Conflicts of interest (regularly) play a role in the private equity practice. In this article we discuss some relevant developments regarding conflict of interest rules in the context of the private equity practice.
Dutch statutory law
When carrying out their duties, members of the management board must be guided by the company's interests and the enterprise connected with it. The Dutch statutory conflict of interest rules provide that a member of the management board of a Dutch legal entity with a conflict of interest must refrain from participating in the deliberations and the decision-making process (the so-called 'abstention rule'). The term 'deliberation' means the discussion within the board about a proposed resolution prior to the actual decision-making. If all management board members have a conflict of interest where a particular resolution is concerned and a management board resolution cannot be adopted as a result thereof, the resolution is to be adopted by the supervisory board. If no supervisory board has been established or if all supervisory board members have a conflict of interest, the resolution is to be adopted by the general meeting. This is the 'escalation rule'; from the management board to another body, namely the supervisory board and subsequently the general meeting. It is possible to deviate from this statutory rule in the articles of association. For example, by providing that in the event of a conflict of interest the resolution can still be adopted by the management board (with the conflicting interest) or that another temporary member of the management board is appointed to participate in the deliberations and decision-making.
When is there a conflict of interest?
There is a conflict of interest if the management board member has to deal with "such incompatible interests that it can reasonably be doubted whether the management board member was guided in his actions solely by the interests of the company". In order to determine whether a conflict of interest exists, all facts and circumstances of the respective case must be taken into account. If the management board member has a personal interest that conflicts with that of the company, this can in any case constitute a conflict of interest. An example is the situation in which a director personally benefits financially from a certain transaction, while the company does not. Case law seems to indicate that not only personal interests can constitute a conflict of interest. Interests other than personal interests may also conflict with those of the company, and thus creating a conflict of interest. One example is a qualitative interest of supervisory directors (i.e., supervisory directors who are appointed by a large shareholder and at the same time hold other high positions with that large shareholder) that does not run parallel with the interests of minority shareholders. The conflict of interest concept seems to be interpreted broadly: any interest that does not run parallel with that of the company can constitute a conflict of interest.
Developments regarding conflict of interest rules in the context of the private equity practice
The preceding general rules on conflicts of interest also apply to transactions in which private equity funds are involved. Conflict of interests may occur, among others, in so-called 'leveraged buy-outs' (LBOs), a common transaction structure in the private equity practice, whereby a company is acquired by one or more private equity investors together with the management team of that company and whereby the purchase price is financed for a (large) part with external debt. Private equity investors usually attach great importance to the (continued) close involvement of directors (and sometimes other executives) of the portfolio company. To incentivize the managers of the company and to give them an interest in a future exit, private equity investors usually require that the managers co-invest with them in the portfolio company. In this manner, alignment of interests is created. The (financial) involvement of the management board with the company and the use of (considerable) amount of debt to finance part of the acquisition price, which ends up in the company itself by means of a debt push, conceals a risk of a conflict of interest. The Enterprise Chamber has issued two interesting judgments on this topic.
The first judgment is the PCM decision of 2010. In the PCM decision the Enterprise Chamber considered with regard to the management participation scheme offered to the management board members of PCM that it is not an unusual instrument, but - by its nature – entails a risk of conflicting interests. The management participation at PCM was designed in such manner that the potential proceeds of the participating management board members and other executives were not related to the performance of PCM, but to the exit proceeds to be allocated to the private equity investor. As a result of the participation, the interests of the management board members (who should primarily act in the interests of the company) were aligned with the interest of the large shareholder: i.e., obtaining a maximum return upon exit. According to the Enterprise Chamber, none of the participants in the decision-making process that led to the LBO had been aware of the possible (excessive) effects of the management participation scheme (i.e., that at any moment the participants could receive more than ten times (!) their original investment). The Enterprise Chamber found that the management board members of PCM should have realized that their participation in the management participation scheme could give rise to serious doubts about their integrity when weighing the legitimate interests of all stakeholders of the company, including the interests of its shareholders, employees, customers, clients and suppliers (etcetera). and for that reason, should have strongly advised against the introduction of this scheme.
In the PCM decision, the Enterprise Chamber also formulated an important rule for management board members and supervisory board directors. The Enterprise Chamber ruled that effectuating an LBO is always accompanied by a significant financial burden on the (target) company. It is because of this characteristic that the LBO requires the special attention of those who are obliged to pay attention to the interests of the company (and its stakeholders) concerned and who participate in the decision-making process leading to the company's involvement in an LBO transaction. With a view to these interests, it will therefore be the task of the management board members and supervisory board directors to consider the advantages envisaged and reasonably achievable by the company in connection with the LBO against the disadvantages, including those of a financial nature. The careful recording thereof by the management board members and supervisory board directors is crucial.
In 2019, the Enterprise Chamber issued another decision relevant to the private equity practice: Estro. In this decision, the Enterprise Chamber considered that the management board members of Estro - in view of the bonus and participation arrangements made with them - had an obvious personal interest in the success of the acquisition of Estro by private equity investor Providence. Based on the significant amounts that the Estro management board members received out of their participation, the Enterprise Chamber concluded that their personal interests in the transaction were so substantial that there were doubts whether they had been guided solely by the interest of the company (and its stakeholders) when making the decisions they had to make in respect of the acquisition of Estro. These doubts were also supported by the fact that the management board failed to carefully weigh the interests of Estro and the enterprise connected with it in the acquisition and the accompanying debt push down. According to the Enterprise Chamber, in case of an LBO, the members of the management board should make a detailed analysis of the advantages and disadvantages of the intended decision in advance. According to the Enterprise Chamber, this requires a solid report prepared by independent advisors. The Estro decision contains (yet again) a clear instruction for management board members and supervisory board directors who are involved in a LBO and also have (substantial) financial interests in it themselves. If there is a conflict of interest in such a transaction, extra care is required in the decision-making process (among others by weighing the advantages attached to the LBO against the disadvantages, including those of a financial nature) and management board members and supervisory board members are well advised to request the assistance of independent experts (legal and/or financial).
How to act in case of a conflict of interest?
In practice, a conflict of interest does not have to be an issue, as long as the management board members make sure that they observe the (statutory) conflict of interest rules. First of all, these are the abstention rule and the escalation rule as discussed above. In addition to the statutory abstention rule and escalation rule, the Dutch courts have formulated rules of conduct in various cases which management board members must take into account when acting in conflict of interest situations. These include the following three rules of conduct: (i) the conflicted member of the management board must keep the various interests apart, (ii) in order to ensure this, the management board member must exercise as much transparency as possible and (iii) if the circumstances so require, the member of the management board must engage (independent) experts.
Conflicting interests (regularly) play a role in the private equity practice. However, this does not have to be an issue for transaction structures that can be observed in the private equity practice (e.g., LBOs), as long as the management board members of such companies always act in accordance with the (stricter) duties of care that apply to them in connection with conflicts of interest.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.