industry players. While thevolume of sales in 2001 and 2002 maynot have outstripped that of the late’90s, many of the industry’s tradition-ally active buyers have been sidelinedby the prevailing credit crunch, ortransformed into sellers. The result is a buyer’s market, with many formerbuyers out of the game.

Faced with these developments,certain players with access to capital,including some private equity firms,have seen an opportunity. MidAmericanEnergy emerged as Berkshire Hathaway’splatform for investment in the energysector. KKR teamed with TrimaranCapital Partners to buy DTE Energy’selectric transmission assets. Anotherprivate equity firm has purchased gaspipeline facilities from the WilliamsCompanies. As a general matter, how-

ever, the sales to date have involvedtransportation assets (e.g., transmis-sion systems or gas pipelines) orgeneration assets with future outputthat has been sold under long-termsupply or output contracts. To date,very few, if any, pure merchant plants(i.e., generation plants that must relyentirely on sales in the wholesaleenergy market) have changed hands,although the field of potential sellersappears to be growing.

Why Private Equity?Private equity firms have a couple ofthings going for them in the currentmarket. First, and most importantly,they have the ability to access substan-tial equity capital on an assured andtimely basis. Private equity players mayhave other advantages, as well:

• As private entities, they may have a greater willingness and ability toexpand into the energy sector, whichhas had more than its share of head-line-grabbing scandals that mayprompt those closer to the glare ofpublic opinion to hesitate.

• In at least some instances, privateequity firms may enjoy a regulatoryadvantage over other market players. A neighboring integrated electricutility may face tough scrutiny by boththe Justice Department/FTC and theFederal Energy Regulatory Commissionas to the competitive implications ofany acquisition that would expand orcontinued on page 27


Germany to Modernize Fund Lawsalert

In an effort to attract foreign investmentfunds and managers, the GermanMinistry of Finance recently publishedits long-awaited draft of legislation forreform of Germany’s heavily criticizedand outdated public investment fundand tax laws. The laws will now beconsidered by the German Parliamentand are expected to become effectiveon January 1, 2004.

Although the focus of the legislationis on the offer and sale of public fundsin Germany, there are some new provi-sions that are meaningful to our privateequity clients. The legislation providesthat investment management compa-nies regulated in another EU memberstate and complying with the UCITSregime can provide fund-managementservices, including investment advice,distribution and depositary services, toGerman clients. This should make iteasier for our private equity sponsorswith subsidiaries licensed in London,for example, to provide cross-borderservices in Germany.

With respect to non-Europeaninvestment management companies,the Ministry of Finance has the power

to promulgate a kind of passportingregime, depending upon reciprocity in the relevant non-European homecountry. We are hopeful that the reci-procity will be used to permit U.S.managers registered with the SEC tooffer services in Germany.

Moreover, codifying recent practice,outsourcing of discretionary invest-ment management will be expresslypermitted. U.S. and other non-Euro-pean investment managers can importtheir investment management servicesinto Germany by entering into anoutsourcing agreement with either aGerman-licensed management com-pany or another licensed Europeanmanagement company that is pass-ported in Germany. While outsourcingof portfolio management has in practicebeen used over the past few months,the new law explicitly blesses thesearrangements and makes clear thespecific basis on which they can beimplemented.

For the first time, Germany will alsopermit the organization and offer ofhedge funds for sale in Germany. Themuch-hyped hedge fund provisions

offer little additional opportunity forprivate equity sponsors, though. A Ger-man hedge fund cannot invest morethan 30% of its net assets in unlistedsecurities, such as direct investmentsin private equity or private equity funds.In fact, the Ministry of Finance clearlystated that the hedge fund provisionswere meant to prevent hedge fundsfrom being used as pseudo-privateequity funds.

The new Act will also make signi-ficant changes to the taxation of funds,especially foreign funds, sold in Ger-many. The existing distinction betweenwhite, gray and black funds, and thepenalizing taxation of black funds willbe abolished after a transition period of two years. We will provide you with a more detailed analysis of these taxchanges in an upcoming issue of ThePrivate Equity Report. — Marcia L. [email protected]

— Patricia [email protected]

— Christian R. [email protected]

remember, however, is that a “houseindependent,” depending on the natureand extent of any ties with the privateequity firm, may not be able to act as an independent director in a situationin which the company has a seriousconflict of interests with the private

equity firm – e.g., serving on an SLC ifthere’s derivative litigation against theprivate equity firm, or serving on aspecial committee to consider a goingprivate transaction involving the firm.Private equity firms should also remem-ber that relationships with directors may

in some contexts be disqualifying, evenif they’re not economic relationships. — Meredith M. [email protected]

— William D. [email protected]

How “Independent” is Independent Enough? (cont. from page 3)


recipient’s “base amount,” which, inthe case of an employee, is generallythe individual’s average W-2 com-pensation for the five calendar yearspreceding the calendar year in whichthe change of control occurs.1 Thisamount is usually referred to as the“Safe Harbor Amount.”

This tax (and the loss of the deduc-tion) does not apply with respect tochange of control of a corporation thathad no class of stock that was readily onan established securities market2 imme-diately prior to a change of control solong as, after adequate disclosure toshareholders of all material facts con-cerning all payments that would besubject to such tax, the persons who,immediately prior to the change ofcontrol, owned at least 75% of the votingpower of all outstanding stock of thecorporation entitled to vote approvedthe making of such payments. Thisapproval must determine the right ofthe affected individuals to receive theapplicable payment.

Prior PracticeWhat this has meant in the past is that, whenever any compensatory plan,program or arrangement has beenadopted by a closely held company,shareholders would approve the provi-sions of that arrangement which would

permit the payment of additional com-pensation (or that would accelerate thetiming of the payment of such compen-sation) upon a change of control. Thus,when a new stock-option plan wasimplemented that had a provision toaccelerate vesting upon a change ofcontrol, or an employment agreementwas being negotiated that wouldprovide for severance benefits (whetheror not specifically related to the occur-rence of a change of control), theapproval of the requisite shareholderswould be obtained at that time. Thisallowed the participants in the plan orthe employee covered by the agreementto know with certainty what benefitswould be payable upon a change ofcontrol, and still provide the opportu-nity to preserve the deduction for thecorporation and for the employee toavoid the added tax. The only perceivedrisk was that the shareholder populationmight change sufficiently prior to theactual change of control so that thosewho approved the payment would notqualify to grant the required approved;that is, the approving shareholders wouldnot constitute 75% of the shareholdersof the outstanding stock entitled to voteat the time of the change of control.

The New StandardThe Revised Regulations now specifythat to meet the applicable disclosurerequirements there must be “full and truthful disclosure of the materialfacts” surrounding the parachutepayments that are the subject of theshareholder action. However, indefining what is material, the IRS hasmade it virtually impossible to meetthis standard of approval prior toknowing the details of the actual changeof control upon which the paymentsare eventually to be made:

For each disqualified individual,material facts that must be disclosedinclude, but are not limited to, theevent triggering the payment or payments, the total amount of thepayments that would be parachutepayments if the shareholder approvalrequirements... are not met and abrief description of each payment(e.g., accelerated vesting of options,bonus, or salary). An omitted fact is considered a material fact if thereis a subsubstantial likelihood that areasonable shareholder would con-sider it important.3

Thus, while not all payments thatwould or could be parachute paymentsneed be presented to shareholders forapproval, the IRS requires disclosure ofall parachute payments for the approvalof any such payment to be effective. Thispresents two huge practical problems:

1. How does the corporation identifythe “total amount of the payments”that would be parachute payments inadvance of the actual transaction?

2. If an employee is to receive morethan one parachute payment, howdoes the approval of each such pay-ment both determine the right toreceive the payment and discuss all of the payments that may be made?

Presumably, the IRS would have torecognize that the “total amount” maybe determined by a formula, since it isoften the case that the actual amountpayable to shareholders in a change ofcontrol will not be known at least untilclosing (such as in a stock for stockdeal where the value of the considera-tion to be received can fluctuate withmarket prices) or after closing (such aswhere there is a closing balance-sheetadjustment or an escrow arrangementor earn-out that is not settled until wellafter closing). It might be possible to

Presented for Your Approval: Parachute Payments Enter the Twilight Zone (cont. from page 1)

1 If the employee has been employed less than five years,the average is generally determined based on his or herperiod of employment.

2 Because this provision treats all entities that are consid-ered part of the same control group of corporations forfederal tax purposes as a single entity, to use this exception,no other company under common control with suchcompany can have any class of stock that is traded on anestablished securities market.

3 The IRS has also stated that the disclosure must be madeto every shareholder of the corporation entitled to vote.Since these shareholders are determined “immediately priorto the change in control,” any change in the composition ofthe shareholders (other than during the limited grace periodpermitted under the regulations) would cause this conditionnot to be satisfied.


assert that this disclosure requirementcan be met by illustrating the effect ofthe change of control provisions atvarious stock prices or with the appli-cation of other sets of assumptions(such as the date at which an employee’semployment would terminate due to a change of control), so that share-holders would generally understandthe amounts that could possibly bepayable upon an actual change of con-trol. However, the IRS position on thefirst issue clearly precludes the abilityto give a blanket approval of a genericprovision, such as with respect to achange-of-control provision in a stock-option plan, as the shareholders willnot know the amount payable to eachemployee, nor will they be able todetermine such amount pursuant to a formula, as they will not know theamount of options that each suchemployee will eventually hold.

Moreover, even if the shareholderswere to approve each and every compensatory arrangement that con-tained any change of control provisions,the requirement that the shareholdersreceive disclosure of all parachute pay-ments cannot be met if an employeereceives a stock-option grant withchange-of-control provisions, a sever-ance commitment or a retention pay-ment after the date on which a priorchange of control benefit has beenapproved. For example, if an executive is granted stock options, the vesting of which is contingent on a change incontrol, in year one; awarded in year-two participation in a bonus plan thatpays prorated payments in the event of a change of control; and granted aseverance commitment in year three(whether or not specifically contingenton a change of control), none of thesepayments could be approved by share-holders at the time that they wereadopted and satisfy the requirementsimposed by the IRS in the Revised

Regulations. If each were approved asadopted, the corporation could not givethe shareholders adequate disclosure at the time of adoption of the first twobenefits in the example, because allparachute payments would not beknown at that time due to the additionof the third benefit. Moreover, as theshareholder approval “must determinethe right of the disqualified individual to receive the payments,” approval afteradoption will generally not satisfy thiscondition. Thus, approval of the first twobenefits could not be obtained when thelast benefit is approved, because theseearlier benefits will already have beenapproved or committed when the lastbenefit is adopted.

What the Executives Will WantIt is unlikely that the employees atprivately held companies will be willingto leave to some future shareholdervote the question of what severancethat they will receive or what happensto their options in the event of a changeof control. They will argue (as do theexecutives at public companies) forcertainty and for the corporation to bearthe possible impact of the parachuteprovisions by providing a full tax gross-up so that the corporation pays all thecosts associated with the additional taxon the employees, including the incomeand employment taxes payable withrespect to the gross-up. And the cost of the gross-up (which itself will beentirely non-deductible) will be in addi-tion to the lost tax benefits that thecorporation will incur due to the denialof the tax deduction.

RecommendationThe best solution is half a loaf now, withthe rest to come on a contingent basis.That is, change-of-control provisionswould be incorporated into the variouscompensatory agreements, as they havebeen in the past. Now, however, all com-

pensatory arrangements would providethat, in no event, will the amounts pay-able in connection with a change ofcontrol exceed the Safe Harbor Amountreferred to above, unless the shareholdersvote, in connection with the transaction,to remove the cap. Existing programscould be revised to add such a limit.This may require employee consent, butif there is no commitment regarding a gross-up, the employee will very likelybenefit from the proposed revision,because he or she will bear the burdenof the added excise tax. Employees whohave gross-ups will be reluctant to givethem up, but that could be made acondition of any future compensationaward that is made (including an addi-tional award that is an inducement towaive the gross-up).

By imposing the cap, the employeeswould have a commitment up to themaximum amount that could be paid to them without the additional tax beingapplicable, which can provide themsignificant benefits given the favorableway in which the parachute impact ofcertain awards – such as time-vestedstock options – is measured for pur-poses of applying such a cap. And, ifthe shareholders agree to lift the cap,the full benefits would be paid, without a tax and without the loss of any taxdeduction. Moreover, the corporationcould even commit to employees toexercise its commercially reasonablebest efforts to obtain the necessaryshareholder approval at the time of thetransaction. No shareholder shouldmake any legally binding commitmentprior to the time the actual vote issought in connection with the actualchange of control transaction. However,a shareholder might, in appropriatecircumstances, earlier express its then-current intention to support the waiverof the cap if and when requested. — Lawrence K. [email protected]


Fund Terms and Conditions: Beware of “Solving the Valuation Conundrum” (cont. from page 5)

Those assumptions may change overtime (look, for example, at valuations inthe telecommunications and energyindustries today versus 1999). Investingin privately held concerns means thatthere is no reliable market available forcomparison.

However, there are some thingsinvestors and sponsors can do to helplessen some of the tension surroundingvaluation issues. Investors can take stepsto educate themselves, such as under-

standing their sponsors’ valuationmethodologies and discussing with thegeneral partner the fund’s approach todistributions when there are problems in the portfolio. Sponsors, in turn, whilecontinuing to pursue uniform standards,will be well served by maintaining openlines of communication with theirinvestors about the fund’s investments.Sponsors need to be frank with theirinvestors when a portfolio company istroubled, take write-downs when war-

ranted and take steps to assure theirlimited partners that they are doingeverything in their power to avoid aclawback situation. Trust on each sidethat the other party is working towardsunderstanding the particular portfolioand doing what is necessary to avoid a clawback can go a long way towardavoiding this particular risk of privateequity investing. — Jennifer J. [email protected]


Making Sense of the Cash Balance Plan Brouhaha (cont. from page 9)

ment and then discount back using agovernment-prescribed interest rate tothe date the lump-sum payment is tobe made. This is a hard-and-fast rule,and by requiring that the government-prescribed discount rate be used isintended to prevent individuals (whomight not know about present valueconcepts, etc.) from “selling” theirpension benefit for too little.

Early designers of cash balancepension plans wanted the lump-sumpayment always to equal the indi-vidual’s account balance at any time. That was one of the hoped-for design“features” or selling points of cashbalance plans. Young and mobileworkers would know that their benefit at any time was their account balance,which was portable in that they couldtake the money if they left the company(and roll it over into an IRA or otherplan if they desired).

Thus the goal of the designers ofcash balance plans was to “force” theearly lump-sum payment to equal theaccount balance. The only way to besure of this is to project forward from

termination of employment to normalretirement age, and then discount backagain at the same interest rate. Thus,one approach would be to take theaccount balance and project forward atthe interest rate that would be creditedto the account balance under the plan,and then discount back using that rate.That, however, was found to run afoulof the requirement that the early lumpsum be discounted back from thenormal retirement age benefit at thegovernment-prescribed interest rate.

The other approach to “force” anearly lump sum to equal the accountbalance would be to project forward atthe government-prescribed interest rateand then, safely, discount back at thatsame prescribed rate. However, when adifferent (and more favorable) method is used to credit interest on the accountsof those employees who have not leftservice, this approach denies the partic-ipant a portion of his or her accruedbenefit. For example, if the plan providesthat an individual’s account balance will generally be credited at a floatingone-year T-Bill rate, then that is whathas to be used to project forward tonormal retirement age, rather than therate that the government prescribes foruse in discounting the normal retire-ment benefit back to its present value.

So the bottom line is: A cash balanceplan is subject to the rules for definedbenefit plans. When calculating earlylump-sum payouts, the plan rate mustgenerally be used to project forward tonormal retirement age. The govern-ment-prescribed rate must be used todiscount back. These rates will usually

differ, so the hypothetical early lump-sum payment calculated for eachindividual will, as a result, differ fromthe individual’s account balance. Thiswas the issue for Xerox, and a costlyone because the normal crediting ratewas much more generous than theapplicable discount rate.

These mismatch quirks could cuteither way, depending on the differencebetween the rate being used to projectthe account balance forward to normalretirement age versus the rate that mustbe used to discount back to determinethe lump sum. (Although the plan shouldbe able to use the account balance as a floor, that is, as the minimum amountpayable.) In Xerox’s case, it helped theindividuals. Which is why the plan partic-ipants sued. The law does, however,seem settled that there is no “hybrid”exception to the defined benefit pensionplan rules on how to calculate lump-sum payments made ahead of normalretirement age. Buyers of companiesshould make sure that any cash balanceplans in the target company havetackled this issue and that early lump-sum payments as well as employeedisclosure of “lump-sum” accountbalances has been accurate.

The Trouble With Cash Balance Plans: Round 3The IBM case broke some new groundin the dispute over cash balance plansbecause the district court judge foundthat in addition to all of these otherproblems with cash balance plans, theplans actually violated a provision ofERISA that acted as a prohibition againstage discrimination.

The IBM case broke some

new ground in the dispute

over cash balance plans

because the district court

judge found that in addition

to all of these other problems

with cash balance plans,

the plans actually violated

a provision of ERISA that

acted as a prohibition

against age discrimination.


The district court’s reasoning wasseductively simple (and distressinglyconclusory), and can be summarizedas follows: Section 204(b)(1)(H) ofERISA prohibits a plan from reducing“the rate of an employee’s benefitaccrual…because of the attainment ofany age.” Although the law does notdefine what “the rate of an employee’sbenefit accrual” means (that would be too helpful), it must be measured by the value of an annuity commencingat normal retirement age (65). If thereare two employees identical except forage, a cash balance plan formula thatcredits them with the same formulaamount discriminates against the olderworker. How can this be? Because thatsame dollar credited to the youngeremployee will grow over time andproduce a larger annuity at his normalretirement date, whereas the dollarcredited to the older employee will notgrow as much because there is lesstime for the employee to receive theinterest credits before retirement.

This article is not the place for adetailed discussion of the merits of the district court’s decision in the IBMcase, but suffice it to say there aresome flaws in the court’s reasoning.Another district court in Onan Corpor-ation, a particularly detailed opinion,also examined this same question andheld exactly to the contrary, reasoningthat a review of the legislative historyshowed that the provision at issue wasintended to apply only to situationswhere the employee continues to workbeyond normal retirement age, a factthat is apparent from the very headingof the corresponding provision of theInternal Revenue Code. (ERISA and

the Internal Revenue Code have manyprovisions that are intended to operatein tandem. Only the ERISA section wasproperly before these courts, becausethe meaning and interpretation of theCode provisions are between the IRSand the plan and sponsoring employer.)

In addition, even if the ERISA provi-sion were intended to apply in thesecircumstances, there is no such require-ment that “the rate of an employee’sbenefit accrual” be measured solely byreference to the value of an annuitycommencing at normal retirement age,a concept that got the IBM court befud-dled. As noted below, the IRS has issuedproposed regulations that address thisvery requirement and take a contraryview of this requirement in the context of cash balance plans.

So Where Are We Now?It’s important to note that defenders of cash balance plans are not propo-nents of age discrimination. A findingthat the particular ERISA provision atissue in the IBM case is not a violationof the non-discrimination rule wouldstill leave a whole armada of protec-tions for employees. It may be that it is too late to change the political tenor of the plan debate, but it is a pointworth keeping in mind.

If we were keeping score, one districtcourt has held that cash balance plansviolate the prohibition on age discrim-ination, but without much analysis.Another court in a fully reasoned opinioncame to the contrary conclusion. Stillanother district court volunteered thatcash balance plans do not violate theage-discrimination rule, but this was in non-binding dicta. Three Courts ofAppeals have looked at cash balance

plans in depth and failed to note thisalleged fundamental flaw, but that issuemay not have been properly raised be-fore those courts, so we should not taketoo much comfort from this.

The IRS has issued proposed regu-lations that would provide an expresssafe harbor under the tax Code’s analo-gous no-age-discrimination provisionfor cash balance plans that met certainrequirements, so it appears that the IRSand the Treasury do not share the viewsof the IBM court. Recently, however, theHouse of Representatives tacked on aprovision to an appropriations bill thatwould prohibit the IRS from issuingthose regulations in final form. So whoknows if the regulations will be issued.

At this point, IBM’s much-publicizedappeal and a reversal of the districtcourt’s decision would help remove some(but not all) of the uncertainty that hangsover cash balance plans, an uncertaintythat buyers and sellers of companiesmay assess differently (and therefore“price” differently). Some quantum ofrisk remains. Even ill-reasoned decisionslike the one in the IBM case sometimesdo prevail.

A legislative solution would avoid all doubt, but gridlock seems the order of the day, and resolving the confusionover cash balance plans may not be highon Congress’ list – particularly becauseof some of taint that goes back to theway plans were converted in the past.Until the law is clearer, it may be hard toassess the impact of cash balance planson acquisition transactions. — David P. [email protected]


An Introduction to Private Equity Firm D&O Insurance Coverage (cont. from page 15)

number of technical requirements.Although these requirements will needto be reviewed on a case-by-case basis,they are unlikely to create difficulty in thecontext of typical private equity carriedinterest arrangements. The safe harborenvisages that the carried interest will beheld through an English limited part-nership, but it recognizes that non-UKinvestors may invest through alternativestructures (for example, a limited partner-ship formed under the laws of Delawareor the Cayman Islands).

The safe harbor does not apply toissuances to executives of (or increasesin an executive’s interest in) carriedinterest in relation to portfolio invest-ments that have appreciated in valueon an aggregate basis. For example, if

an executive forfeits all or a portion of his or her carried interest in respect of appreciated portfolio investments in connection with the termination of the executive’s employment, and theforfeited carried interest is reallocatedto the other fund executives based on a formula or otherwise, the other exec-utives who are resident and ordinarilyresident in the UK will be subject to tax under Schedule 22. In this situa-tion, the UK-based executives shouldconsider whether to make the electionto be taxed currently under Schedule 22 in order to reduce the eventual taxcharge at the time the fund makesdistribution of carried interest.

The new safe harbor for carried inter-est holders affords significant relief for UK-based carried interest holders.

Nevertheless, it is important to get aUK tax advisor on board to ensure thatissuances and reallocations of carriedinterest are structured in the most taxefficient manner for the UK-based executives and the private equity firm,particularly in light of the short timeframe for making the election underSchedule 22 if the safe harbor is notavailable. Since the new rules are broadlydrafted and the safe harbor will requiresome interpretation, the UK tax advisorwill also be able to advise upon the wayin which market practice in relation toSchedule 22 is evolving. — Peter F. G. [email protected]

— Kerry [email protected]

that a portfolio company should haveits own D&O policy. If coverage needsto be extended (because the portfoliocompany has no coverage or inade-quate coverage), information about theparticular portfolio company boardmembership should be obtained andsubmitted to the insurer. The insurerwill review the information and mayextend coverage on a case-by-case basis,perhaps with an additional premium.

Under certain policy forms, coveragefor the directors becomes unclear inthe event of bankruptcy of the insuredcompany. In the case of bankruptcy, in order to maintain the policy for thebenefit of the directors and officers,express language must be included inthe policy to make sure the directorsand officers will continue to be covered

in the event the corporation is financiallyunable to indemnify them. In addition,suits brought by a bankruptcy trusteeor creditors’ committee against thedirectors and officers should expresslybe included as covered.

Another issue to look for is thatmost D&O insurance policies expresslyexclude coverage for liability arising out of an individual rendering “professionalservices.” Thus, when a director orofficer, who, for example, is a CPA,renders advice in his or her capacity as an accountant, liability arising fromaccounting errors is most likely notgoing to be covered by most D&O poli-cies. The professional services exclusionin firm D&O insurance could be verybroad and, in some cases, should bemodified or a separate professional

liability insurance policy may be appro-priate to provide full protection.

ConclusionPrivate equity firms thinking aboutpurchasing firm D&O insurance shouldclosely evaluate their exposures andmake sure that the policy is crafted toaddress their particular needs, includingtheir organizational structure. Properlytailored firm D&O insurance can be anasset in attracting talented individualsto private equity firms. It is importantto review the proposed firm D&O insur-ance form and endorsements thoroughlyto ensure that the private equity firm is properly covered. — Robert J. [email protected]

— Heidi A. [email protected]

UK Provides Relief for Carried Interest Holders from Application of New Tax Rules (cont. from page 17)

Is It Time for a Power Play? (cont. from page 18)


entrench an existing distribution ortransmission network.

• Private equity firms may also have anedge over regulated utilities where thetarget is, or includes, so-called “quali-fying facilities” (QFs). The Public UtilityRegulatory Policies Act of 1978 (PURPA)was enacted by Congress to encouragethe introduction of non-utility genera-tors into the U.S. electric industry. QFsinclude certain cogeneration units orsmall power-production facilities ofup to 80 megawatts. PURPA accordsQFs two principal benefits: (1) requiringelectric utilities to purchase QFs elec-tric output at the utilities’ avoidedcosts of producing power and alsorequiring that they interconnect withany QF in their service territory; and(2) exempting QFs from the provi-sions of the Public Utilities HoldingCompany Act and the Federal PowerAct, including provisions relating to rate regulation. Because PURPArestricts the ownership of a QF to “aperson not primarily engaged in thegeneration or sale of electric power,”where a target includes QFs that haveabove-market, long term power salescontracts (as is frequently the case), a private equity firm (unlike a regu-lated electric utility) may be able topreserve the attractive economics ofQF status post-acquisition.

Bridging the Experience GapWhile private equity players may havesome advantages as potential buyers,they are likely to be starting from asignificant knowledge deficit in a highlycomplex industry. This deficit poseschallenges for informed pricing. Thereis the need to evaluate the condition of assets, related fuel and transmissionarrangements, environmental risks,applicable regulatory framework, existingoutput/power purchase agreements,

dispatch constraints, operational agree-ments and the ins and outs of theenergy-trading business. Moreover,given the substantial uncertainty as towhen the market for generation assetsmay rebound, any prospective buyerneeds a clear strategy for operating anddeploying resources during the interimperiod. To address this steep learningcurve, a number of approaches areopen to private equity sponsors andinvestors, including:

• Hiring experienced industry players.With the slump in energy-tradingoperations and IPPs, it should comeas no surprise that there are personswith substantial industry experienceavailable in the marketplace. Suchindividuals can be invaluable to equityfund sponsors in the due diligenceprocess and in monitoring risk manage-ment and operations post-acquisition.

• Equity fund/industry-player partnerships.Creating a successful new privateequity fund requires substantial timeand effort. Some power/energy playershave sought to shortcut that processand speed their access to capital byjoint venturing with an existing majorprivate equity fund interested in gainingexposure to the market.

• Partnering with sellers. Given thecomplexity of efficiently operating ageneration facility and trading its out-put, it may make sense to structureacquisitions where sellers providethese services going forward, eitheron a pure contractual basis or inconjunction with a retained owner-ship interest or output arrangement.The questionable credit of manysellers adds risk to over-reliance uponthis approach, however.

• Partnering with fuel suppliers. Most of the newer power generation on the market is gas fired, and fuel

supply is the greatest expense of gas-fired generation. It may be possible to address fuel supply and associatedcost fluctuation risks by partneringwith a gas supplier willing to enterinto a tolling agreement, providing for an assured long-term gas supplyin return for a portion of the output of the facility.

• Sector-specific funds. On the investorside, a number of private equity fundsfocusing on the power and energysector have been set up in the last fewyears. Given the volume of assets onthe market, and the prevailing sensethat the current depressed market maynot last for long, the number of follow-on funds, as well and new funds ofthis type, are likely to be multiply in thenear term.

Notwithstanding the numerouschallenges facing the energy sector andthe not-inconsiderable barriers to entryfor a non-strategic buyer, private equityfirms may find with careful planningand structuring that the power play is a golden opportunity. — John M. Allen, [email protected]

Creating a successful new

private equity fund requires

substantial time and effort.

Some power/energy players

have sought to shortcut that

process and speed their access

to capital by joint venturing

with an existing major private

equity fund interested in gain-

ing exposure to the market.

France: Private Placement of Foreign Closed-End Funds Now Easier

alert

Two recent amendments to French law now make it easier for foreignclosed-end funds to privately placetheir interests in France, especiallythose funds established in non-Organ-ization for Economic Cooperation andDevelopment (OECD) countries andthose offered to “qualified investors.”

The Prior RegimeUnder French law, an offer of financialinstruments (including interests in a non-French closed-end fund) is con-sidered a private placement, andtherefore exempt from the prospectusdelivery requirement, if it is made to“qualified investors” and/or a “closecircle” of investors acting in each casefor their own account. “Qualifiedinvestors” are institutional investorsand other corporate investors speci-fically listed in the law. A “close circle”of investors consists of investorsother than “qualified investors” whoknow one of the members of theissuer’s management personally andwho have either a family or profes-sional relationship with such member.

Until recently, the implementationof these private-placement exemptionswas subject to two major obstacles.

First, it was not possible for fundsestablished in jurisdictions that werenot members of the OECD, such asthe Cayman Islands, to offer their inter-ests in France, even under a private-placement exemption, without the priorauthorization of the Ministry of Finance.This authorization was never granted.Thus, an offering in France of interestsin Cayman Islands funds, even to a

few institutional investors, was impos-sible. Fund sponsors and their advisorshad developed the practice of makingthe placement outside France, (i.e.,sending the offering materials to anaddress outside France, executing the subscription agreement outsideFrance and having the stock certifi-cates, if any,depositedwith a custodianoutside France).

Second, the démarchage (solicita-tion) rules were very restrictive. Inparticular, démarchage was prohibitedwith respect to financial instruments(including interests in a closed-endfund) not listed on a stock exchange.Whereas the démarchage rules wereclearly intended to be consumer-pro-tection rules, this prohibition applied to offerings made under the private-placement exemptions, including to“qualified investors.” As interests inclosed-end funds are almost neverlisted on an exchange, this meant that offerings to “qualified investors,”although exempted from the prospec-tus delivery requirement, could nottechnically be offered to such investorsby way of démarchage. In order to avoidthis restriction, and, as suggested by the French Securities Commission, it was usually recommended that theoffering materials be sent to potentialinvestors upon their written request.The subscription agreement was sentsubsequently, and only upon thepotential investor’s written request.

The Liberalized RulesThe first amendment makes theoffering of closed-end funds estab-

lished in non-OECD countries, suchas the Cayman Islands, possible.Decree No. 2003-196, dated March 7,2003, no longer requires the priorauthorization of the Ministry of Financewith respect to the offering of interestsin closed-end funds. Authorization is,however, still required for the offeringof non-OECD open-end funds.

The second improvement resultsfrom amendments to the démarchagerules, which were introduced by LawNo. 2003-706 dated August 1, 2003.Similarly to the old provisions, thenew law prohibits the démarchage ofpersons for the purchase of financialinstruments (including interests innon-French closed-end funds) whichare not listed on a French or E.E.A-regulated market or a “recognized”market. The new law, however, expresslyprovides that the démarchage rules do not apply to contacts with “qualifiedinvestors.” On the other hand, anoffering made in reliance on the “closecircle” private-placement exemptionremains subject to the démarchagerules. For example, an offering of inter-ests in a non-French employee fund to employees in France will be subjectto the démarchage rules, even if it can be made in reliance on the “closecircle” private-placement exemption.

If you have any questions concerningthe application of the new rules, pleasecontact our Paris office. — Sylvie [email protected]


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