How To Refinance A Distressed Company While Walking The Fiduciary-Duties Line Abstracted from: Dilutive Venture Capital Financings Of Distressed Companies

Thursday, September 4, 2003

Richard Dickson & David Bell, CAReview of Securities & Commodities Regulation - Vol. 36, No. 5, Pgs. 73-81, http://www.fenwick.com

How To Refinance A Distressed Company While Walking The Fiduciary-Duties Line Abstracted from: Dilutive Venture Capital Financings Of Distressed Companies

By: Richard Dickson and David Bell Fenwick & West, Palo Alto, CAReview of
Securities & Commodities Regulation - Vol. 36, No. 5, Pgs. 73-81

Overview: Describes the conflicts of interest that directors face when arranging for the dilutive financing of a company in financial distress. Suggests actions that the board can take to protect the directors against conflict-of-interest claims.

Clash of fiduciary duties.
The directors of distressed, venture-capital-backed companies, like other corporate directors, are bound by duties of care and loyalty. As Richard Dickson and David Bell make clear, when the company seeks additional financing from its existing investors, the effects are dilutiveparticularly for those investors who choose not to participate in the new funding round. Board members who
represent the funding investors walk a fine line. They may benefit because
the company’s valuation and therefore the price of its shares will be lower than in prior rounds. Yet directors may not act in their own self-interest unless the actions are completely fair to the company and the shareholders. When the company is insolvent, directors may owe fiduciary duties to the creditors rather than the shareholders, but if the board’s actions or inactions brought the company to this precipice, directors who approve an inside-led round of dilutive financing face an increased risk of litigation.

To show that they have exercised the requisite level of care,
the directors must consider all alternatives in addition to the dilutive financing. If it determines that the financing is appropriate, the board is wise to enlist an independent third party to lead the investors and set the financing terms or obtain an independent appraisal of the company, and then carefully document these efforts.

Obtain appropriate approvals.
A committee of disinterested directors should approve the transaction whenever the deal will be led by an investor affiliated with the company. As a practical matter, remind the authors, it is often difficult to form a committee of disinterested directors because most of the directors represent prior investors or officers who may have conflicts of interest.

Different stockholder approvals will be required depending on the structure of the transaction. Although getting the approval of a majority of the disinterested stockholders seems helpful, it sometimes is difficult to determine which stockholders will participate in the later round until the actual closing.

Rights offerings.
The board can minimize the risk of a dilutive financing by making a rights offering to existing shareholders. This would give the existing shareholders the opportunity to participate in the financing on the same terms as the investors represented by the interested directors. Directors may want to expand the rights offering to include any warrant and option holders. Unfortunately, the authors caution, employee warrant and option holders often are not accredited investors. As a result, the offering may not qualify for the securities law exemptions that the company would like to use. The directors will need to ascertain how many shares are offered to each security holder, which may be especially difficult if the offering is oversubscribed.

Special financing terms.
Distressed companies frequently must accept terms that would be unacceptable to a financially sound enterprise. The authors
list several possibilities: for example, the investors may demand
liquidation preferences that are senior to the preferences granted to earlier-round investors; preferences for more than 100% of their
investment; recapitalization of the existing security structure, converting the existing preferred stockholders to common stockholders; the right to force the other stockholders to sell the company at any time when it is in the interest of the new investors to do so. The financing might also impose special terms to retain key management who would otherwise be inclined to leave because of the company’s financial difficulties.

Abstracted from Review of Securities & Commodities Regulation, published by
Standard & Poor’s, 55 Water Street, New York, NY 10041

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