A New York court has issued a forceful ruling that directors of a target company in a leveraged buy-out (LBO) can be liable for breach of fiduciary duties if they fail to assess the seller’s post-sale solvency. The ruling may force directors to think twice about selling via LBO’s with very high debt-to-equity ratios, and may even have a chilling effect on private equity-driven LBO’s in general.
In 2014, Jones Group, a publicly traded company (owner of the Nine West and Anne Klein brands), entered into a take-private bid from private equity (PE) sponsor Sycamore Group. Under the terms of the transaction, Jones Group would merge with a Sycamore affiliate and be renamed Nine West Holdings, Inc. Sycamore was to contribute $395M in equity to Nine West, while Nine West would take on $1BN to $1.2BN in debt through the LBO structure. Jones Group shareholders would cash out at $15/share, for a total value of approximately $1.2BN. Notably, Jones Group was advised that it could support a 5.1x debt-to-EBITDA ratio.
At the last minute, the terms of the LBO were further negotiated, and Sycamore proposed to (1) increase the Jones Group’s debt leverage to 7.8x EBITDA (borrowing $350 million more than initially anticipated, and saddling Nine West Holdings with $1.55BN in debt), and (2) carve out and transfer Jones Group’s crown jewel brands to other Sycamore affiliates post-closing, at “substantially less than fair market value.”
The board could have bowed out of the deal due to the changed terms, but voted to proceed – although it expressly excluded the new debt and carve-out transactions from their approval. The transaction proceeded; four years later, in 2018, the “RemainCo” Jones Group filed for Chapter 11 bankruptcy.
A litigation trust formed out of the bankruptcy process brought suit against the former directors and officers of the Jones Group, alleging (inter alia) breach of fiduciary duties and aiding and abetting breaches of fiduciary duties related to the 2014 LBO. (A separate shareholder derivative suit had been filed during negotiations, but settled pre-closing.)
The United States District Court for the Southern District of New York (SDNY; Judge Jed Rakoff), denied a motion to dismiss the suit, allowing the breach of fiduciary duties claims to move forward. In doing so, the court determined that directors could be liable for their failure to adequately investigate the Jones Group’s post-sale solvency. The directors had argued that they could not be held liable for post-sale asset dispositions (e.g., sale of the “crown jewel” businesses, which allegedly made it impossible for the RemainCo to pay off the debts taken on in the LBO process) that they had not approved. The court rejected this argument, ruling that pre- and post-sale transactions should be “collapsed” and treated as an “integrated transaction” for the purpose of assessing fiduciary duties – because, in this case, the harm of the post-sale acquisitions was foreseeable. Notably, the court stated that while the traditional business judgment rule applied, it did not insulate the directors from fiduciary liability where they were alleged to have acted recklessly, by failing to make an adequate investigation into the surviving RemainCo’s solvency; likewise, the directors’ decision to expressly exclude the new debt and carve-out transactions from their approvals did not shield them from liability.
The Nine West ruling only addressed the motion to dismiss, and did not make any findings of actual liability – although this initial ruling certainly does not bode well for the directors. Wall Street immediately recognized the ruling as a broader shot across the bow for LBO’s that sell companies for a market-clearing price, to the benefit of existing shareholders – but that leave otherwise solvent companies to be sold into circumstances that cause their bankruptcy. At minimum, the ruling exposes a tension between directors’ duty to maximize shareholder value, and their fiduciary duties to the corporation. Directors contemplating LBO’s (often in take-private scenarios) can no longer ignore what the target company’s balance sheet looks like after it is sold to a new buyer. In other words, the days of selling a company to the highest bidder, regardless of the consequences – may be over. So far, the initial ruling has not put a dent into the overall appetite for highly leveraged LBO’s. A decision on the merits in favor of Nine West Holdings may change that.