Corporate Directors Beware - A Recent S.D.N.Y. Opinion Suggests That Former Directors of Selling Corporations Can Face Personal Liability for Post-Closing Insolvency
January 12, 2021
In a recent opinion entitled In re: Nine West LBO Securities Litigation, 20 MD. 2941 (JSR) (S.D.N.Y. Dec. 4, 2020), Judge Jed Rakoff of the Southern District of New York cautioned that former directors of a selling corporation who approve a sale of the corporation as part of a leveraged buyout may face personal liability for their failure to adequately investigate the viability of the corporation following the closing of the transaction.
Some of the key-takeaways from the Nine West decision are as follows:
- The business judgment rule1 may not apply to the directors of a selling corporation who fail to adequately assess the post-transaction solvency and viability of the corporation.
- Directors of a selling corporation may be deemed to have acted “recklessly” if they consciously disregard the post-transaction solvency of the corporation.
- Directors of a selling corporation may be held liable for “aiding and abetting” a breach of fiduciary duties by incoming directors, where the outgoing directors approve a transaction knowing that, post-sale, the buyer will, or plans to, take certain actions that will render the corporation insolvent.
Nine West involved an underlying transaction between Jones Group, a publicly traded Pennsylvania corporation and global seller of footwear and apparel, which included brands such as Nine West, Anne Klein and Gloria Vanderbilt (“Jones Group”), and Sycamore Partners Management, LP, a Delaware limited partnership and private equity sponsor (“Sycamore”), whereby Sycamore offered to purchase the Jones Group for $15 per share, for a total implied enterprise value of $2.15 billion. Nine West, 20 MD. 2941 (JSR) at 2-3. The board of directors of Jones Group was advised by its financial adviser that in the context of a transaction in which Jones Group retained all of its businesses, including its “crown jewel” brands, Stuart Weitzman and Kurt Gieger, the corporation could support a debt to EBITDA ratio of 5.1 times its estimated 2013 EBITDA. Id. at 2. Initially, there were five key integrated components of the merger agreement between Jones Group and Sycamore, which were to occur substantially concurrently with the closing. These key terms provided that: (i) Jones Group would merge with a Sycamore affiliate, whereby Nine West Holdings, Inc. (“NW Holdings”) would be the surviving entity, (ii) Sycamore and another private equity sponsor firm would contribute at least $395 million in equity to NW Holdings, (iii) NW Holdings would increase its debt from $1 billion to $1.2 billion (the “Additional Debt”), (iv) the Jones Group shareholders would be cashed out at $15 per share, for the total implied enterprise value of $2.15 billion, and (v) the Stuart Weitzman and Kurt Geiger “crown jewel” brands and another business unit would be sold to certain Sycamore affiliates for substantially less than their fair market value (the “Carve Out Transactions”), while other less-attractive brands would remain with NW Holdings. Id. at 3-4.
Prior to the closing of the transaction, Sycamore required certain modifications to the terms of the agreement, including reducing its equity contribution from $395 million to $120 million and increasing the Additional Debt from $1.2 billion to $1.55 billion. Id. at 5. This resulted in NW Holdings having debt that would be 7.8 times the adjusted 2013 EBITDA, as calculated by Jones Group’s management, and 6.6 times the adjusted 2013 EBITDA, as calculated by Sycamore, both of which debt multiples exceeded the 5.1 times adjusted 2013 EBITDA that the directors were advised the corporation could sustain. Id. In addition, while the directors of Jones Group were not aware that certain projections provided to them by Sycamore leading up to the closing may have been manipulated, the board received updated monthly reports from Jones Group management which indicated that that the projected performance of the brands that were to remain with NW Holdings were in decline, and the board was aware that NW Holdings would be more-heavily leveraged after the closing of the merger. Id. at 6.
In early 2014, after the announcement of the merger, but prior to closing, some of the stockholders filed suit against Jones Group, its directors, officers and Sycamore asserting that the directors breached their fiduciary duties to Jones Group by deciding to sell to Sycamore for the allegedly inadequate consideration of $15 per share. Nine West, 20 MD. 2941 (JSR) at 7. In response, the board formed a special litigation committee which made several findings in favor of the board, including that the board “acted on an informed basis in good faith and in the best interests of [Jones Group] in agreeing to the merger with Sycamore.” Id. The parties eventually settled these claims. Id. at 8.
The merger ultimately closed in 2014, whereby Sycamore’s principals became the sole directors of NW Holdings. Sycamore then proceeded to complete the Carve Out Transactions by selling off the “crown jewel” brands to the Sycamore affiliates at prices substantially below market value.2 Id. at 6.
In 2018, NW Holdings filed for bankruptcy and the bankruptcy court approved NW Holdings’ Chapter 11 plan. Id. at 9. In the bankruptcy litigation that ensued, the litigation trustee and indenture trustee (who were appointed under the bankruptcy plan), brought suit against the former Jones Group directors and officers regarding the unsettled claims. Id. at 10.
Nine West Ruling
The court’s ruling in Nine West was made pursuant to motions filed by the defendant directors’ and officers’ to dismiss plaintiffs’ remaining claims against them for breach of fiduciary duty, aiding and abetting breach of fiduciary duty, unjust enrichment, fraudulent conveyance and violation of certain Pennsylvania state law claims. Id. at 11.
The defendant directors moved to dismiss the plaintiffs’ breach of fiduciary duty claims, arguing that their decision to enter into the merger agreement was protected by the business judgment rule. Id. at 25. In deciding whether the business judgment rule precludes liability of the directors, the court opined that under Pennsylvania law, the business judgment rule can be overcome if a majority of the board of directors was not disinterested or if the directors did not assent to the transaction in good faith after a reasonable investigation. Id. at 27. While the court held that the plaintiffs failed to adequately plead that the directors were not disinterested, the court found in favor of the plaintiffs that the complaint adequately pleaded that the directors failed to adequately conduct a reasonable investigation into the post-sale implications of the transaction. Id. at 28, 31. In doing so, the court agreed with plaintiffs’ argument that “business judgment” presupposes consideration by the directors in rendering their decisions, and therefore, will not protect directors with respect to matters that lacked such consideration. Id. at 29. The court also expressly rejected the directors’ argument that they could not be held liable for transactions that occurred post-closing, stating that:
“[m]ultistep transactions can be treated as one integrated transaction where, as here, the plaintiff pleads that the transaction ‘reasonably collapse[s] into a single integrated plan’ and ‘where the plaintiff pleads a cause of action for breach of fiduciary duty based on the foreseeability of the alleged harm.’”
Nine West, 20 MD. 2941 (JSR) at 30.
Accordingly, the court held that the directors would not be entitled to the protections of the business judgment rule based on their failure to make an investigation into the ramifications of the post-closing transactions, reasoning that “[b]ecause the director defendants made no investigation whatsoever into the propriety of the Additional Debt and Carve Out Transactions, they cannot take cover behind the business judgment rule with respect to those components of the 2014 Transaction.” Id. at 31.
The court also determined that the plaintiffs adequately pleaded that the directors acted recklessly with respect to their approval of the transaction, thus eliminating the applicability of an exculpation clause under the corporation’s bylaws. Id. at 34. The court found that in order to adequately plead “recklessness,” the plaintiffs were required to allege that the former directors “knew, or had reason to know, of the facts that created a degree of risk that the 2014 Transaction would harm the Company, and that they deliberately acted or failed to act in disregard of the risk.” Id. at 34. In this instance, the recklessness was made worse by fact that the directors failed to investigate the terms of the deal further after Sycamore modified them to the detriment of NW Holdings. Thus, with respect to this cause of action, the court concluded that the plaintiffs adequately pleaded recklessness based on the directors’ conscious disregard for whether the Additional Debt and Carve Out Transactions were in the best interest of NW Holdings, and whether they would leave NW Holdings insolvent. Id. at 34-35. The court concluded:
“At this stage of the case, taking all allegations as true and making all reasonable inferences in the light most favorable to the Litigation Trustee, the Court holds that the complaints have stated a claim for breach of fiduciary duty against the director defendants. Moreover, because the director defendants failed to make a reasonable investigation (or any investigation, for that matter) into the Additional Debt and Carve-Out Transactions even in the face of red flags suggesting the 2014 Transaction would render the Company insolvent, they are not entitled to the protections of the business judgment rule or the Company's exculpatory bylaw. For that reason, their motion to dismiss the breach of fiduciary duty claims is denied”
Id. at 35-36.
Finally, the court held that the plaintiffs adequately pleaded a valid claim for aiding and abetting a breach of fiduciary duty. The court found that that the former directors had actual or constructive knowledge that the incoming Sycamore directors would carry out the post-closing transactions that would leave NW Holdings insolvent. Id. at 38.
It is important to remember that the Nine West holding was made in the context of whether the plaintiffs’ claims were sufficiently pleaded to survive a motion to dismiss, and not as an ultimate finding of fact at trial. In addition, the court’s holding was largely based on relevant Pennsylvania law, and the application of other state law may not have led to the same result. However, the element of recklessness the court said was adequately pleaded may also preclude the protection of charter provisions providing for breach of fiduciary duty exculpation under Delaware law, as “conscious disregard of duties” may constitute bad faith, for which monetary damages cannot be exculpated under Section 102(b)(7) of the Delaware General Corporation Law. See In re Walt Disney Co. Derivative Litig., 906 A.2d 27, 66 (Del. 2006). Moreover, Delaware law was cited favorably by the Nine West court in supporting the notion of collapsing a multi-step transaction.
The Nine West holding sends a clear message that the directors of selling corporations, in a leveraged buy-out situation, should not solely focus on maximizing shareholder value in the short term (i.e., in terms of obtaining the highest price from a would-be buyer), but also the post-closing ramifications on the selling corporation based on the buyer’s plans for subsequent transactions, specifically those that may render the corporation insolvent. As discussed, the Nine West holding suggests that the business judgment rule will not apply to directors who fail to adequately consider the post-transaction solvency of the selling corporation.
To address the concerns raised by the Nine West decision, directors should consider the following steps as part of their transaction analysis:
- obtain professional guidance regarding the debt to equity ratios that the corporation can support, and investigate whether the agreed upon terms of the transaction will exceed those thresholds;
- understand the post-transaction plans of the buyer, and inquire into the post-transaction solvency of the corporation in connection with those plans;
- obtain representations and warranties from the buyer that (i) the transaction will not render the corporation insolvent, and (ii) that any actions of the buyers that will occur, or are planned to occur, subsequent to the transaction, will not render the corporation insolvent;
- ensure proper documentation of the transaction, including any minutes or notes regarding the decision-making process by the directors authorizing of the transaction; and
- consult with legal counsel, who can advise on these issues and any other issues that may arise pursuant to a particular transaction.
1 The business judgment rule generally protects directors from liability for decisions made: (1) in good faith; (2) where the director or officer is not interested in the subject of the business judgment; (3) is informed with respect to the subject of the business judgment to the extent he reasonably believes to be appropriate under the circumstances; and (4) rationally believes that the business judgment in question is in the best interests of the corporation. Nine West, 20 MD. 2941 (JSR) at 26 citing In re Lampe, 665 F.3d 506, 516-517 (3d Cir. 2011).
2 The Sycamore directors caused NW Holdings to sell the “crown jewel” brands to the Sycamore affiliates for $641 million. Nine West, 20 MD. 2941 (JSR) at 6. This was not only substantially below their estimated value of at least $1 billion, but also even less than the $800 million that the Jones Group had paid to acquire these brands a few years earlier. Id.