Private Equity and the Impact of the COVID-19 Pandemic: Part 3 of 3

Viviane Falzon is the Head of Complex Management Liability Claims at Ironshore /Liberty Mutual Insurance Co.  Viviane has been with Liberty since October 2016 in her current role.  She has 30 years’ experience in the insurance industry and is licensed attorney with diversified claims and underwriting experience in domestic and international Financial Lines and Specialty insurance products, including Directors and Officers, Investment Managers and Financial Institutions, Professional Errors and Omissions, Employment Practices Liability, Pension Trust Fiduciary Liability, Crime and Fidelity, Cyber Crime and Liability, Representations and Warranties, Surety, and Construction Risk policies.

Scott A. Schechter is a partner at Kaufman Borgeest & Ryan LLP and has been with the firm since 2001.  Scott’s practice concentrates on representing international and domestic insurers in all aspects of claims handling and coverage litigation, particularly in the areas of Directors and Officers Liability, Financial Institutions Liability (with an emphasis on banking, private equity, hedge funds, venture capital, and investment advisers), and Professional Liability.  Scott also defends individuals and companies in professional liability and commercial litigation.

Joshua A. DiLena is a partner at Kaufman Borgeest & Ryan LLP and has been with the firm since 2010.  Joshua’s practice focuses on Management and Professional Liability involving financial institutions, particularly private equity firms; and also includes the areas of public and private Directors and Officers Liability, Errors and Omissions, and Fiduciary Liability.  Joshua represents insurers in all aspects of the claims handling process, as well as coverage litigation.

Matthew E. Mawby Is a partner at Kaufman Borgeest & Ryan LLP and has been with the firm since 2015.  Matt’s practice focuses on complex coverage litigation and arbitration, particularly in the areas of Financial Institutions Liability, Directors and Officers Liability, Professional Liability, and Employment Practices Liability.  Matt also counsels international and domestic insurers in all aspects of claims handling and resolution of coverage disputes.  Matt also defends individuals and companies in commercial litigation and arbitration.

Andrew S. Paliotta is an associate attorney at Kaufman Borgeest & Ryan LLP and has been with the firm since 2018.  Andrew’s practice concentrates on representing international and domestic insurers in insurance coverage matters and coverage litigations/arbitrations involving Directors and Officers Liability, Employment Practices Liability, Errors and Omissions, and Professional Liability claims.  Andrew also represents commercial entities in arbitration and litigation in both state and federal court in professional liability actions and various commercial and construction claims.

This post is Part 3 of this article. Part 1 is available here, and Part 2 is available here

VIII. Impact on SPAC Transactions

A special purpose acquisition company (“SPAC”) – also referred to as a “blank check company” – is formed to raise funds through an initial public offering (“IPO”) to be used to acquire an operating company or companies at a later date.[1]  The SPAC’s offering documents are not required to identify any specific target company; and the funds raised through the IPO could be utilized for any business combination in the future (subject to certain time restraints and possibly a focus on a specific industry sector), thus the moniker “blank check.”

Naturally, a public equity offering via an IPO does not constitute a private equity transaction.  Historically, private equity fund managers may have engaged in transactions with unaffiliated SPACs in order to divest an underlying portfolio company.  In recent years, however, a number of private equity fund managers have branched out to sponsor their own SPACs.[2]  For example, Apollo Global Management (a leading private equity fund manager) recently announced that it was seeking to raise $400 million in a SPAC IPO.[3]

In 2020, SPACs (broadly, not limited to private equity sponsored SPACs) raised over $83 billion in IPOs, more than six times the total from 2019 ($13.6 billion).[4]  So far in 2021, SPAC IPOs have already surpassed the record figure set in 2020, raising more than $95 billion.[5]  One of the protections offered by a SPAC is that funds raised through the IPO (or the vast majority thereof) are required to be held in trust until deployment on the ultimate acquisition.  If the acquisition does not occur within a set time-frame (typically two years from the IPO), the funds are to be returned to the investors (plus accrued interest); and the investors also have an opportunity to seek redemption of their shares at the IPO price at the time the ultimate transaction is announced.  As such, SPACs can be viewed as a favorable investment opportunity with downside protection in uncertain economic times.[6]

As with secondaries discussed above, the investor demand for SPAC opportunities may exceed the underlying supply of acquisition targets, with estimates of $40 billion in IPO proceeds available for acquisition targets.[7]  As noted above, SPACs are required to complete a business combination within a set timeframe; or return the IPO proceeds to the investors.  The SPAC sponsor (or founder) does not typically receive compensation until the closing of the business combination (at which point its “founders shares” would equate to a 20% ownership in the combined entity).  This may create an incentive to push through deals on tighter time frames – particularly if the market turmoil created by the pandemic continues well into 2021 – and could lead to allegations of lack of due diligence caused by conflicting interests.

VIII.    How has COVID-19 affected Liberty Mutual in Underwriting Products offered in the Private Equity Space?

Management Liability Market

For the past five years, the Private Equity Liability space has been identified as an area of focus and growth for Ironshore Insurance, (specialty underwriter for Liberty Mutual). We are currently building a portfolio of policies and insureds across a diverse spectrum of fund sizes and investment strategies.

Ironshore currently has dedicated teams underwriting the Private Equity and General Professional Liability (GPL) Lines along with Portfolio Company D&O (Commercial D&O). We consider ourselves as differentiators in the marketplace because of our diverse underwriting experience and knowledge, our constant collaboration between our Claims and Underwriting teams, and Liberty Mutual’s Financial Strength and relationships with Private Equity Firms.

Certainly COVID-19 has presented challenges in underwriting this business.  In addition to taking into consideration the financial strength and financial health of Portfolio Companies, we are looking into how the Private Equity Sponsors have assisted their Management teams throughout the crisis.  We are focusing on building a book of business based on limits management and attachment points with Insureds and Sponsors having Assets Under Management or Committed Capital of between $250 million and $10 billion.  While we will entertain submissions from a broad array of investment mandates, our underwriting appetite is concentrated on the prospective management team, experience and prior performance.

Ironshore’s Financial Institution team currently underwrites its standard Private Equity /General Partnership  Liability Policy for Fund Sponsors which provides the following coverages: Management Liability (D&O), Investment Advisor’s E&O (PL), Employment Practices Liability, Pension Trust Liability, and Crime coverage.  The Commercial D&O team underwrites coverages for the Portfolio Companies on Ironshore’s corresponding Public or Private D&O insurance forms, Employment Practices Liability, Fiduciary Liability and Crime Policies. The optional Crime coverage is underwritten by our Fidelity team of underwriters.  These products have been widely recognized as a competitive “base” form in the marketplace.

Liberty Mutual can also offer core coverages, such as workers compensation, general liability, auto liability, excess liability, umbrella, property, and inland marine, for Private Equity firms and their portfolio companies.

Representations & Warranty Market

In January 2019, Liberty Global Transactions Solutions (GTS) was formed in the United States to underwrite Representations & Warranties Policies.  The underwriting team has grown substantially due to this ever-developing market and demand for this product in the Private Equity space.  Currently, Liberty GTS has a team of 17 underwriters situated in New York, Houston, San Francisco, Boston and Toronto, Canada.  Most of our underwriters have experience as corporate attorneys so they are well versed in the needs of our corporate clients which consist mostly of Private Equity firms and strategic buyers.

Liberty GTS does business with the full brokerage communities. Underwriting these Private Equity deals has been challenging through COVID-19; however, we have seen a strong past several months of both submission and deals in active underwriting.  For instance, at the end of May 2020, we saw over 50% fewer submissions than we did at the same time in 2019 largely due to changes in the M&A landscape caused by COVID-19.  By the end of June 2020, we saw 22% fewer new submissions than in the prior year, and by the end of July 2020 we were down 9%.  However, by the end of August 2020, we started to see a shift as submissions were up by 23%, followed by 49% in September 2020.  This trend continued as we saw an increase in submissions by nearly 70% by the end of October 2020 and 93% by the end of November 2020 with no signs of slowing down.  Regarding bound deals, in 2020 we have almost doubled our numbers compared to 2019 and have seen a very busy and almost unprecedented M&A season as we approached the end of 2020.  We attribute this increase in business and success due to Liberty’s commitment to this line of business, the expansion of its underwriting team, its commercial mindset in getting deals done and working closely with its Claims organization in following through with its promises to its clients.

Conclusion

If anything is certain, it is that the COVID-19 pandemic has created a world of uncertainty for every aspect of daily life and the impacts of COVID-19 will continue long after the majority of the world is able to become vaccinated. For PE firms, the impacts will likely include increased due diligence into the types of businesses they invest in and the portfolio companies they acquire, as well as the potential for increased scrutiny of the employment practices of their portfolio companies and how they view business opportunities moving forward.  Given the impacts from COVID-19 creating the potential for heightened scrutiny and exposure for PE firms not just in the remainder of 2021, but potentially years from now, the pandemic is also creating unknown levels of uncertainty for underwriters in the professional liability market.  A recent special report issued by AM Best in conjunction with the Professional Liability Underwriting Society[8] found that two-thirds of respondents to a special survey found that the pandemic has created the highest level of severity on D&O renewal pricing – where reports indicate rate hikes of more than 20% and include more restrictive terms and conditions. Respondents also reported a “tightening” of terms and conditions on Employment Practices Liability coverage, which is not unexpected given the potential employment exposures discussed in this report.  For other professional lines, the impact may not be felt for years such as medical professional liability lines, where malpractice litigation related to COVID-19 may be delayed due to court backlog or legal battles over immunity statutes enacted in various states.

The first part of this article is available here, and the second part is available here

[1] https://corporatefinanceinstitute.com/resources/knowledge/strategy/special-purpose-acquisition-company-spac/

[2] https://pitchbook.com/news/articles/private-equity-spacs-2020s

[3] https://www.reuters.com/article/us-spartan-acquisition-ipo/apollo-backed-spac-aims-to-raise-400-million-in-u-s-ipo-idUSKBN26U2LS

[4] https://hbr.org/2021/02/the-spac-bubble-is-about-to-burst

[5] https://www.spacanalytics.com/

[6] https://www.penews.com/articles/the-spac-market-is-deflating-heres-why-20200817#

[7] https://www.spacanalytics.com/

[8] https://amp.insurancejournal.com/news/national/2020/11/13/590495.htm

Neither Ironshore nor any other Liberty Mutual company (the “Insurer”) are engaged in the practice of law. The foregoing information is for informational purposes only. It is not a substitute for legal advice from a licensed attorney, nor does it create an attorney-client relationship. The Insurer disclaims all liability arising out of this resource.

This document provides a general description of this program and/or service. Not all insurance coverages or products are available in all states or regions and policy terms may vary based on individual state or region requirements. See your policy, service contract, or program documentation for actual terms and conditions. Some policies may be placed with a surplus lines insurer. Surplus lines insurers generally do not participate in state guaranty funds and coverage may only be obtained through duly licensed surplus lines brokers.

Private Equity and the Impact of the COVID-19 Pandemic: Part 2 of 3

Viviane Falzon is the Head of Complex Management Liability Claims at Ironshore /Liberty Mutual Insurance Co.  Viviane has been with Liberty since October 2016 in her current role.  She has 30 years’ experience in the insurance industry and is licensed attorney with diversified claims and underwriting experience in domestic and international Financial Lines and Specialty insurance products, including Directors and Officers, Investment Managers and Financial Institutions, Professional Errors and Omissions, Employment Practices Liability, Pension Trust Fiduciary Liability, Crime and Fidelity, Cyber Crime and Liability, Representations and Warranties, Surety, and Construction Risk policies.

Scott A. Schechter is a partner at Kaufman Borgeest & Ryan LLP and has been with the firm since 2001.  Scott’s practice concentrates on representing international and domestic insurers in all aspects of claims handling and coverage litigation, particularly in the areas of Directors and Officers Liability, Financial Institutions Liability (with an emphasis on banking, private equity, hedge funds, venture capital, and investment advisers), and Professional Liability.  Scott also defends individuals and companies in professional liability and commercial litigation.

Joshua A. DiLena is a partner at Kaufman Borgeest & Ryan LLP and has been with the firm since 2010.  Joshua’s practice focuses on Management and Professional Liability involving financial institutions, particularly private equity firms; and also includes the areas of public and private Directors and Officers Liability, Errors and Omissions, and Fiduciary Liability.  Joshua represents insurers in all aspects of the claims handling process, as well as coverage litigation.

Matthew E. Mawby Is a partner at Kaufman Borgeest & Ryan LLP and has been with the firm since 2015.  Matt’s practice focuses on complex coverage litigation and arbitration, particularly in the areas of Financial Institutions Liability, Directors and Officers Liability, Professional Liability, and Employment Practices Liability.  Matt also counsels international and domestic insurers in all aspects of claims handling and resolution of coverage disputes.  Matt also defends individuals and companies in commercial litigation and arbitration.

Andrew S. Paliotta is an associate attorney at Kaufman Borgeest & Ryan LLP and has been with the firm since 2018.  Andrew’s practice concentrates on representing international and domestic insurers in insurance coverage matters and coverage litigations/arbitrations involving Directors and Officers Liability, Employment Practices Liability, Errors and Omissions, and Professional Liability claims.  Andrew also represents commercial entities in arbitration and litigation in both state and federal court in professional liability actions and various commercial and construction claims.

This post is Part Two of this article. Part One is available here, and Part Three will be available on the PLUS Blog tomorrow. 

IV. Unprecedented Bankruptcies

The COVID-19 pandemic and resulting societal shifts in the “norm” have had a devastating impact on businesses in the retail and hospitality spaces. People around the world were quarantined in their homes for months and unable to patronize these businesses and have experienced a complete change in the way they lived their lives.  There were 630 corporate bankruptcies filed in 2020, a 9% increase compared to 2019 and the largest number since 2010;[1] and over 40 of these bankruptcies involved companies with over $1 billion in debt.[2]

In some spaces, such as brick and mortar retail, the pandemic may merely be the final nail in the coffin for those businesses who have been facing declining sales due to the rise of e-commerce for years such as once retail giant Neiman Marcus (owned by a consortium including PE firm Ares Management) and J. Crew (owned by TPG Capital and Leonard Green & Partners)[3].   Further, a shift to “working from home” for many people around the globe for an unknown period of time has led to “business-wear brands” — practically unessential due to working from home — also filing for bankruptcy including Tailored Brands (Men’s Warehouse), Brooks Brothers and Ascena Retail Group, which owns Ann Taylor and Lane Bryant.[4]

In addition, with state and local governments having implemented bans on dining inside of restaurants across the country, over ten restaurant chains or operators of franchises have filed for bankruptcy since April 2020, including NPC International (the second largest franchise operator in the United States which operates over 1,600  Pizza Hut and Wendy’s chains), California Pizza Kitchen, Ruby Tuesday, Friendly’s Restaurants and Sizzler.[5]  Even with some states and cities moving to re-open indoor dining, or have already done so, people are still hesitant to patronize restaurants as they did pre-COVID, which may lead to additional bankruptcies.

Bankruptcies have always been a source of D&O claims brought on behalf of the debtor’s estate (by creditors or the trustee), and the pandemic may only increase claims brought against bankrupt entities’ directors, officers or shareholders.  These claims could include allegations of mismanagement, breach of fiduciary duties and corporate waste, including against PE firms that took dividends from struggling portfolio companies.  For insurers, an examination of the “Insured v. Insured” exclusion, which generally bars claims brought by or behalf of an Insured Organization, in D&O polices may be prudent at this time. While most I v. I exclusions contain a carve-back for actions brought by the Bankruptcy Trustee, Receiver or Liquidator, the identity of the persons or entities on whose behalf the underlying claim is being prosecuted can be confusing in the bankruptcy context as well as whether they fall within the carve-back.  One recent case on this issue is Westchester Fire Insurance Co. v. Schorsch et al., 2020 WL 4905056 (N.Y. App. Div. 1st Aug. 20, 2020).  In Schorsch, a creditor trust commenced an action against the debtor’s directors and officers, alleging that they had breached their fiduciary duties. The insurer denied coverage based on the policy’s insured vs. insured exclusion and the insured sued alleging the carve-back provided coverage for claims “brought by the Bankruptcy Trustee or Examiner of the Company or any assignee of such Trustee or Examiner, or any Receiver, Conservator, Rehabilitator, or Liquidator or comparable authority of the Company.” Id. at *3.  The Appellate Division, First Department in New York found that the carve-back restored coverage excluded by the I v. I exclusion, holding that “when read together, the bankruptcy exception restores coverage for bankruptcy-related constituents, such as the bankruptcy trustees and comparable authorities, and the insured vs. insured exclusion precludes the possibility of a lawsuit by a company as Debtor in Possession, or by individuals acting as proxies for the board or the company [and]… the D & O claims are prosecuted by the post-confirmation Creditor Trust, a separate entity” Id. at  6; and that “by including the undefined and open-ended phrase “comparable authority” into the D & O policy’s bankruptcy exception, the parties created a broadly applicable exception with no clear limiting principles other than that there should be no coverage where the D & O claims are prosecuted by the DIP or by individuals acting as proxies for the board or the company.”  Id. at 8.  As such, underwriters should be wary of including broad phrases such as “comparable authority” in policy clauses especially in the bankruptcy context where the identity of claimants can take many different forms, and in a post-COVID 19 world where an “explosion” of bankruptcies, including those that may not occur for several months, are likely on the horizon.

V. Unraveling of Previously Negotiated Deals in the Wake of COVID-19

What may have looked like a good business opportunity for PE firms in late 2019 or even early 2020 changed once the full effect of the COVID-19 pandemic and resultant shutdowns began to be realized.  This is especially true for certain mergers and acquisitions, three of which have recently been in the headlines.  In May 2020, the Carlyle Group, Inc. and GIC Pte. Ltd. backed out of their plans to purchase a stake in American Express Global Business Travel[6] as the pandemic wreaked havoc on the airline and hotel industry, with government shutdowns leading to airlines having to cancel flights and hotels needing to close.  In April 2020, COVID-19 led to a breakdown of a plan between L Brands and PE firm Sycamore Partners to take retailer Victoria’s Secret private. This breakdown led to a series of lawsuits being filed in Delaware by Sycamore Partners which alleged that L Brands’ decision to close down stores, furlough employees and forgo rent payments violated the merger agreement between the two parties, before the two parties agreed to cancel the deal.[7]

These two examples are dwarfed by the $16.2 billion acquisition of jeweler Tiffany & Co. by Moët Hennessy Louis Vuitton SE (“LVMH”), where LVMH filed suit in Delaware to void the agreement.  LVMH alleged that mismanagement by the Board of Tiffany & Co. during the pandemic, including the decision by Tiffany & Co. to pay its full dividend throughout the pandemic, have made the merger deal invalid.[8]  While LVMH and Tiffany & Co. ultimately resolved the dispute through a modification of the merger consideration, the allegations raised in LVMH’s are instructive as to how such claims may proceed in the future.

At issue in the action between LVMH and Tiffany & Co. was whether or not the alleged mismanagement during the COVID-19 pandemic has triggered the “material adverse event” (“MAE”) clause in the merger agreement. A MAE clause is “included within the closing conditions of an acquisition agreement in order to provide purchasers with an ’out’ in the event of unforeseen material adverse business or economic changes affecting or involving the target company or assets between the execution of the definitive acquisition agreement and the consummation of the transaction.”[9]  Like the debate over whether the COVID-19 pandemic constitutes a force majeure event in contracts, whether or not the pandemic, and a business’ actions or inactions in response to same, constitutes a MAE to cancel a deal is a novel issue.  However, Delaware, which has jurisdiction over the LVMH/Tiffany & Co. dispute, has only once before allowed a company to withdraw from a deal based on a MAE.  In Akorn, Inc. v. Fresenius Kabi AG, 2018 WL 4719347 (Del. Ch. 2018), judgment aff’d, 2018 WL 6427137 (Del. 2018), the Delaware Chancery Court upheld the termination of the merger agreement finding that Akorn breached its representations in the merger agreement regarding regulatory obligations which the court found would take several years and millions of dollars to remedy, which constituted a MAE.  In the 2019 decision in Channel Medsystems, Inc. v. Boston Scientific Corporation, 2019 WL 6896462 (Del. Ch. 2019), the Delaware Chancery Court cited again to the Akorn decision reiterating that “the important consideration therefore is whether there has been an adverse change in the target’s business that is consequential to the company’s long-term earnings power over a reasonable period, which one would expect to be measured in years rather than months. Id. at 25 (emphasis added).  While LVMH and Tiffany & Co. decided to avoid litigation, and the question of a MAE, the impact was not inconsequential; the companies decided to lower the valuation of Tiffany & Co. by approximately $400 million and reduce the stock sale price from $135 to $131.50.  Whether the effects on a company’s business due to the pandemic will last years rather than months (or at least more months than have already passed) still remains to be seen, but it is an important issue to follow in the area of M&A.

VI. Increase in Secondaries Fund Activities

As a general matter, investments in private equity funds are illiquid, primarily designed to be held for the duration of the lifetime of the fund (10-15 years).  Given the private nature of the offering, there is no public market to freely trade the limited partnership interests in the funds; and the limited partnership agreements typically impose transfer restrictions in order to maintain compliance with the exemptions from registering the securities.  That being said, a number of fund managers have formed private equity secondary funds (or secondaries), which are designed to acquire interests in existing funds from limited partners seeking an early exit.   In such a situation, the secondary fund acquires the selling limited partner’s interest in the existing fund, while also assuming its obligations, including the obligation to satisfy unfunded capital commitments.  These secondaries transactions can also be led by the underlying general partners of the primary funds, particularly in the context of a restructuring where they may be seeking to extend the lifetime of the funds.[10]

While secondary funds have been around for some time, there has been an uptick in secondaries fundraising and secondaries deal flow in recent years.  In this regard, between 2008 and 2017, secondaries fundraising increased from approximately $7 billion to $37 billion in 2017.[11]  While fundraising dipped in 2019 (to $26 billion),[12] secondaries deal volume reached an all-time high of $88 billion that year after steadily increasing from $58 billion in 2017 and $74 billion in 2018.[13]

The COVID-19 pandemic has impacted the secondaries market in two measurable ways to date.  First, there has been a marked increase in secondaries fundraising, with first half 2020 totals ($44 billion) already exceeding the full year totals for 2019, and with funds available for investment (or dry powder) increasing to $125 billion at the end of June  2020.[14]  (As of printing, results from second half 2020 have not been publicly reported.)   In this regard, it is anticipated that the financial impact of the pandemic will lead limited partners to seek an exit in order to obtain liquidity, bolstering the market for secondaries fund investments.  In addition, secondaries deals led by the general partners of the underlying private equity funds are also expected to increase, particularly with respect to older vintage funds who may seek additional time to wind-down – avoiding the sale of their underlying portfolio whose value was likely adversely affected by the pandemic – while obtaining liquidity for their limited partners who want to divest (or with respect to newer vintage funds, avoid ongoing capital commitments).[15]

Second, notwithstanding the increased demand for investment in secondaries funds and record fundraising in the first half of 2020, the deal volume has decreased.  The transaction volume in the first half of 2020 was $18 billion, with certain estimates for the full year of between $40 billion and $50 billion (which would reflect a marked decrease from the record $88 billion in 2019).[16]  The volume reduction does not appear to be based upon an under-supply of transaction opportunities, but rather a cautious approach by secondaries fund managers waiting to obtain current valuations of portfolio assets reflecting the impact of the pandemic.[17]

It is likely too early to speculate regarding the potential claims activity involving secondaries transactions that may arise; and the apparently cautious approach taken by secondaries fund managers (broadly) is certainly a positive sign.  Historically, we are not aware of significant litigation arising out of secondaries fundraising or secondaries transactions.  However, issues surrounding valuation of portfolio investments – particularly where such valuations are used in connection with the solicitation of fund investments – have come under scrutiny in the past.  Given the uncertainties created by the COVID-19 impact on underlying portfolio companies, valuations provided to secondaries funds in connection with secondaries market transactions could be a source of future disputes.

The first part of this article is available here, and this article will be concluded in a following post. 

[1] https://www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/slowdown-in-us-corporate-bankruptcies-continues-as-covid-19-recovery-looms-62931408

[2] https://www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/us-corporate-bankruptcies-end-2020-at-10-year-high-amid-covid-19-pandemic-61973656

[3] https://www.wsj.com/articles/coronavirus-unravels-private-equity-playbook-for-some-retailers-11589115600

[4] https://finance.yahoo.com/news/a-scary-number-of-retail-companies-are-facing-bankruptcy-amid-the-coronavirus-pandemic-180604964.html

[5] https://www.nbcnews.com/business/consumer/which-major-retail-companies-have-filed-bankruptcy-coronavirus-pandemic-hit-n1207866

[6] https://www.wsj.com/articles/deals-are-being-dropped-as-buyers-turn-wary-during-the-pandemic-11599829200

[7] https://www.cnbc.com/2020/04/22/sycamore-partners-tries-to-get-out-of-deal-to-take-over-victorias-secret.html

[8] https://www.wsj.com/articles/lvmh-says-tiffanys-handling-of-pandemic-invalidates-deal-11599744782

[9] Joseph B. Alexander, Jr., The Material Adverse Change Clause, Prac. Law., October 2005, at 11.

[10] https://docs.preqin.com/reports/Preqin-GP-Led-Secondary-Transactions-November-2016.pdf

[11] https://www.preqin.com/insights/research/blogs/a-record-year-for-private-equity-secondaries-fundraising

[12] Preqin Secondary Market Update H1 2020.

[13] https://www.commonfund.org/research-center/articles/private-capital-secondaries-an-overview

[14] https://www.preqin.com/Portals/0/Documents/About/press-release/2020/Aug/SEC-H1-2020.pdf?ver=2020-08-12-141905-610

[15] https://www.penews.com/articles/gp-led-secondaries-to-increase-in-post-covid-19-resurgence-20200706

[16] https://www.commonfund.org/research-center/articles/secondaries-opportunity

[17] Id.

Neither Ironshore nor any other Liberty Mutual company (the “Insurer”) are engaged in the practice of law. The foregoing information is for informational purposes only. It is not a substitute for legal advice from a licensed attorney, nor does it create an attorney-client relationship. The Insurer disclaims all liability arising out of this resource.

This document provides a general description of this program and/or service. Not all insurance coverages or products are available in all states or regions and policy terms may vary based on individual state or region requirements. See your policy, service contract, or program documentation for actual terms and conditions. Some policies may be placed with a surplus lines insurer. Surplus lines insurers generally do not participate in state guaranty funds and coverage may only be obtained through duly licensed surplus lines brokers.

Private Equity & the Impact of the COVID-19 Pandemic: Part 1 of 3

Viviane Falzon is the Head of Complex Management Liability Claims at Ironshore /Liberty Mutual Insurance Co.  Viviane has been with Liberty since October 2016 in her current role.  She has 30 years’ experience in the insurance industry and is licensed attorney with diversified claims and underwriting experience in domestic and international Financial Lines and Specialty insurance products, including Directors and Officers, Investment Managers and Financial Institutions, Professional Errors and Omissions, Employment Practices Liability, Pension Trust Fiduciary Liability, Crime and Fidelity, Cyber Crime and Liability, Representations and Warranties, Surety, and Construction Risk policies.

Scott A. Schechter is a partner at Kaufman Borgeest & Ryan LLP and has been with the firm since 2001.  Scott’s practice concentrates on representing international and domestic insurers in all aspects of claims handling and coverage litigation, particularly in the areas of Directors and Officers Liability, Financial Institutions Liability (with an emphasis on banking, private equity, hedge funds, venture capital, and investment advisers), and Professional Liability.  Scott also defends individuals and companies in professional liability and commercial litigation.

Joshua A. DiLena is a partner at Kaufman Borgeest & Ryan LLP and has been with the firm since 2010.  Joshua’s practice focuses on Management and Professional Liability involving financial institutions, particularly private equity firms; and also includes the areas of public and private Directors and Officers Liability, Errors and Omissions, and Fiduciary Liability.  Joshua represents insurers in all aspects of the claims handling process, as well as coverage litigation.

Matthew E. Mawby Is a partner at Kaufman Borgeest & Ryan LLP and has been with the firm since 2015.  Matt’s practice focuses on complex coverage litigation and arbitration, particularly in the areas of Financial Institutions Liability, Directors and Officers Liability, Professional Liability, and Employment Practices Liability.  Matt also counsels international and domestic insurers in all aspects of claims handling and resolution of coverage disputes.  Matt also defends individuals and companies in commercial litigation and arbitration.

Andrew S. Paliotta is an associate attorney at Kaufman Borgeest & Ryan LLP and has been with the firm since 2018.  Andrew’s practice concentrates on representing international and domestic insurers in insurance coverage matters and coverage litigations/arbitrations involving Directors and Officers Liability, Employment Practices Liability, Errors and Omissions, and Professional Liability claims.  Andrew also represents commercial entities in arbitration and litigation in both state and federal court in professional liability actions and various commercial and construction claims.

This is post is Part 1 of 3. Part 2 will be available tomorrow here on the PLUS Blog.

I. Introduction

Coronavirus disease 2019 or “COVID-19,” first discovered in late 2019, has impacted over 188 countries to date.  As of the writing of this article, there have been over 30 million cases of COVID-19 in the United States alone.[1]  While the impact on health and welfare cannot be understated, the economic impact of COVID-19 has also been enormous, adversely affecting every type of business from the multi-national corporation to the mom and pop shop.  The focus of this article is the effects of COVID-19 at the private equity level, which present challenges unique to the PE space, as well as some challenges shared by other businesses around the world.   In addition, we will explore the potential implications of COVID-19’s impact on PE firms and their insurers.

II. Increased Regulatory Scrutiny

While every insurer of a PE firm is familiar with a claim submission consisting of a subpoena, formal order of investigation or target letter, and the underwriting risks posed by administrative and regulatory investigations/proceedings, the attempts by the government at both the federal and state levels to quell the economic impacts of COVID-19, and the potential for allegations of fraud, will only increase these potential risks.  The outpouring of relief in both monetary form (as discussed below) and forbearance on certain regulatory requirements (such as the SEC temporarily suspending the requirement under the Investment Company Act for in-person board votes) will potentially lead to greater scrutiny by regulators moving forward.

            A. PPP Loans and Private Equity

On March 27, 2020, the Coronavirus Aid, Relief, and Economic Security (“CARES”) Act, a $2 trillion-dollar economic relief package, was signed into law.  Part of the CARES Act was implementation by the Small Business Administration (“SBA”) of the Paycheck Protection Program (“PPP”): “a loan designed to provide a direct incentive for small businesses to keep their workers on the payroll.”[2]  (The Consolidated Appropriations Act, 2021, expanded the PPP by authorizing second draw loans for small businesses that had previously received a PPP loan.)   In April 2020, the SBA issued an “Interim Final Rule” that provided, among other things, that “private equity firms are primarily engaged in investment or speculation, and such businesses are therefore ineligible to receive a PPP loan,”[3] thus precluding (at least on its face) the use of PPP loans for PE operations.  The foregoing Rule did not foreclose the opportunity for portfolio companies owned by PE firms (and backed with PE funds) to obtain PPP loans as long as they fulfilled the other loan qualifications, including that the business had 500 employees or fewer.[4]

In July 2020, after pressure from Congress, the SBA publicly released PPP loan data, including the identities of the businesses that received loans of more than $150,000.  While the loan data did not reveal the exact amount of the loans, it did reveal that at least ten PE firms received loans of between $150,000 and $1 million.[5]  While a partner in one PE firm noted that the funds were used “to cover only salaries of support staff that would have been laid off,”[6] it is undeniable that the disclosure of the loan data placed increased scrutiny on businesses that received the loans, the SBA and banks that underwrote and issued the loans, which also led to some businesses deciding to return the funds. The critical point is that a business was required to certify its compliance with the PPP’s qualification rules prior to disbursement of the loan.  These certifications will inevitably come under increased scrutiny for the truthfulness in the disclosures.

The CARES Act created a Special Inspector General for Pandemic Recovery (“SIGPR”) in the Treasury Department with the authority to investigate and audit a PPP loan (to “conduct, supervise, and coordinate audits and investigations of the making, purchase, management, and sale of loans, loan guarantees, and other investments…”) and to refer matters to the Department of Justice (“DOJ”) for a civil or criminal proceeding.[7]  In this regard, the DOJ’s Fraud Section has charged over 100 defendants for alleged PPP or similar loan fraud.[8]  Further, it also appears that the Division of Enforcement of the SEC has issued requests for information to several companies that received PPP loans in order to examine whether “positive or insufficiently negative statements in recent 10-Qs may have been inconsistent with certifications made in PPP applications regarding the necessity of funding.”[9]

In the insurance coverage context, the increased scrutiny of PPP loan recipients (whether PE firms or other companies) may lead to more inquiries, investigations, and potentially civil and criminal proceedings by various government entities (the DOJ, SEC, U.S. Attorney and even the IRS), which could lead to an increase in claims submissions moving forward.  Given the breadth of PPP loans provided by the SBA – which as of March 21, 2021 was over 8.2 million loans for a total of over $718 billion[10] – it could take some time for the government to uncover and investigate potential fraud and misrepresentations in the PPP loan process, which is a risk that certainly should be considered in the underwriting process.

III. Employment-Related Claims

One area of concern for PE firms and their portfolio companies is the increased risk of employment-related claims arising out of the COVID-19 pandemic.  The increased use of furloughs, layoffs, and salary reductions by PE firms and their portfolio companies is likely to result in increased employment-related litigation.  Furthermore, companies may face increased exposure to lawsuits for failure to adequately protect employees who have been directed to return to the office.  While many types of employment claims may be made relating to the COVID-19 pandemic, several specific areas of liability may be of particular concern to private equity firms and/or their portfolio companies.

            A. FFCRA Lawsuits & Private Equity

In March 2020, the Families First Coronavirus Relief Act (“FFCRA”) created two new emergency paid leave requirements in response to the COVID-19 pandemic.   First, the “Emergency Paid Sick Leave Act” (“ESPLA”) requires employers with 500 or fewer employees to provide two weeks of paid sick leave to employees at partial pay, up to a specified cap.  Second, the “Emergency Family and Medical Leave Expansion Act” (“EFMLEA”), which amended the Family and Medical Leave Act (“FMLA”), permits certain employees to take up to twelve weeks of expanded family and medical leave, ten of which are to be paid leave at partial pay, up to a specified cap.  Certain states and localities have also passed similar legislation expanding paid leave options to employees impacted by the COVID-19 pandemic.   While the FFCRA’s expanded leave expired on December 31, 2020, litigation surrounding the FFCRA is certain to last well beyond the end of last year.

For private equity firms, which tend to employ fewer than 500 employees and will therefore be required to provide qualifying employees with expanded leave benefits under the ESPLA and EFMLEA, caution must be taken when evaluating leave requests and considering whether qualifying employees have met all legal requirements.  The FFCRA incorporates the FLSA’s remedies provisions, such that an employee who is denied expanded leave will be able to recover damages in the form of lost wages, salary, benefits and other compensation (or the costs of actual monetary losses resulting from the denial of leave, such as costs of child care).  Further, a successful employee is entitled to liquidated damages equal to the employee’s actual damages, plus interest – effectively doubling an employer’s exposure.  While benefit caps reduce exposure to an individual claim by an employee, plaintiffs’ attorneys may find bringing class action or collective action cases to be lucrative when an employer has improperly denied a larger number of expanded leave requests.

From a coverage standpoint, given that the ESPLA and EFMLEA programs incorporate the FLSA’s remedies provisions, wage and hour exclusions found in many types of insurance policies may preclude coverage for lawsuits alleging improper denial of ESPLA and EFMLEA benefits.

            B. Other Potential Employment-Related Disputes

Given that many businesses, including private equity firms, have employed or are considering employing cost-cutting measures such as layoffs, furloughs or salary reductions, private equity firms must also be mindful of the potential for discrimination and retaliation lawsuits that may result from reductions in force or pay.  As with all reductions in force, even if individual employees are separated for legitimate, non-discriminatory business reasons, discharged employees may be able to assert a discrimination claim based on disparate impact.  For example, if a company has greatly increased the diversity of its employees in the past year pursuant to diversity and inclusion initiatives, conducting layoffs or furloughs based only on seniority might have a disparate impact on minority employees who were most recently hired.  Retaliation claims are also a concern – particularly if employees who have expressed health concerns about returning to work are chosen for separation or furlough.  Given these potential claims, among others, private equity firms should carefully consider how to carry out reductions in force or reductions in salary before implementing such programs.

            C. WARN Act

The federal Workers Adjustment and Retraining Notification Act (“WARN Act”) requires that employers provide 60 days’ written notice before effecting plant closures and mass layoffs, or be subjected to liability for back pay and benefits.  The WARN Act potentially creates exposure to a PE firm and its affiliated entities when a portfolio company acquired by the PE firm ceases operations without providing the required notice under the WARN Act.

In the context of the COVID-19 pandemic, it is important to keep in mind that the WARN Act does have several exceptions to the 60-day notice requirement, including when layoffs are required due to a natural disaster or unforeseeable business circumstances – i.e., a “sudden, dramatic, and unexpected” event that the employer could not have reasonably foreseen.  While the latter exception may apply to many businesses forced to conduct layoffs due to declines in revenues resulting from the pandemic, employers must still provide employees with as much notice of a plant closure or mass layoff as practicable.

A Florida federal district court recently denied a motion to dismiss a WARN Act claim based on plant closures or mass layoffs necessitated by the COVID-19 pandemic in Benson v. Enterprise Leasing Co., No. 20-cv-891, 2021 WL 1078410 (M.D. Fla. Feb. 4, 2021).   There, Defendants argued that dismissal was warranted on the basis of the two exceptions/affirmative defenses, which appeared on the face of the complaint.  With respect to the natural disaster defense, while the Court recognized that COVID-19 is a natural disaster, it explained that to rely on this defense, the plant closing or mass layoff must have been a direct result of the natural disaster; and here, the shutdowns indirectly resulted from COVID-19 through the economic downtown caused thereby.  The Court recognized that the second defense – unforeseeable business circumstance – was an appropriate affirmative defense in this context, but could not dismiss on this basis because there was a fact issue as to whether notice had been given as soon as practicable.

The district court in Benson certified its decision for immediate appeal to the United States Court of Appeals for the Eleventh Circuit, which will undoubtedly be closely monitored and the decision may provide insight into how courts will treat WARN Act claims related to the pandemic.

With respect to private equity firms, existing case law indicates that such firms should be concerned about potential WARN Act liability if affiliated portfolio companies institute mass layoffs without providing the required notice to impacted employees.

In particular, several cases decided over the past few years have held that a private equity firm, while not a direct employer of impacted employees, may nevertheless be held liable for violations of the WARN Act under a “single employer” theory.  Courts have routinely used a five-factor test promulgated by the Department of Labor (“DOL”) to determine whether a private equity firm can be considered a “single employer” with its affiliated portfolio company: (1) common ownership; (2) common directors and/or officers; (3) de facto exercise of control; (4) unity of personnel policies; and (5) operational dependency between the PE firm and its portfolio company.  While each case is necessarily based on its unique facts, some courts have focused almost exclusively on the element of de facto exercise of control.  In those cases, a private equity firm is much more likely to be held liable under the WARN Act if it makes the decision to conduct the layoffs or strongly pressures the portfolio company to conduct the layoffs.

In an effort to minimize potential WARN Act liability and exposure, PE firms are well-advised to take steps to separate themselves from their portfolio companies’ decisions to conduct mass layoffs.  Of course, with the hands-on management approach of many PE firms with respect to their portfolio companies, the WARN Act will undoubtedly be an area of increased activity and increasing risk for PE firms and, particularly, for their portfolio companies.

From an insurance coverage perspective, insurers providing private equity coverage typically include exclusions for WARN Act claims.  However, because coverage questions turn on specific policy language and factual circumstances of each case, the scope of a WARN Act exclusion may not be sufficient to preclude an insurer’s coverage obligations in some instances.  Thus, the likelihood of increased exposure to PE firms for WARN Act claims may, in turn, also impact private equity insurers with narrowly-worded WARN Act exclusions, and this risk should be considered during the underwriting process.

This article will be continued in a following post. 

[1] https://covid.cdc.gov/covid-data-tracker/#cases_casesinlast7days

[2] https://www.sba.gov/funding-programs/loans/coronavirus-relief-options/paycheck-protection-program

[3] https://home.treasury.gov/system/files/136/Interim-Final-Rule-on-Requirements-for-Promissory-Notes-Authorizations-Affiliation-and-Eligibility.pdf

[4] The so-called “affiliate rule” is particularly important in the PE context as a business must include the employees of any companies that it is “affiliated” with which includes “an entity, concern, or individual that owns or has the power to control more than 50% of the concern’s voting equity.”  See https://www.sba.com/funding-a-business/government-small-business-loans/ppp/affiliation-rules/

[5] https://www.wsj.com/articles/private-equity-firms-borrow-from-ppp-despite-later-rule-barring-them-11594114201

[6] Id.

[7] https://www.govinfo.gov/content/pkg/BILLS-116hr748enr/pdf/BILLS-116hr748enr.pdf

[8] https://www.justice.gov/criminal-fraud/cares-act-fraud

[9] https://www.thecorporatecounsel.net/blog/2020/05/ppp-loans-sec-enforcement-sweep-of-public-company-borrowers.html

[10] https://www.sba.gov/funding-programs/loans/coronavirus-relief-options/paycheck-protection-program.

Neither Ironshore nor any other Liberty Mutual company (the “Insurer”) are engaged in the practice of law. The foregoing information is for informational purposes only. It is not a substitute for legal advice from a licensed attorney, nor does it create an attorney-client relationship. The Insurer disclaims all liability arising out of this resource. 

This document provides a general description of this program and/or service. Not all insurance coverages or products are available in all states or regions and policy terms may vary based on individual state or region requirements. See your policy, service contract, or program documentation for actual terms and conditions. Some policies may be placed with a surplus lines insurer. Surplus lines insurers generally do not participate in state guaranty funds and coverage may only be obtained through duly licensed surplus lines brokers.