Public company directors decide, but federal judges rule, and a federal court ruling has raised the specter of directors being less willing to sell to private equity firms because of the risk they would face personal liability for that decision.
On Dec. 4, 2020, Judge Jed S. Rakoff, of the U.S. District Court for the Southern District of New York, in a decision applying Pennsylvania law in In re Nine West LBO Securities Litigation, declined to dismiss breach of fiduciary duty claims against the board of directors of the Jones Group Inc. in connection with the April 2014 take-private acquisition of the company by Sycamore Partners.
Although only a preliminary ruling and not a decision on the merits, it has been described as a potential “game stopper for the private equity business” and a “sobering punctuation mark to a sobering year.”
For the reasons noted below, I think that significantly overstates the matter. The sky is not falling and LBOs are not dead.
About the Transaction
The transaction involved a leveraged buy-out of Jones Group and the simultaneous spin-out of certain of the company’s business lines to an affiliate of Sycamore in 2014.
The merger agreement provided that the following actions would take place “substantially concurrently” at closing: (i) the merger and cash out of the Jones Group public shareholders; (ii) a $395 million equity contribution by Sycamore and the borrowing by the surviving company of any additional $200 million of debt (on top of $1 billion of existing debt that would remain outstanding); and (iii) the transfer of a number of key assets by the surviving company to another Sycamore subsidiary for cash (the carve-out).
Between signing and closing, the equity contribution was reduced to $120 million and the new debt was increased to $550 millio, apparently without any objection from Jones Group. Although the merger agreement contemplated the new debt and the carve-out, and contained customary provisions requiring Jones Group to assist Sycamore in planning for and effecting those transactions prior to closing, the board’s approval of the merger agreement “purported to exclude the additional debt and the carve-out transactions.”
The entity resulting from the merger and carve-out (now named Nine West) went bankrupt in April 2018, four years following the merger. After the bankruptcy, a litigation trust established for the benefit of certain creditors of Nine West brought breach of fiduciary duty claims against the former Jones Group directors.
The director defendants moved to dismiss these claims on the grounds that their approval of the 2014 transaction was protected by the business judgment rule and that they could not in any case be held liable for damages in light of the exculpatory provisions contained in the Jones Group by-laws.
Pennsylvania Corporate Law
Under the Pennsylvania business judgment rule, a decision made in the context of a merger that is approved by a majority of disinterested directors is protected, “unless it is proven that the disinterested directors did not assent to such act in good faith after reasonable investigation.”
The court found that the directors were disinterested, but that they couldn’t rely on the business judgment rule because they “made no investigation whatsoever” into the additional debt incurrence and the carve-out and, in fact, “expressly disclaimed any evaluation of whether [these] components of the transaction would be fair to the Company.”
The directors asserted that they had no obligation to investigate the solvency of the company after giving effect to the additional debt and the carve-out, since these steps were effected after they ceased to be directors (albeit only a moment after and pursuant to the terms of a merger agreement which they had approved). The court disagreed, treating the “substantially concurrent” transactions effected at closing as “a single integrated plan.”
As goes the business judgment rule, so goes exculpation, at least in this case. Under Pennsylvania law, a company cannot exculpate directors for “self-dealing, willful misconduct, or recklessness.”
In declining to dismiss the plaintiff’s claim that the directors were reckless, and thus not entitled to exculpation, the court again pointed to the “conscious disregard” by the directors of whether the additional debt and carve-out would render the company insolvent.
The court also noted a variety of red flags that “should have alerted the director defendants [of the need to] investigate the [post-carve-out surviving company’s] insolvency.”
The Lesson: Process Matters
The directors may ultimately prevail on the merits, if the case isn’t settled before then. And certain elements of Rakoff’s opinion, including its failure to grapple with the potential conflict between the duties of the directors to the company and to the company’s shareholders, can certainly be debated.
But the real takeaway from the decision is the usual one: Process matters. The typical steps that we would advise a target company to take in this situation—including reviewing and understanding the terms of the buyer’s financing commitments, obtaining a solvency representation from the buyer in the acquisition agreement, and confirming with management that they expect to be able to deliver any solvency certificates required at closing—would likely have protected the directors here. That is, had they not arguably put themselves in a position where they could not claim reliance on them.
What didn’t protect the directors was taking the position that they need only consider the merger itself, and that they could ignore those elements of the overall transaction that were necessary components to the merger, contemplated by the merger agreement, and facilitated by actions the company was required to take, but that notionally took place a moment after (but substantially concurrent with) the completion of the merger.
Directors can rely only on advice that they seek; the business judgment rule presupposes a business judgment. LBOs will survive.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Gregory V. Gooding is a corporate partner and member of the Debevoise & Plimpton’s Mergers & Acquisitions Group.