A recent ruling from the United States District Court for the Southern District of New York sent shock waves through the legal and financial community, with some shouting that this “could be a gamestopper for the private equity business.”1 Although the ruling in In re Nine West LBO Securities Litigation2 breaks new ground and arguably narrows the protections available to directors under the normally-broad business judgment rule, there are clear lessons others can take from this saga to prevent a similar fate.
The headline issue that has people up in arms is the court’s holding that directors of a selling corporation may lose the benefit of the business judgment rule and be held liable, under a breach of fiduciary duty theory, for not undertaking a reasonable investigation into the company’s post-sale solvency and the propriety and effect of any contemplated post-closing transactions that could be considered part of the same overall transaction when such transactions may affect the post-sale solvency of the company. In other words, according to the court, a director may be liable for not taking into account transactions expected to occur after the sale closes, the company’s shareholders receive the sale consideration, and new ownership and directors take over. The court similarly determined that directors of the selling corporation may be liable, on an aiding and abetting a breach of fiduciary duty theory, for actions undertaken by the future board of the buyer corporation if the selling corporation’s directors had actual or constructive knowledge of the fiduciary breach of the buyer’s directors. This liability may attach even if the buyer directors were not yet directors, and therefore owed no duties, at the time of their misconduct. In the eyes of this court, it’s no longer a “my watch, your watch” world.
This decision sends a warning that directors cannot ignore what might happen to the company post-closing, especially if they are aware of contemplated actions that might cause the company to become insolvent in the near future. Because LBOs (leveraged buy-outs) by definition leave the company with more debt post-transaction, directors approving these types of transactions may now be more susceptible to breach of fiduciary duty claims if the company later is in financial distress.
While it remains to be seen whether other courts will adopt such an expansive view of directors’ fiduciary duties, directors of companies engaging in corporate transactions, particularly LBOs, can take steps to protect themselves from a similar fate, including:
- perform due diligence on the anticipated post-closing financial position of the company and any contemplated post-closing transactions disposing of assets of the company before approving the transaction; and
- seek representations from the buyer in the merger agreement as to the solvency of the company post-closing and that it does not intend to engage in any transaction post-closing that might negatively impact the solvency of the company.
Although these landmark holdings of Nine West may initially appear fairly daunting, directors should also take note that there are certain limitations to the reach of this case.
- First, it is crucial to recognize the procedural posture of the case. The ruling was on a motion to dismiss, meaning that the court’s decision was based on an interpretation of the facts in the light most favorable to the plaintiffs. The actual facts developed by the record may be more favorable to the directors.
- Second, key portions of the ruling depended on Pennsylvania corporate law (as interpreted by a New York federal court), which may or may not apply in other cases. It is much more common for large companies to organize under Delaware law, where Delaware corporate law would apply.
- Third, as discussed above, the actions directors can take to avoid this result may not be as onerous as they might initially appear.
- Finally, this case appears to have particularly egregious facts (at least as alleged by the plaintiff and reflected in the written decision), while other cases may be less clear-cut.
Nevertheless, caution is advised.
While this decision focuses on the actions of the directors on the sell-side of this transaction, there are also lessons from the Nine West story for private equity firms that may engage in LBO or other M&A transactions on the buy-side, as they and their principals may face litigation if one of their portfolio companies ends up in bankruptcy. More on that below.
In 2014, The Jones Group, a public company that owned many marquee shoe and apparel brands, engaged in a leveraged buyout with the private equity firm Sycamore Partners. The merger agreement involved five “integrated components” that would “occur substantially concurrently”:3
- The Jones Group would merge with a Sycamore affiliate and be renamed Nine West.
- The Jones Group’s public shareholders would receive consideration of $15 cash per share, for a total of approximately $1.2 billion.
- Sycamore would contribute $395 million in equity to Nine West.
- Nine West would sell the “crown jewels” of the company, the Stuart Weitzman and Kurt Geiger brands, to other Sycamore affiliates for substantially less than their fair market value (the “Carve-Out Transaction”).
- Nine West would increase its debt from $1 billion to $1.2 billion (the “Additional Debt Transaction”).
Although the merger agreement obligated the company to assist Sycamore with the Carve-Out and Additional Debt Transactions, the unanimous approval of the merger agreement by the board of directors (the “Board”) of the Jones Group purported to exclude consideration of these transactions.
Before closing, but after the Board approved the merger agreement, Sycamore altered the terms of the deal, reducing its equity contribution from $395 million to $120 million and arranging for additional new debt, which would increase Nine West’s total debt from $1.2 billion to $1.5 billion. The Board did not exercise its “fiduciary out” clause at this point, despite the tightened equity cushion and its awareness of the “decline in actual and projected performance of businesses that would” remain in Nine West.4
Upon the closing of the merger, two principals of Sycamore became the sole directors of Nine West. Following the closing, they caused Nine West to consummate the Carve-Out Transaction, selling the lucrative businesses to newly formed Sycamore affiliates for $641 million, “a price substantially below their fair market value of at least $1 billion.”5
Several years later Nine West filed for chapter 11. The trustee for a litigation trust created under the chapter 11 plan (the “Litigation Trustee”) filed a complaint against the former Jones Group directors, alleging a breach of fiduciary duty, as well as aiding and abetting breaches of fiduciary duty, in connection with the 2014 leveraged buyout. As discussed below, the court refused to grant the defendant directors’ motion to dismiss these counts, issuing the decision that created the buzz.
Under Pennsylvania law, which applied because the Jones Group was a Pennsylvania corporation, directors of a corporation owe the duties of care and loyalty and enjoy the benefit of the business judgment rule. Pennsylvania law provides even greater protection to directors for decisions made in the context of mergers and acquisitions, where they are presumed to satisfy the business judgment standard unless it is proven by clear and convincing evidence that the board was not disinterested or that the directors did not approve the transaction “in good faith after reasonable investigation.”6
Here, the court found that the Litigation Trustee successfully alleged that the directors did not conduct a “reasonable investigation” in connection with the 2014 transaction, thereby losing the protection of the business judgment rule. In particular, the Board should have, but did not, investigate whether the 2014 transaction “as a whole” would render the company insolvent. In a nutshell, the issue was that the directors were narrowly focused on the merger itself and the consideration payable to the company’s shareholders, and they did not focus on the elements of the transaction that would only impact the company post-merger, particularly the Additional Debt and Carve-Out Transactions. The directors admitted as much, but they argued they had no obligation to investigate the solvency of the company after those transactions, because they had no role in those transactions. Indeed, those transactions were effectuated after the defendant directors ceased to be directors.
The court disagreed and relied on the “collapsing” transaction to treat all the 2014 transactions as one, including the merger, the Additional Debt Transaction, and the Carve-Out Transaction. Specifically, relying on the Hechinger case from Delaware,7 the court held that collapsing multistep transactions is appropriate where they are part of “a single integrated plan” and the plaintiff pleads “a cause of action for breach of fiduciary duty based on the foreseeability of the alleged harm.”8 The court also pointed out the directors’ failure to conduct an investigation after Sycamore made the deal worse from a solvency perspective (more debt and less equity), a particularly glaring error given that the Board could have exercised its fiduciary out at that time.9 Because the directors made “no investigation whatsoever” into the post-sale solvency of the company, they could not then “take cover behind the business judgment rule.”10
The court also found that the directors could not take advantage of the exculpatory language in Jones Group’s bylaws, which, as permitted by Pennsylvania law, limited a director’s liability to cases where the breach constituted “self-dealing, willful misconduct, or recklessness.”11 Here, the court found that the Litigation Trustee adequately pled that the directors acted recklessly in approving the 2014 transaction by “consciously disregard[ing]” whether the Additional Debt and Carve-Out Transactions were in the company’s interests12 and ignoring certain “red flags” that “should have put the director defendants on notice” that these transactions would leave the company insolvent. For example, considering the Jones Group’s $2.2 billion valuation in 2014 and subtracting the $800 million historical purchase price of the carve-out businesses (which the Jones Group purchased in 2010 and 2012), the remaining company would have a valuation of $1.4 billion, below the $1.55 billion in debt the company took on in connection with the transaction. The directors also ignored the fact that the debt for Nine West would be 7.8 times Adjusted EBITDA, after having been explicitly warned by an outside advisor prior to the transaction that the company could not sustain an Adjusted EBITDA multiple beyond 5.1, even when retaining all brands. In the court’s view, these red flags should have caused the directors to inquire into the remaining company’s solvency rather than disclaiming any view of the Additional Debt and Carve-Out Transactions.
Furthermore, the court determined that the Litigation Trustee adequately alleged that the directors aided and abetted the Sycamore principals in their fiduciary breaches to Nine West by approving the transaction and assisting them in carrying it out. The directors argued in response that, first, they could not have aided and abetted with actions that occurred before the Sycamore principals even became directors (and thus before they owed any fiduciary duties to the company) and, second, that the directors did not “knowingly participate” in the breaches, a necessary element of the claim under Delaware law, which governed the company post-closing. The court quickly dispensed with the first argument by way of a hypothetical, reasoning that if a person were to become a director tomorrow and asked a friend to help with a plan to defraud the corporation today, the friend ought not to escape liability just because the director’s duties had not yet attached.13 Regarding the second argument, for the reasons discussed above, the court ruled that the defendant directors had actual or constructive knowledge that the buyer’s directors would carry out the Carve-Out Transaction and leave the company insolvent, and therefore, by approving the merger, they knowingly participated in the breach by the future directors.14 As a result, the court found that the plaintiffs had successfully met their burden and their claims could survive a motion to dismiss.
A Word of Caution for Private Equity Sponsors
Although not the focus of the decision discussed in this blog post, it is worth noting that Sycamore, the entity on the buy-side of the transaction, did not escape unscathed in its aftermath. During the Nine West chapter 11 case, Sycamore, along with Nine West’s minority equity holder, settled potential claims against it and the Sycamore-appointed directors arising out of the 2014 transaction. The settlement required the payment of a combined $120 million to the Nine West bankruptcy estates and Sycamore agreeing to cause one of its portfolio companies, which was among Nine West’s largest customers, to make certain required minimum purchases of product from Nine West post-bankruptcy to bolster the company’s financial position. Admittedly, Sycamore may have been just fine with this outcome when considering that the transaction was not unwound as a judicial remedy. Because these claims were settled, they were not included in the Litigation Trust’s lawsuit. Yet the court’s description of the actions by Sycamore and the buyer directors, and its willingness to entertain an aiding and abetting claim predicated on those directors’ underlying breaches of fiduciary duties, could lead one to surmise that it may have found serious wrong-doing on the part of those parties had the claims not been released.
Takeaways from SDNY Decision
If this decision is followed by other courts and, in particular, applied to Delaware companies, the job of being a director in the midst of deciding whether to approve an M&A transaction, particularly an LBO, will become more stressful. The key question, however, is how much?
If they fear the fate of the directors in Nine West, directors may decide to perform additional steps prior to completing a transaction. As discussed above, these steps are not as onerous as they would appear to be at first glance. However, it is important to keep in mind that courts will be interpreting the propriety of directors’ actions with the benefit of hindsight, making for a fact-intensive inquiry that could be difficult to predict. It is, therefore, important not only that directors take all appropriate actions, but also that the contemporaneous record reflect the deliberations and actions taken by the directors.
It remains to be seen how these cases will play out as they move beyond the motion to dismiss stage. We will watch and report here on anything significant. But going forward, what is entirely foreseeable is that the conduct of the directors here, having conducted no investigation whatsoever and allowing the company to be left insolvent on their way out the door, may no longer be appropriate if other courts follow the Nine West lead.
Another tip to directors: check your D&O insurance to make sure you are sufficiently covered. We have previously posted about that issue.
Of course, every transaction is different, and the applicable law may require more or less of directors than what is described here, so while this blog post is designed to provide helpful high-level guidance, it is important that directors be advised by reputable counsel when approving a major transaction. In other words, this blog entry should not be considered legal advice. For any questions, please reach out to Weil partners:
- Sujeet Indap, Dealmakers Warn of Chilling Effect on Buyouts from US Court Ruling, FIN. TIMES (Dec. 15, 2020), https://www.ft.com/content/01affe9d-89a7-4c0e-8a15-d6d544d4ce04 (quoting Brian Quinn, a corporate law professor at Boston College).≈
- Case No. 20-2941 (S.D.N.Y. Dec. 4, 2020) (Rakoff, J.).≈
- Nine West, slip op. at 4.≈
- Id. at 6.≈
- 15 Pa. Cons. Stat. §1715.≈
- In re Hechinger Investment Co. of Delaware, 274 B.R. 71 (D. Del. 2002); see also United States v. Tabor Court Realty, 803 F.2d 1288, 1302 (3d. Cir. 1986) (relevant here as a Third Circuit case interpreting Pennsylvania law that finds courts may treat multistep LBO transactions as one transaction and which Hechinger relies on in its reasoning).≈
- Hechinger, 274 B.R. at 91.≈
- Nine West, slip op. at 29.≈
- Id. at 31.≈
- 15 Pa. Cons. Stat. §1713(a).≈
- Nine West, slip op. at 34.≈
- Id. at 37.≈
- Id. at 38.≈