Did a New York Federal Court Just Burst a Private Equity Bubble?
Recently, a U.S. District Court for the Southern District of New York issued a significant ruling in In re Nine West LBO Securities Litigation, Case No. 20-2941 (S.D.N.Y. Dec. 4, 2020) (Rakoff, J.), which could shift the risk of a failed leveraged buyout (LBO) to a selling corporation's directors. In Nine West, the court refused to dismiss a suit which alleged that the directors of a selling corporation face personal liability based on claims of breach of fiduciary duty to the seller corporation, as well as aiding and abetting a breach by the buyer's board for leaving the target company insolvent as a result of the transactions contemplated in the sale. While the private equity industry often has to defend against claims involving failed LBOs, the Nine West ruling represents a significant shift by introducing the specter that a target's board could be on the hook for the failures or lack of success by the buyer's board even many years after a transaction has closed. While the facts of Nine West, discussed below, may be particularly egregious, the case more generally presents a fundamental expansion of the liability typically understood for directors and officers of a selling corporation and individuals in those positions, as well as advisors, should carefully consider its warnings.
Jones Group's Board Focused on Maximizing Shareholder Returns
In 2014, Sycamore Partners, a private equity firm, acquired The Jones Group, a Pennsylvania public company, via a leveraged buyout. Sycamore would pay the Jones Group's public shareholders $15 in cash per share, aggregating approximately $1.2 billion. As is typical, Sycamore proposed financing the purchase price largely via a loan secured by the assets of the Jones Group which would merge into a Sycamore affiliate – "Nine West." Initially, Sycamore was to contribute $395 million in equity at closing. Critically, Sycamore also planned to transfer certain assets of the Jones Group – often described as Jones Group's "crown jewels" – to other Sycamore affiliates for what the plaintiffs claimed was less than their fair market value (Affiliate Transfer). Although the merger agreement for the LBO did not require Jones Group's board of directors to approve the Affiliate Transfer (as this transaction would not close until after the closing of the LBO), the Jones Group had to assist Sycamore with the Affiliate Transfer and, as is also typical, Sycamore's efforts to raise debt to consummate the LBO.
After the Jones Group's board approved the LBO, but prior to closing, Sycamore proposed reducing its equity contribution from $395 million to $120 million and arranged for additional debt to complete the deal. This revised financing plan meant that the target's debt following the closing would be around 25 percent to 50 percent higher than the Jones Group board's financial advisors had indicated that the company could sustain, even if it's most profitable lines were not spun out in the Affiliate Transfer. Although the merger agreement contained a "fiduciary out," even after the change in debt terms, the Jones Group board declined to exercise that right despite the board being advised that the additional debt coupled with the Affiliate Transfer would significantly stress the company post-closing. The LBO closed and following closing, Sycamore/Nine West completed the Affiliate Transfer. Per the complaint, the Affiliate Transfer resulted in the transfer of assets of at least $1 billion being transferred for $641 million.
Four years later, Nine West filed for bankruptcy.
SDNY Court Refuses to Dismiss Lawsuit Claiming Jones Group's Directors Breached Duties
As Jones Group was a Pennsylvania corporation, its directors owed a duty of care and loyalty to the Jones Group. Pennsylvania law, like that of many states, affords directors of a selling company the benefit of the business judgment rule absent clear and convincing evidence that the board 1) was not disinterested in the transaction or 2) did not approve the transaction in good faith after conducting a reasonable investigation. Because the Jones Group board asked the court to dismiss the case, the court only had to determine if the plaintiff's complaint validly alleged that the directors should lose the presumption afforded by the business judgment rule.
At central issue was the Jones Group board's need to investigate the post-closing transactions associated with the LBO – namely the 1) Affiliate Transfer and 2) leveraged loans to finance the Sycamore acquisition. Critically, the court concluded that the Jones Group board needed to investigate the Affiliate Transfer and leverage post-LBO in order to conduct a "reasonable investigation." The board argued that, as a matter of law, it did not have to investigate these post-closing transactions – despite it being well aware of the nature of the transactions and their impact on the Jones Group – as those transactions would not occur on "their watch." According to the board, its investigation only needed to focus on pre-closing matters, as post-closing transactions represented distinct transactions which it could not control and which would have no effect on the success following the closing.
The court, however, disagreed that the Jones Group board should have easily compartmentalized pre- and post-closing activity given its awareness of those transactions and the impact on the seller. By treating the pre- and post-closing transactions as a singular transaction, in reliance on Delaware law, the court found ample reason not to dismiss the complaint against the Jones Group board for breach of fiduciary duty based on the foreseeability of the alleged harm. Moreover, the court noted that the Jones Group board had the ability to terminate the deal when it became worse for the Jones Group based on its knowledge that the same would jeopardize the company's solvency, but failed to do so. Because the directors made "no investigation whatsoever" into the post-sale solvency of the company, the court ruled the directors lost the business judgment rule's protection.
The Jones Group, like most companies, had exculpatory language in its bylaws, which limited the director's liability absent "self-dealing, willful misconduct, or recklessness." The court held that the plaintiff adequately alleged "recklessness" because the directors "consciously disregard[d]" the post-closing transactions and ignored "red flags" concerning the company's on-going solvency. The court noted that Nine West's debt (after giving effect to the Affiliate Transaction) would 1) exceed the company's assets and 2) be nearly 8 times Adjusted EBITDA, even though advisors communicated that the Jones Group (without giving effect to the Affiliate Transaction) could only support an Adjusted EBITDA ratio of less than 5.1.
In respect of claims of aiding and abetting the Sycamore parties in the breach of their fiduciary breaches, the court found that the Jones Group's directors could not escape liability given the actual or constructive knowledge of what was likely to occur post-closing. The board's "not on our watch" argument also failed because, according to the court, although the Sycamore parties' duties may have attached post-closing, they were devised pre-closing and the Jones Group agreed to support those transactions pre-closing as part of the larger transaction critical to Sycamore and the ability to deliver value to the Jones Group's shareholders.
Although the Nine West decision involved a Pennsylvania company and was in the context of a motion to dismiss where the directors could not factually defend their conduct, the decision is significant because it expands the scope of risks that directors must examine to satisfy their fiduciary duties in connection with a transaction. Specifically, directors and their advisors should recognize the Nine West decision as reiterating the following:
- maximizing shareholder returns will not, in and of itself, discharge fiduciary obligations
- the business judgment rule may not provide protection where directors fail to adequately assess the selling company's post-sale solvency, and
- "aiding and abetting" liability may arise based on post-sale conduct known at the time of closing and for "recklessly" assessing the selling company's post-sale solvency
Regardless of the ultimate outcome of the Nine West litigation, exiting boards are now on notice that they may become litigation targets of a failed LBO. Given some of the continuing uncertainty raised by Nine West, boards will be wise to carefully document steps taken to assess the fairness of the transaction and likelihood of long-term solvency of the target. Unfortunately, given the court's guidance and the factual nature of any possible dispute, no single factor or "deal term protection" is likely to prove dispositive, although there are many terms that could prove helpful. On balance, the expansive view of fiduciary obligations adopted by Nine West could cause boards to become more conservative in pushing deal valuations that could impact shareholder returns and the buyout industry generally.
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