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Buyer Beware: Structured and Leveraged Buyout May Breach Fiduciary Obligations
March 03, 2021
Most mergers and acquisitions and bankruptcy practitioners are well aware of the ever-increasing use of leveraged buy-out ("LBO") by publicly traded companies and private equity groups alike in highly structured liquidation or restructuring proceedings, both inside and outside of the bankruptcy context. A recent decision out of the Southern District of New York dictates extra layers of caution in determining whether to proceed with such transactions.
The decision in the case of In re Nine West LBO Securities Litigation involves a complex procedural history. At its base, however, the Trustee for the Nine West Litigation Trust (the "Trust"), established as part of the 2018 bankruptcy filing by Nine West, brought various claims against former officers, directors, and shareholders of a fashion retail company called The Jones Group (the "Company"). These claims arose out the merger between the company and an affiliate of private equity firm Sycamore Partners Management, L.P. ("Sycamore") to form Nine West Holdings, Inc. ("Nine West").
The details of the merger are predictably complex. As summarized by the court, however, the transaction involves five integrated components that would occur simultaneously. First, the company and a Sycamore affiliate would merge into Nine West. Second, Sycamore and another private equity firm would contribute $395 million in equity to Nine West. Third, Nine West would increase its debt from $1 billion to $1.2 billion. Fourth, Jones Group shareholders would receive cash out payments of $15 per share, totaling $1.2 billion. Fifth, the company would jettison two brands and a business unit (the "Carve-Out Businesses") for less than fair market value.
The company's board voted to approve the merger, though there is some confusion over how and whether the board approved the additional debt and sale of the Carve-Out Businesses. The court focused heavily on the fact that the merger documents considered all of these transactions part and parcel of the same transaction and that the company's board actively assisted in reviewing and preparing documentation to support the additional debt and sale of the Carve-Out Businesses.
The transaction became even more complex when Sycamore changed its terms. Sycamore reduced the equity contribution to just $120 million and arranged for new debt that would increase Nine West's debt to $1.55 billion (instead of the $1.2 billion proposed). As a result, while a third-party, Citigroup Global Markets ("Citigroup"), advised the board that the company could support a debt to EBITDA ration of 5.1 times its estimated 2013 EBITDA, the new debt increased that ratio to between 6.6 and 7.8 (depending on whether the company's management or Sycamore's numbers were correct). Nonetheless, the directors and officers of the company approved the transaction and participated heavily in its execution. Predictably, the new Nine West filed bankruptcy just four years after the merger.
As a result of the transaction, however, Nine West, inclusive of its debtholders and unsecured creditors, were left in the lurch. Unlike the circumstances we most often see, where unsecured creditors are generally content to recover a few bread crumbs, they sought to hold the company's directors and officers liable. As a result, they plead various claims of breach fiduciary duties, aiding and abetting same, fraudulent conveyances, and unjust enrichment, among other things. The factual record of these transactions, of course, is well established by this point. Based on that record, the court denied motions to dismiss the breach of fiduciary duty claims and aiding and abetting claims against the company's directors. The officers, on the other hand, avoided this result, as the court granted their motions to dismiss.
The court allowed the breach of fiduciary duty claims to proceed against the directors despite the heavy shields normally afforded by the business judgment rule and despite company bylaws that precluded liability in all but rare instances. In short, the court said that the directors had enough information to be able to form a conclusion based on a reasonable investigation that the complex series of merger transactions would leave the company insolvent. As for the bylaws, the court held that a careful review of the history of valuations raised enough "red flags" that the directors were, at the very least, reckless in their approval of the transaction.
Practically, the thorough decision offers some clues as to how directors and officers might better review transactions to avoid the implication of this decision. That said, had the directors followed that roadmap (refusing to ignore the valuation discrepancies and impact of the Carve-Out Businesses), it is doubtful that Sycamore would have been willing to complete the transaction. After all, the goal was simple. Like most LBOs financed by private equity, Sycamore convinced the company to jettison its most favorable assets at a much lower debt load and gave themselves the ability to double down on their win through the resulting bankruptcy of the company holding the remaining assets. Had the directors and officers followed the court's roadmap, it is hard to believe Sycamore finds much benefit from the transaction.
That said, the decision will hardly stop parties from trying to gain financial advantage through LBOs. As a result, the decision casts a warning shot to directors and officers - either they get better insurance or think long and hard about whether they should approve transactions of this type. We would, of course, anticipate that this decision will create a new focal point of director and officer litigation in the coming years.
Bankruptcy & Creditors' Rights