A NASTY PIECE OF FINANCIAL ENGINEERING ON TRIAL

Maybe you haven’t yet heard of a tax receivable agreement, or TRA.  You wouldn’t be alone.

Here’s how it works:  A person, often a company’s founder, or entity, often a private equity firm, operates a company that generates tax deductions, tax credits, depreciation and operating losses that will serve to offset future taxable income.

The next step is an initial public offering, preferably to public investors who do not fully appreciate the value of the tax benefits and are satisfied to acquire the company minus those benefits, which they leave to the original owner in exchange for a reduced acquisition price. The company must then set aside an amount each year to pay the original owners the value of tax benefits. 

The trade, consisting of the payment of the amount of write-offs to be paid to the pre-IPO owner in exchange for an apparently favorable price, will work out for that owner only if the company has taxable income. Otherwise, there is nothing to write off.

In 2015, Lone Star,[1] a private equity fund, acquired a public company, Foundation Building Materials, Inc. (the “Company”), in a going-private transaction.  Lone Star’s acquisition appears to have been motivated in large part, by the value of the Company’s tax assets.

Less than 18 months later, Lone Star took the company public again.  Lone Star retained a 65.4% interest in the Company and, post-IPO, kept control of a majority of its directors.  Lone Star, still mindful of the value of the Company’s tax assets, entered into a TRA with the Company.  TRAs often provide that some fraction, usually a large fraction, of the tax assets are to be paid to the pre-IPO owners over a number of years.  Lone Star negotiated a deal in which it retained 90% of the benefits of the pre-IPO tax assets.  In other words, if the Company had taxable income post-IPO, Lone Star would receive from the Company most of the value of its tax assets in any year.

The TRA also provided that, if there were a change of control, Lone Star could terminate the TRA and receive a lump sum payment equal to the present value of the tax assets, calculated at a discount rate favorable to Lone Star and based on the assumption that the Company could fully utilize the tax benefits for each year the TRA covered.

So Lone Star thought it had made a pretty good deal.  But on January 1, 2018, the Tax Cuts and Jobs Act[2] took effect.  Among other provisions, it reduced the corporate federal income tax rate to 21% from 35%.  Suddenly, the benefits Lone Star anticipated would, by its own estimate, be reduced in value by some $68 million.

Later in January, Lone Star began to explore its options.  One in particular seemed especially promising:  a sale of the Company.  Lone Star representatives on the board led the sale process.  The attractiveness of a sale to Lone Star was obvious.  Whatever the Company was worth to shareholders on its own in a sale, on account of the TRA, it was worth much more to Lone Star.

Under the circumstances, Lone Star might be tempted to cash out and receive an early termination payment close to the full value of the tax assets and be less concerned about the effect of a sale on monitory shareholders.  The conflict of interest should have been obvious.  To address the conflict, but well after the sale process was underway, the board created a special committee, apparently giving the committee the power to disapprove the sale.

After a process that lasted two years, the board negotiated a deal, which the committee approved, in which Lone Star received at closing the early termination payment of $74.8 million in accordance with the TRA, and a payment of $8.6 million for tax benefits through January 2021.

Other shareholders representing the class of minority shareholders sued Lone Star, its directors and advisors in Delaware state court, claiming to have been injured by the transaction.[3]  The minority owners charged a breach of fiduciary duty—in other words, that Lone Star and the board, abetted by other participants in the process, had acted against their best interests.

One area of the plaintiffs’ focus was the role of the board-appointed committee.  They alleged that the committee was passive, that it went months without meeting, including during the period when the terms of the sale were being negotiated, and that, most importantly, the committee repeatedly deferred to the Board and acted as if the sale were a fait accompli.

The Lone Star defendants claimed they had satisfied their obligations as fiduciaries and asked that the Delaware court dismiss the case.  Where such an issue is projected, Delaware courts apply a number of tests depending on the circumstances.  The most restrictive standard, the “entire fairness test,” applies where, as here, there is an actual conflict of interest.  Applying the test involves two inquiries:  Was the process fair?  Was the price fair?

So the court needed to decide whether there was sufficient evidence to deem the transaction unfair to the minority owners, procedurally and substantively.  The process involved a committee Lone Star established to assess the propriety of the transaction.  But the committee’s actions, and its inaction, suggested it was under Lone Star’s thumb. 

In Delaware, a controlling corporate shareholder have a fiduciary duty to the other owners, when the controller acts in place of the directors.  Thus, Lone Star’s obligations were identical to those of the directors Lone Star placed on the board: to maximize the long-term value of the Company for the benefit of its shareholders.[4] 

As to the substance, the transaction provided Lone Star with two forms of compensation.  First, payment for its stock, consideration shared pro rata with the minority shareholders.  And second, the early termination payment, which was not shared ratably, but benefitted only Lone Star.  Lone Star’s decision to sell may have been triggered, not by an attractive price for its shares, but by an unwelcome change in the tax law, at least for Lone Star, which substantially reduced the value of its tax assets and spurred the effort to recover the lost value.  A sale appeared to be Lone Star’s stratagem to reclaim that lost value.

For the Delaware court, it was “reasonably conceivable” that Lone Star’s actions in initiating a questionable sales process was motivated by self-interest, not entirely fair to the minority owners, and therefore a breach of its fiduciary duty.[5]  It was also inferable, on the facts before the court, that remaining an independent Company was a better alternative, especially for the minority shareholders.  The court therefore left it for the parties to prove their flatly contradictory claims at a trial.

To be sure, Lone Star was conflicted, and the sales process it employed had the earmarks of a slight at hand, and appeared rigged in Lone Star’s favor and unresponsive to the interests of the minority shareholders.  But in spite of the conflict and the dubious process, the price it negotiated might be an entirely fair one.  All of these things can be true at the same time.  Lone Star will now have the burden to prove to the court that they are. 

[1] Lone Star" refers to both the Lone Star Fund IX (U.S.), L.P., which made the acquisition described in the text, and LSF9 Cypress Parent 2 LLC, which the Fund used for investment.

[2] Public Law 115-97, 131 Stat. 2054.

[3] Firefighters' Pension System v. Foundation Building Materials, Inc., Docket No. 2022-0466-JTL (Del.Ch.).

[4] E.g., Gantler v. Stephens, 965 A.2d 695 (Del. 2009).

[5] Opinion Addressing Motion to Dismiss Under Rule 12(b)(6), Firefighters Pension System v. Foundation Building Materials, Inc., Docket No. 2022-0466-JTL (decided May 31, 2024).