The duties of private equity directors of distressed companies: avoiding an intrinsic fairness review.

• Author: Hahn, Richard F.

When times are good, the goal of private equity professionals serving as directors of portfolio companies is relatively straightforward-maximization of value for the corporation's shareholders. Moreover, the interests of the two constituencies that the private equity professional serves--his private equity firm employer and the portfolio company's shareholders--are typically aligned as the private equity firm is usually the portfolio company's largest shareholder.

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When a portfolio company becomes insolvent, however, the legal standard by which the actions of a private equity professional serving on its board are judged may be materially more demanding. Private equity professionals serving as directors of portfolio companies during the current economic downturn should therefore understand the duties they owe to the stakeholders in the corporations they serve and the impact of the corporation's financial condition on these obligations.

Directors typically owe the corporation and its shareholders a duty of care and a duty of loyalty. The duty of care requires that directors exercise the degree of care that an ordinary and prudent person would use in similar circumstances. The duty of loyalty requires that directors act in good faith in the best interests of the corporation and its shareholders and that they not engage in self-dealing.

Challenges to directors' decisions are generally difficult to sustain because of the protection afforded to directors by the "business judgment rule." So long as directors are not "interested" in the matter before them, they benefit from the presumption that they acted on an informed basis, in good faith and in the honest belief that their decision was in the best interest of the corporation.

But the business judgment rule does not apply where it can be shown that a majority of the directors were either interested in a transaction--by, for example, standing on both sides of the transaction or expecting to derive a personal and substantial financial benefit therefrom--or lacked independence such that the decision was not based on the merits of the transaction. In these cases, the burden of proof shifts to the directors to show the "intrinsic fairness" of the transaction--that the actions of the board were both procedurally and substantively fair. A court's determination as to whether to apply the intrinsic fairness test, given the higher standard...