In In re Nine West LBO Securities Litigation, Case No. 20-2941 (S.D.N.Y. Dec. 4, 2020), U.S. District Court Judge Jed Rakoff denied a motion to dismiss claims brought by the Nine West liquidating trustee against former directors of Jones Group (the predecessor to Nine West) for breach of fiduciary duty and aiding and abetting breach of fiduciary duty stemming from a 2014 going-private transaction with private equity sponsor Sycamore Group. While it remains to be seen whether the defendant directors ultimately will be found liable for such claims, we highlight certain lessons learned and best practices that can be followed in light of the ruling.
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 sponsor Sycamore Group.
The transaction (which contained a fiduciary out) contemplated that: (1) Jones Group would merge with a Sycamore affiliate and be renamed Nine West Holdings, Inc., (2) Sycamore and another firm would contribute at least $395M in equity to Nine West (later reduced pre-closing), (3) Nine West would increase its debt from $1B to $1.2B (later increased pre-closing), (4) Jones Group shareholders would be cashed out at $15 per share (total value of approximately $1.2B), and (5) certain crown-jewel brands (the carve-out business) would be sold to Sycamore affiliates post-closing at “substantially less than fair market value.”
A shareholder derivative action was brought and settled pre-closing, which claimed the Jones Group shareholders were receiving inadequate value in the transaction.
Four years later, Nine West filed for bankruptcy. A bankruptcy litigation trustee brought claims against the former directors and officers of Jones Group on theories of breach of fiduciary duty, aiding and abetting breach of fiduciary duty, and other claims in connection with the Sycamore Group LBO.
In December 2020, District Judge Rakoff issued a decision denying the motion to dismiss of the former Jones Group directors with respect to the claims of breach of fiduciary duty and aiding and abetting breach of fiduciary duty, and granting the dismissal of those claims against the former officers. Of particular note, the court ruled that:
- While the business judgment rule applied, it did not insulate the directors from liability where they acted recklessly by failing to make an adequate investigation into the surviving company’s solvency.
- The court held that even though the Jones directors did not approve the post-closing carve out transaction or the new debt placed on the business, the entire LBO/take private transaction could be treated as an “integrated transaction,” where the directors were aware of these steps as integral to the deal. The directors’ decision to expressly exclude the new debt and carve-out transactions from their approvals did not shield them from liability.
- The court held the complaint alleged sufficient allegations that the directors acted recklessly by failing to conduct a “‘reasonable investigation’ into whether the 2014 transaction – as a whole – would render the Company insolvent” in light of various “red flags” including that the estimated post-closing/post-spin valuation of the company ($1.4B) was less than the amount of the surviving entity’s total post-transaction debt ($1.55B), the expected adjusted EBITDA multiple (6.6x or 7.8x) was higher than the 5.1x multiple the Jones Group banker advised the board the company could sustain, and that the purchaser was using “unreasonable and unjustified” EBITDA projections in obtaining a solvency opinion in connection with the carve-out transaction.
- While the company’s bylaws contained a limitation of liability (as permitted under Pennsylvania law), the directors could not rely on such protections to the extent they acted recklessly in failing to consider and act on sufficient information.
- The directors may be liable for aiding and abetting breaches of fiduciary duty by the new board. The court concluded that the directors “knowingly participated” in the conduct alleged to give rise to breach of fiduciary duties by the Nine West board as they had actual or constructive knowledge that the new board members would carry out the transaction and leave the Company insolvent. The fact that the directors’ actions occurred pre-closing, when the new directors had not yet been appointed, alone did not defeat such a claim.
- The court dismissed the breach of fiduciary duty and aiding and abetting claims against the Jones Group officers. The court held a claim did not lie against the former officers, relying on Pennsylvania law limiting officer liability “to the extent they have discretionary authority over, and the power to prevent, the complained of transactions,” and concluding it was not adequately alleged that the officers had control over the transaction.
- The pre-closing shareholder settlement did not bar the claims, where the settlement was only with the former shareholders in their capacity as such and the allegations there were in conflict with the claims currently brought rather than being identical.
Takeaways and Best Practices to Consider
While it is not clear whether the litigation trustee’s claims will be proven up at the end of the day, the decision suggests that boards considering LBOs and spinoff transactions can take certain steps to minimize the risk of claims if the business later faces financial distress. These include:
- A board contemplating entering into such a transaction should consider the entirety of the transaction being proposed, recognizing a court may collapse the transaction, including the incurrence of new debt or a spin-off of assets post-closing, in determining whether the transaction left the company insolvent.
- To the extent deal terms change pre-closing, the board should refresh and re-evaluate its approval of the transaction following such changes, particularly if the transaction has a fiduciary out.
- In sale transactions, a board generally should focus on obtaining the highest price for the company’s shareholders consistent with its fiduciary duties; however, in a leveraged buyout transaction, the board also should consider known and available information about the likely solvency of the post-sale company in deciding whether a potential transaction presents unacceptable litigation risks.
- While a solvency opinion may be helpful to demonstrate the surviving company’s solvency at the transaction’s close, it must be based on realistic assumptions and projections to be probative of solvency.
- A company’s officers may have less risk of potential liability to the extent they do not control the approval of the transaction.
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