Recent Judge Rakoff Decision May Curb Private Equity Leverage Abuses By Pinning Liability on Directors of Selling Company
For decades, authorities and experts have tried restricting excessive borrowing by private equity investors, since it’s been repeatedly shown that they leave lots of bankruptcies in their wake. And these abuses continue because private equity looting fee structures result in general partners make out handsomely whether or not the business does well. In 1987 (no typo), the Treasury proposed limiting the deduction of interest on highly leveraged transactions. That idea went by the wayside thanks to the 1987 crash. Other proposals to restrict debt levels have similarly not gone anywhere. Yet now an important ruling looks set to deliver where regulators and legislators have failed.
The decision is related to bankruptcy ruling, In re Nine West LBO Securities Litigation, in early December. I’m late to it; several readers called it to my attention via a William S. Cohan op ed in the New York Times, The Private Equity Party Might Be Ending. It’s About Time. I think Cohan is overstating its significance; investment bankers and lawyers are prone to howling loudly about anything that might reduce the size of their meal tickets while working full bore to preserve them. But Nine West does appear likely to restrict very highly leveraged deals by pinning the liability tail for likely insolvencies on the directors and officers of the selling company.
The very short version of this story is that the directors of the selling company approved a sale transaction that they knew would saddle the company, renamed Nine West, with more debt than its own bankers had said it could support while removing its best assets. They sat pat as the buyer revised the deal to load even more debt on the acquisition. Yet the board sat pat even though it had a fiduciary “out” clause. The directors and officers are have lost a motion to dismiss against litigation filed by the creditors of the Nine West alleging breach of fiduciary duty. Judge Jed Rakoff accepted some of the creditors motions, including the denial of the defendants’ motion to dismiss, because the board had a duty to creditors and approved actions that would render the company insolvent.
As Ropes & Gray, counsel to Bain among many others, put it (emphasis theirs):
Under Nine West, directors of a selling corporation face a serious risk of personal liability where they do not assess a buyer’s post-transaction viability.
Given its potentially drastic implications, Nine West should be carefully reviewed by corporate directors and market participants.
Now to unpack the facts and reasoning a bit more (the opinion is embedded at the end of the post).
The Jones Company owned a series of clothing and shoe brands including Nine West. Most were flagging save two recently-purchased, outperforming stars: Stuart Weitzman and Kurt Geiger.
The directors decided to explore a sale of the company in 2012. Their banker, Citigroup, said the business could support up to 5.1x its then estimated 2013 EBITDA.
In 2013, private equity firm Sycamore responded to Citi’s shopping of the company and offered a $15 a share deal, with four additional things happening more or less simultaneously with the purchase of shares from the current owners:
1. Merging Jones Day into a new company to be called Nine West
2. Contributing $395 million in new equity to the company
3. Increasing debt from $1 billion to $1.2 billion
4. Stuart Weitzman, Kurt Geiger and one other business would be sold to other Sycamore entities for less than their fair value
The board tried to have it both ways. It approved the Merger Agreement but pretended to nix the extra debt and the sale of the prime assets. But the Merger Agreement obligated the seller to assist Sycamore with both activities. Sycamore made more changes before the deal closed, namely increasing the additional debt by $355 million and reducing the equity addition from $395 million to $120 million. Notice how even before you get to raiding the best assets, the deal is a cash out? The buyers are providing only $120 million in equity but adding $550 billion in debt…which they could easily partly dividend out.
The ruling also describes how Sycamore provided obviously false financial forecasts to Duff & Phelps to get them to value “RemainCo”, meaning Nine West after the best bits were spun out. Duff & Phelps came up with a $1.58 billion valuation, meaning even with not-credibly rosy forecasts, Sycamore planned to put debt on the company that was virtually equal to its total value. The board chose to ignore the clearly dodgy forecasts even as the performance of the company kept decaying before closing.
Needless to say, this structure also gave RemainCo a higher leverage ratio that the seller’s bankers had said the company could support even if it had retained its prize businesses.
Before the transaction closed, some shareholders sued, arguing the $15 a share was too low and therefore a breach of fiduciary duty. After some jousting, the claims were dismissed with prejudice.
When the deal closed, key executives and board members received golden parachute payments ranging from $425,000 to $3 million.
Nine West went bankrupt in 2018. Nine West settled with Sycamore but not with the former officers and directors of the seller, Jones Group. Those claims were transferred to a Litigation Trust for the benefit of the bankrupt estate, as in the creditors.
The Jones Group defendants made the usual handwaves: the resolution of the shareholder litigation these claims, and the directors were entitled to “business judgment” protection under Pennsylvania law and the company’s by-laws. They landed like duds, hence the alarm across Corporate America.
The matter of the dismissed shareholder suit is germane only to this suit, but it still gave the opportunity for a delicious shellacking by Judge Rakoff:
The 2014 Settlement extends only to claims that could have been brought by the shareholder plaintiffs “in their capacity as shareholders.”… Fraudulent conveyance claims, however, can be brought only by or on behalf of creditors…. Because the shareholder plaintiffs could not have brought these fraudulent conveyance claims “in their capacity as shareholders,” the claims are not barred by the 2014 Settlement.
As for the related question of res judicata (emphasis original):
It is well-established that a judgment rendered in derivative action “brought on behalf of the corporation by one shareholder will generally be effective to preclude other actions predicated on the same wrong brought by other shareholders.”…
Whereas the shareholder plaintiffs argued that the directors and officers breached their fiduciary duty by failing to generate enough money for the shareholders, the Litigation Trustee now argues that the directors and officers breached their fiduciary duty by distributing too muchmoney to shareholders, thereby rendering the Company insolvent. While the two sets of claims challenge the same one transaction, the incentives of the shareholder plaintiffs — to generate more money for the shareholders — were directly opposed to those of the Litigation Trustee, who seeks in this very action, for example, to claw back money paid to the shareholders as fraudulent conveyances
Now to the meatier part, the rejection of the notion that the directors can hide behind their assertion that they exercised “business judgement,” too bad about the smoldering wreck. Turning the mike over to Governance & Securities Watch:
The headline issue that has people up in arms is the court’s holding that directors of a selling corporation may lose the benefit of the business judgment rule and be held liable, under a breach of fiduciary duty theory, for not undertaking a reasonable investigation into the company’s post-sale solvency and the propriety and effect of any contemplated post-closing transactions that could be considered part of the same overall transaction when such transactions may affect the post-sale solvency of the company. In other words, according to the court, a director may be liable for not taking into account transactions expected to occur after the sale closes, the company’s shareholders receive the sale consideration, and new ownership and directors take over. The court similarly determined that directors of the selling corporation may be liable, on an aiding and abetting a breach of fiduciary duty theory, for actions undertaken by the future board of the buyer corporation if the selling corporation’s directors had actual or constructive knowledge of the fiduciary breach of the buyer’s directors. This liability may attach even if the buyer directors were not yet directors, and therefore owed no duties, at the time of their misconduct. In the eyes of this court, it’s no longer a “my watch, your watch” world.
Even though Jones and Nine West were governed by Pennsylvania law, the relevant provisions of Delaware law are sufficiently similar so as to be causing some consternation.
One troubling element of the legal write-ups I have seen so far (Ropes & Gray, Quinn Emanuel) is that they give prominent play to how this decision complicates the “duty” of a board to “maximize shareholder value”. This sort of blather confirms that the M&A bar has been captured by Wall Street. Directors have duties to the corporation, not to shareholders in particular. As we’ve repeatedly explained, the “maximizing shareholder value” fetish was created by economists, not by statute or precedent, although it saddly has been turbo-charged with equity-linked executive compensation schemes. These lawyers need some brain bleach.
The Harvard Law School Forum on Corporate Governance thinks the alarm about Nine West is overdone but prudent sellers should nevertheless take some precautions, such as:
Based on Nine West, the target board involved in an LBO should evaluate the likelihood of post-closing solvency of the company….
The equity and debt being provided for the deal are being provided by sophisticated parties who have negotiating leverage and access to all relevant information.…
The equity being contributed meaningfully exceeds any value to be distributed to the buyer or its affiliates shortly following closing.
There was more than one bid for the company, with pricing and a capital structure roughly similar to that in the approved transaction..
The buyer provides representations and warranties in the merger agreement relating to the post-closing solvency of the company….
If there are “red flags” as to a risk of insolvency post-closing, a broader evaluation may be warranted.
Note that the Nine West asset shuffle did indeed result in Sycamore pulling out more dough at closing than it put in thanks to the grab of the crown jewel businesses.
I haven’t heard a peep as to whether Judge Rakoff’s assessment, that the Jones board was reckless, would void its D&O insurance if confirmed in later rulings, making the directors liable. But even if not, if the Litigation Trustees prevail, their insurer will get a big bill and D&O insurers generally will be on notice that they actually might have to pay out claims now and again. So expect to see additional behavior changes as this case moves forward.