Caesars examiner: Paul Weiss was probably conflicted – but not liable

March 17, 2016

(Reuters) – Under ordinary circumstances, according to former Watergate investigator Richard Davis, it’s not a problem for a single law firm to represent private equity investors and their portfolio companies simultaneously. That makes sense: When the portfolio companies do well, their private equity owners make money. But there is an important exception. If a portfolio company becomes insolvent, its creditors – typically noteholders – take precedence over the private equity sponsors, who are equity holders. Law firms have to be very, very careful when insolvency looms, according to Davis, and they attempt to represent both the private equity interests and the interests of the subsidiary. If those interests diverge, the law firm is conflicted.

Davis’ analysis was not hypothetical. The former Weil Gotshal & Manges partner was appointed a year ago to investigate transactions in which the parent company of Caesars Entertainment, taken private in 2008 by Apollo Global Management and TPG Capital, transferred key assets out of its debt-laden operating unit. Noteholders in the operating unit contended the asset transfers were fraudulent conveyances that stripped the subsidiary of value in advance of its bankruptcy.

Davis mostly agreed – and private equity lawyers should regard his findings as a red flag about restructuring wobbly portfolio companies.

As my Reuters colleagues Tom Hals and Tracy Rucinski reported earlier this week, the examiner concluded in a report released Tuesday that Caesars and its private equity sponsors could be on the hook for as much as $5 billion to creditors of the bankrupt operating unit. His scathing 1,800-page report, which can be downloaded via the Caesars’ docket at Prime Clerk, is expected to shift the balance of power in the Chapter 11, giving new leverage to bondholders asserting asset-stripping claims against Caesars parent and the private equity firms.

Davis found that in two of the transactions he investigated, Caesars counsel Paul Weiss Rifkind Wharton & Garrison was probably conflicted because it represented both the parent company and its wholly owned subsidiary. In one deal – a 2013 refinancing of Caesars’ commercial mortgage-backed securities liability after the real estate crash reduced the value of the properties underlying the securities – the parent company (through a new subsidiary) acquired the newly built luxury tower of the Las Vegas hotel and a planned shopping and entertainment strip connecting various Caesars properties. The second of the conflicted deals was the 2014 creation of joint services company that took over, among other things, the operating company’s license to Caesars’ valuable customer loyalty program.

Both deals effectively delivered valuable assets from the operating company to the parent company, yet the operating company did not have independent legal or financial advisers to assure it received fair consideration. In fact, when Caesars did create independent board committees or bring in advisers, it was to advise the parent company on the buy side, not the operating company on the sell side.

Paul Weiss argued that all of the transactions the examiner investigated, including the two in which he found the firm was probably conflicted, were intended to benefit both the parent and subsidiary so there was no conflict.

Moreover, the law firm said, the potential for conflict would only have arisen if the operating company was insolvent, and, as far as Paul Weiss knew, the company was above water when the law firm advised on restructurings. Among other things, Paul Weiss said, the operating company was still paying bills.

Davis found those defenses inadequate. “Paying current bills,” he wrote, “is not the legal definition of solvency, and saying transactions were in the interests of creditors begs the real question since an independent counsel might have assessed the merits of these transactions, from (the operating company’s) perspective, differently.” By the fall of 2013, according to the examiner, Paul Weiss had seen plenty of evidence that the operating company could not pay maturing debt, including an October 2013 analysis by Caesars that highlighted a multibillion-dollar shortfall in the operating company’s obligation.

The examiner also suggested that the general counsel of Caesars was concerned in at least one asset transfer deal about Paul Weiss’ dual representation of the buyer and the seller. According to Davis’ report, the parent company general counsel was “uncomfortable with the advice he was receiving from Paul Weiss” about the need for an independent board committee to evaluate Planet Hollywood and a casino in Baltimore, which were to be transferred to the parent company. After he “sought a second opinion from another firm,” the parent company board set up an independent committee.

The good news for Paul Weiss is that despite Davis’ conflict-of-interest conclusion, he said he does not believe the bankrupt operating unit has much of a case against the firm, either for aiding and abetting a breach of duty by board members or for legal malpractice. Under Delaware precedent, the examiner said, lawyers are liable for aiding and abetting only when they had “affirmative knowledge of some fraud” or stepped outside their ordinary role as counsel. “This simply is not the case here,” he wrote.

And any malpractice claim would be doomed by speculation about what independent advisors might have recommended to the operating company, Davis said. “Although the conflict was real, and Paul Weiss lawyers should have recognized the need for independent directors and advisors at (the operating company) by no later than late 2012 to early 2013, and advised its clients accordingly, the evidence does not support a conclusion that Paul Weiss lawyers knowingly acted at any time to injure or prejudice (the subsidiary) or its creditors,” the examiner wrote.

No law firm, though, wants to be called out for failing to avert a conflict, which brings me back to my original point. In the restructuring context, conflicts arise when insolvency divides the interests of shareholders and creditors. Paul Weiss insisted it wasn’t conflicted because it was not on notice of the operating company’s insolvency. Davis, the examiner, acknowledged that lawyers are not financial advisers and cannot be expected to perform solvency analyses.

But according to him, solvency “is a mixed question of law and fact,” and “insolvency creates a potential conflict before a bankruptcy becomes probable.” Lawyers who want to avoid the embarrassment Paul Weiss is facing from the Caesars report, in other words, should not assume there’s no conflict in dual representation of a parent and operating company as long as the latter is not on the brink of bankruptcy.

“The examiner’s report puts the onus on law firms to bow out at the right time,” said James Newell of Buchanan Ingersoll & Rooney. “But knowing the right time isn’t a simple thing.”

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