The United States District Court for the Southern District of New York recently issued the opinion In re Nine West LBO Securities Litigation, Case No. 20-2941 (S.D.N.Y. Dec. 4, 2020), a ruling that may become the basis for serious consequences for corporate decision makers.
Background
In 2014, publicly traded apparel and footwear company Jones Group was part of a going-private transaction via leveraged buyout with Sycamore Group, a private equity sponsor. The deal consisted of five primary components:
- Jones Group would merge with a Sycamore affiliate, and, as the surviving corporation, be renamed Nine West Holdings, Inc.
- Sycamore (along with another private equity firm) would contribute at least $395 million in equity to Nine West.
- Nine West would increase its debt from $1 billion to $1.2 billion.
- The Jones Group shareholders would be cashed out at $15 per share, for a total of approximately $1.2 billion.
- A selection of brands (the “Carve-Out Businesses”) would be sold to other Sycamore affiliates for substantially less than their fair market value.
However, before the deal was closed, the terms were changed so that Sycamore’s equity contribution was drastically reduced ($395 million down to $120 million) and Nine West’s debt was increased to $1.55 billion.
Four years later, in April 2018, Nine West filed for reorganization under Chapter 11. The Nine West liquidating trustee subsequently brought claims against the former directors of Jones Group for both breach of fiduciary duty and for aiding and abetting the breach of fiduciary duty, arguing that these breaches resulted in the bankruptcy of Nine West. The trustee’s argument was that the former directors of Jones Group failed to conduct a “reasonable investigation” into whether the components of the original LBO transaction would leave the resulting company (Nine West) insolvent.
The former directors of Jones Group sought to dismiss these claims, citing protection under the “business judgment rule” and the Jones Group’s exculpatory bylaws. The “business judgment rule” typically shields corporate directors from liability to shareholders as long as the directors have acted in good faith, without breaching their duty of loyalty to the corporation and with due care.
The former Jones Group directors also pointed out that several of the transactions contributing to Nine West’s insolvency were completed after they no longer were directors of Jones Group, such as the addition of debt and the sale of the “carve-out businesses.” The directors therefore argued that they could not be held liable for the consequences of those transactions.
Court Decision & Implications
In a decision that shocked much of the business world, the Court denied the dismissal of these claims. In his opinion, Judge Jed Rakoff wrote that “multistep transactions can be treated as one integrated transaction” and that the Jones Group directors could be held accountable for “foreseeable harm” caused by any component of the LBO, even one not formally approved by them and enacted after their tenure.
Moreover, the directors would not be covered by the “business judgement rule” because they had made no effort to investigate the effect the additional debt and the sale of the “carve-out businesses” would have on the company’s post-transaction solvency. The Court also determined that the board of directors would not be covered under the Jones Group’s exculpatory bylaws because they had acted “recklessly” in approving the 2014 LBO without first conducting a thorough investigation.
Although the opinion is only a denial of a motion to dismiss, it clears the path to possible liability for the directors. For directors of corporations being sold, this rule is a warning that, even when exiting, directors must take care to investigate and evaluate the effect that the sale and any related transactions will have on the surviving corporation’s creditors and shareholders.
As part of this investigation and evaluation, directors can take steps to mitigate the risk of liability, such as retaining counsel to answer questions and create projections regarding solvency; performing due diligence on the entirety of the transaction, including any post-sale transactions intended by the buyer; keeping thorough documentation of the analyses and considerations being performed; re-evaluating the selling company’s solvency if the terms of the LBO change pre-closing; and obtaining directors and officers (D&O) liability insurance.
If you have any further questions regarding selling directors’ fiduciary obligations and liability exposure related to corporate transactions, please contact William Newman.
