SDNY Allows Nine West LBO Securities Litigation to Move Forward
Judge Rakoff’s decision highlights the importance of directors and officers understanding the solvency consequences of proposed mergers and acquisitions, including adjustments to debt and capital structures, the effects of pre-closing deal changes and post-closing transactions, and the extended shelf-life of causes of action when a transacting company files for bankruptcy protection.
The Transaction to Take Nine West Private
The Jones Group was a publicly traded footwear and apparel company that sold brands such as Nine West, Stuart Weitzman, and Kurt Geiger to retailers. In 2012, the Jones Group’s board of directors (the “Jones Board”) began exploring a sale of its businesses with the assistance of an investment banker. The investment banker advised that the Jones Group could support a debt-to-EBITDA ratio of 5.1 times its 2013 EBITDA if it retained all of its business. In 2013, Sycamore offered to acquire the Jones Group though a Transaction entailing five key components:
- The Jones Group would merge with a Sycamore affiliate to be renamed Nine West Holdings, Inc. (“Nine West”).
- Sycamore would contribute at least $395 million in equity to Nine West.
- Nine West would increase its debt from $1 billion to $1.2 billion (“Additional Debt”).
- The Jones Group’s shareholders would be cashed out at $15 per share.
- Top-performing brands, Stuart Weitzman and Kurt Geiger, would then be sold to another Sycamore affiliate at less than fair market value (the “Carve-Out”).
In December 2013, the Jones Board approved the Transaction but claimed to exclude the Additional Debt and Carve-Out from its approval. Shortly before the Transaction closed, Sycamore adjusted the economic terms of the deal by reducing its equity contribution to $120 million and proportionally increasing Nine West’s Additional Debt to $1.55 billion. According to the Jones Group’s internal calculations, the adjustment increased the debt-to-EBITDA ratio to 7.8x. In light of this, and the planned spin-off of top-performing brands, Sycamore engaged a valuation firm to render a solvency opinion for Nine West’s anticipated remaining businesses (“RemainCo”). Sycamore then instructed the valuation firm to use allegedly “unreasonable and unjustified” EBITDA projections that would support a valuation of RemainCo at $1.58 billion.
In March 2014, a shareholder group commenced direct and derivative litigation against the Jones Group, the Jones Board, and Sycamore alleging breaches of fiduciary duty in connection with the Transaction (the “Shareholder Litigation”). The Jones Board formed a special litigation committee to investigate the claims and determined that the directors had acted on an informed basis, in good faith, and in the company’s best interests. In April 2014, while the Shareholder Litigation was pending, the Transaction closed. Sycamore’s principals became the sole directors of Nine West and executed the Carve-Out sale to its affiliate for less than half the fair market value of Stewart Weitzman and Kurt Geiger, following which, Nine West made substantial change-of-control payments to the Jones Group’s officers. The shareholders later settled the Shareholder Litigation and granted releases to the Jones Group and its officers and directors.
Nine West Files Bankruptcy; D&O Litigation Ensues
In April 2018, slightly less than four years after the Transaction closed, Nine West entered chapter 11 bankruptcy. Nine West emerged from chapter 11 nearly one year later with a confirmed plan of reorganization that, among other things, assigned all of Nine West’s claims arising from the Transaction to a Litigation Trust formed for the benefit of unsecured creditors.
In 2020, approximately six years after the Transaction closed, the Litigation Trustee commenced the D&O Litigation against the Jones Group’s former directors and officers for breach of fiduciary duty and recovery of fraudulent change-of-control payments made in connection with the Transaction. The officers and directors moved to dismiss the claims, arguing: (1) the Business Judgment Rule and corporate bylaws exculpated them from fiduciary liability; (2) Sycamore’s third-party valuation was the only evidence of solvency and defeated the fraudulent conveyance claims; and (3) the prior resolution of the Shareholder Litigation barred all of the claims. The Court’s analysis of these arguments, summarized below, holds valuable insights for company officers and directors considering mergers, acquisitions, and related transactions.
Analysis and Key Takeaways
1) The Business Judgment Rule and Corporate Bylaws Have Limits. Generally, the decision-making processes of directors and officers are protected by the “Business Judgment Rule.” Although the precise contours may vary from jurisdiction-to-jurisdiction, the outline of the defense is more or less the same: it protects (i) decisions made in good faith, (ii) where the director or officer was not interested in the subject of the business judgment, (iii) where the director or officer was informed with respect to the subject of the business judgment to the extent he or she reasonably believed appropriate; and (iv) where the director or officer rationally believed the business judgment was in the best interests of the corporation. Similarly, a company’s bylaws will typically exculpate and indemnify directors and officers for actions taken in the course of their duties, subject to exceptions for gross negligence, recklessness, bad faith, fraud, or criminal conduct.
In the D&O Litigation, however, the Court held that if the Litigation Trustee’s allegations are true, the Jones Board is not entitled to the protections of the Business Judgment Rule or the corporate bylaws because it had acted recklessly in failing to conduct a reasonable investigation into how the Transaction would affect the company’s solvency and viability as a going concern—including with respect to components of the Transaction, such as the below-market Carve-Out sale, set to occur after the merger (i.e., after the directors were terminated). The Court also observed that the Jones Board ignored red flags, such as the 2.7x differential in debt-to-EBITDA ratios between the advice of their investment banker and the projections of Sycamore. As a result, the Court permitted the Litigation Trustee to proceed with his breach of fiduciary claims against the Jones Board.
Conversely, the Court dismissed the Litigation Trustee’s breach of fiduciary claims against the Jones Group’s officers because the ability to modify or prevent the Transaction was within the exclusive province of the Jones Board. Although the officers could theoretically be held liable for aiding and abetting the Jones Board’s breaches, the Court found that the Litigation Trustee did not allege facts sufficient to support an inference of “substantial assistance” in the Jones Board’s conduct (as opposed to merely acting as employees carrying out the board’s decisions).
- As anyone who has served as a director of company officer knows, as transactions approach closing, there is often tremendous pressure to “get it done” notwithstanding last-minute changes to the deal. But that pressure does not relieve directors of the duty to analyze and scrutinize the transaction with respect to both present (i.e., return for shareholders, etc.) and future (i.e., post-transaction solvency) financial implications. The surviving company’s resulting insolvency or future bankruptcy may create liability for directors who ignore red flags concerning the company’s ability to continue as a going concern.
- Directors should apply this scrutiny with equal force to post-closing steps of the transaction to be executed by successor directors. Former directors may still be held liable if they approved the broader transaction with an understanding of what would follow, as a court may collapse all of the steps into a single transaction in evaluating the directors’ exercise of their fiduciary duties.
- Officers may have less exposure for breach of their fiduciary duty in the context of a merger or acquisition but should remain wary of potential liability in connection with such transactions. The risk of liability increases in proportion to the officer’s involvement and, as described below, the extent to which the officer receives payments in connection with the transaction.
2) Solvency Opinion ≠ Insolvency Shield. A claim for constructive fraudulent conveyance generally requires the existence of a transfer for less than reasonably equivalent value when the transferor was insolvent. Where those elements are met, state laws allow creditors to claw back the transfer regardless of the transferor’s or transferee’s intent. In a bankruptcy case, the right to claw back such payments is consolidated in the debtor-in-possession, bankruptcy trustee, or in the case of Nine West, the Litigation Trustee to whom those claims were assigned pursuant to the plan of reorganization.
The Litigation Trustee, in bringing those claims, alleged that the Transaction rendered Nine West insolvent and, once insolvent, Nine West issued constructively fraudulent change-of-control payments as high as $3 million to officers without receiving fair value in return. In moving to dismiss the claims based on insufficient allegations of insolvency, the officers pointed to Sycamore’s solvency opinion, which valued Nine West’s assets at $1.58 billion and liabilities at $1.55 billion. Indeed, the director defendants made similar contentions in defending their scrutiny of the Transactions in furtherance of their fiduciary duties.
As with the directors’ fiduciary duty defenses, however, the Court found that the Litigation Trustee alleged sufficient facts to undermine the efficacy of the solvency opinion. In particular, the Court noted that the Jones Group had a $2.2 billion valuation prior to the Carve-Out transactions and had purchased the top-performing Carve-Out brands for $800 million only a few years prior. As a result, the enterprise value of Nine West, once stripped of the Carve-Out brands, was likely less than its $1.55 billion in liabilities.
- A solvency opinion may provide some measure of comfort at the time of the transaction, but it is not a binding determination of the company’s solvency. As a result, it will not shield recipients from fraudulent conveyance liability, particularly in the presence of facts that undermine the reliability of the opinion. A court will reach its own conclusions on solvency and, as noted above, will take into consideration whether officers and directors blindly relied on a third-party’s assessment in derogation of their own duties to consider the underlying facts.
- Another oft-touted benefit of a solvency opinion is the ability to assert cross-claims against the valuation firm. This too may be cold comfort. In the D&O Litigation, Sycamore—not the Jones Group—retained the valuation firm. As such, the valuation firm may not have had duties to the Jones Group’s officers and directors. And even if the Jones Group had secured its own third-party opinion, they often come with substantial caveats and the statute of limitations on any claims may run before the officer or director is sued for recovery of the transfers.
- The upshot is that although professional advice is often an essential component of a fiduciary’s exercise of business judgment, it does not supplant that judgment. The safest course for officers and directors is to ensure they ask for and obtain the information they need to make reasoned decisions and that they consider any professional advice in the context of that information during the decision-making process.
3) Bankruptcy Creates Additional Risk and Exposure. The third broad category of defenses raised by the officers and directors was that the D&O Litigation was barred by the prior settlement of the Shareholder Litigation. The officers and directors argued, for example, that (i) the claims against them were released; (ii) the entry of final judgment in the Shareholder Litigation barred re-litigation of claims; and (iii) the determination of the Jones Board’s special litigation committee insulated them from liability.
The Court rejected these arguments by distinguishing the interests represented by the shareholders, on the one hand, and the Litigation Trustee, on the other hand. The Litigation Trustee, as the representative of Nine West’s estate, represented the interests of the company and, with respect to the fraudulent conveyance claims, the interests of creditors. The Court found those interests diverged from the interests of shareholders and were (i) not covered by shareholder releases; (ii) not adequately represented in the Shareholder Litigation; and (iii) not within the scope of a state-law defense arising from special litigation committee findings.
- The rights and powers of a bankruptcy estate fiduciary may be substantially broader than the rights and powers of an individual litigant in civil litigation. Further, the interests represented by the estate fiduciary may be different than the interests of represented in litigation filed before the bankruptcy commenced (i.e., “prepetition litigation”). As a result, releases of claims in prepetition litigation may not protect officers and directors of a company (or its successor) that later files for bankruptcy protection.
- Estate fiduciaries also have the benefit of an expanded statute of limitations that lengthens the exposure timeline for officers and directors. So long as the statute of limitations has not expired, the estate fiduciary will have two years from the day a bankruptcy case is filed (i.e., the “petition date”) to commence litigation. This means that in the event of a bankruptcy filing shortly before the termination of a four-year statute of limitations, the estate fiduciary will have until nearly the six-year mark from accrual of the action to file a lawsuit. Officers and directors should therefore be wary that the safe-harbor otherwise provided by the passage of time may not be available against the bankruptcy representative of their former employer.
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