A recent decision by a New York federal district court illustrates significant potential pitfalls for sellers in leveraged buyouts and similarly structured transactions.  In particular, it highlights the potential risks under fiduciary duty theories to directors and private equity-appointed directors, even in multi-step transactions with customary disclaimers and exculpatory by-laws.

In In re Nine West LBO Securities Litigation, Case No. 20-2941. 2020 WL 7090277 (S.D.N.Y. Dec. 4, 2020), the United States District Court for the Southern District of New York entered an order granting in part and denying in part motions to dismiss for various claims for breach of fiduciary duty, aiding and abetting breach of fiduciary duty, and violations of 15 Pa. Cons. Stat. §§ 1551 and 1553.  The Court’s reasoning potentially creates serious ramifications with respect to fiduciaries’ obligations to investigate in the context of a multi-step, leveraged buy-out transaction.

Background

The procedural posture is complicated but its context is important to the Court’s decision.  Nine West’s litigating trustee, successor indenture trustee, and unsecured creditors (the “Plaintiffs”) originally alleged claims of breach of fiduciary duty, aiding and abetting breach of fiduciary duty, fraudulent conveyance, unjust enrichment and violations of 15 Pa. Cons. Stat. §§ 1551 and 1553 against former offers, directors, and shareholders of Nine West’s predecessor company, The Jones Group, Inc. (the “Company”) (collectively, the “Defendants”) based on their conduct in connection with the 2014 leveraged buyout of the Company.

In 2012, Nine West’s Board of Directors (the “Board”) began to consider selling all or part of the Company.  The Board’s financial advisor recommended that, in the context of a transaction where the Company retained all of its business, the Company could support a debt to EBITDA ratio of 5.1 times its estimated 2013 EBITDA.  In April 2013, the private equity firm Sycamore Partners Management, L.P. (“Sycamore”), expressed interest in acquiring the Company.  After some negotiation, Sycamore offered to buy the Company for $15 per share pursuant to a Merger Agreement.

The Merger Agreement involved five steps: (1) The Company would merge with a Sycamore affiliate, and be renamed Nine West Holdings, Inc. (“Nine West”); (2) Sycamore and another private equity firm would contribute at least $395 million in equity to Nine West; (3) Nine West would increase its debt from $1 billion to $1.2 billion; (4) The Company shareholders would be cashed out at $15/share (the “Shareholder Transfers”); and (5) certain of the Company’s more profitable businesses (the “Carve-Out Businesses”) would be sold to a Sycamore affiliate for substantially less than fair market value (the “Carve-Out Transactions”).  The Board unanimously approved of the Merger Agreement, which contained a “fiduciary out” clause allowing the Board to withdraw their recommendation if withdrawal was required by their fiduciary duties to the Company.

After the execution of the Merger Agreement, Sycamore changed its terms, resulting in a structure that required the Company’s debt to be 7.8 times the Adjusted EBITDA calculated by its management.  In characterizing this move,  Plaintiffs later claimed Sycamore created “unreasonable and unjustified” EBITDA calculations for the businesses that would not be sold off pursuant to the Merger Agreement, in order to justify a lower value for the Carve-Out Businesses.  The Merger closed on April 8, 2014, and most of the officers and certain employees received “change in control” payments ranging from $425,000 to $3 million.

After the Merger closed, several stockholders filed suit against the Company and the Directors, alleging the directors had breached their fiduciary duties resulting in an inadequate sale price of $15 per share (the “2014 Litigation”).  In response to certain shareholders’ demand, the Board formed a special litigation committee (the “SLC”) to investigate the claims.  After the SLC determined the Board acted on an informed basis in good faith and in the best interests of the Company, the parties reached a settlement.

In April 2018, the Company’s successor, Nine West, filed for bankruptcy.  The Plaintiffs subsequently brought this action.  The Court dismissed the fraudulent conveyance and unjust enrichment claims in an August 27, 2020 order, and Defendants subsequently moved to dismiss the remaining claims.

Decision

On December 4, 2020, the Court granted the Officer Defendants’ motions to dismiss the breach of fiduciary duty, aiding and abetting, and fraudulent conveyance claims against them.  However, the Court rejected the Director Defendants’ arguments for dismissal, leaving intact the claims against them for breach of fiduciary duty and aiding and abetting breach of fiduciary duty .

The Court first held that the Plaintiffs’ claims were not barred by the 2014 Litigation, whether by the settlement agreement, res judicata, or the SLC process.  As such, the Court next turned to the merits of the claims.

Director Defendant Claims

The Director Defendants first argued that the breach of fiduciary duty claims should be dismissed under the business judgment rule.  The Court noted that, in order to overcome the business judgment rule under Pennsylvania law, the litigating trustee must either allege a majority of the Board was not interested, or that the directors did not assent to the Merger in good faith after reasonable investigation.  Under Pennsylvania law, a director is disinterested unless he has a direct or indirect interest in the person acquiring or seeking to acquire the corporation.  As such, the Court rejected the litigating trustee’s argument that the Director Defendants were interested because they financially benefited from the Merger.

However, the Court found the litigating trustee successfully alleged the Director Defendants’ failure to investigate and assent.  In particular, the Court agreed the Director Defendants’ failed to investigate whether (1) taking on additional debt and (2) The Carve-Out Transactions would render the Company insolvent.  Pursuant to the Merger Agreement, the Director Defendants expressly disclaimed investigation of these two components of the Merger.  The Director Defendants argued their disclaimer was appropriate, as these components were effectuated after the close of the Merger, and after two Sycamore principals became Nine West’s sole directors (the “Nine West Directors”).  However, the Court disagreed, finding the litigating trustee had successfully pleaded “the foreseeability of the alleged harm,” thus allowing the Merger’s “multistep transaction” to be treated as “one integrated transaction.”

Further, the Court also held the Company’s exculpatory bylaws, which limited director liability to cases where the breach constitutes self-dealing or recklessness, did not justify dismissal of the breach of fiduciary duty claims.  Although the Court agreed with the Director Defendants that their conduct did not constitute self-dealing, it nevertheless found the decision to consciously disregard components of the Merger requiring additional debt and sale of the Carve-Out Businesses was reckless.  In particular, the Court pointed to certain “red flags” that should have put the Director Defendants on notice of a need to investigate.

Because neither the business judgment rule nor the Company’s exculpatory bylaws precluded liability, the Court denied the Director Defendants’ motion to dismiss the breach of fiduciary duty claim.

The Director Defendants next argued the Plaintiffs’ claims for aiding and abetting the Nine West Directors’ fiduciary breaches were deficient.  According to the Director Defendants, the acts forming the basis of their aiding and abetting – i.e., approving the Merger and assisting with the completion of the transaction – were taken before the Nine West Directors became directors, and consequently, before they had fiduciary duties to Nine West.  The Court rejected this argument, noting the Director Defendants provided no case law in support of their argument, and that in substance it was “senseless.”

Next, the Director Defendants claimed that the Plaintiffs failed to allege they knowingly participated in the Nine West Directors’ breaches, because the complaints affirmatively allege Sycamore and the Nine West Directors actively concealed their bad acts from the Director Defendants.  The Court also rejected this argument, reasoning that the “red flags” noted by the Court in analyzing the breach of fiduciary duty claim provided the director defendants with “actual or constructive notice” that the Carve-Out Transactions would leave the Company insolvent.  As such, the Court denied Director Defendants’ motion to dismiss the aiding and abetting breach of fiduciary duty claims.

Officer Defendant Claims

The Officer Defendants first argued the claim for breach of fiduciary duty should fail because it sought “to hold them liable for failing to take actions that were out of their control.”  The Court agreed, finding the complaint failed to demonstrate that the Officer Defendants could have prevented the Merger.  Because the complaints alleged the Director Defendants were aware of, and ignored, red flags relating to the Merger, it was implausible that the Officer Defendants could have somehow prevented the transaction from occurring.  The Court, therefore, granted the Officer Defendants’ motion to dismiss the breach of fiduciary duty claims.

The Court also agreed with the Officer Defendants that the claims of aiding and abetting breaches of fiduciary duty, at most, alleged only tangential assistance in the Nine West Directors’ breaches.  The Court dismissed these claims as well.  Finally, the Court dismissed the fraudulent conveyance claims against the Officer Defendants; holding that certain claims were time-barred, while others were inadequately pled.

Takeaways

With respect to major transactions, company fiduciaries cannot always rely on disclaimers, or even exculpatory bylaws, to prevent liability.  Directors should take care to fully educate themselves, because courts may hold them liable for failure to investigate when such investigation, in retrospect, would have revealed red flags.  In particular, in a multi-step transaction, the Court’s holding indicates that fiduciaries can be held liable for acts occurring after their fiduciary duties have terminated, if the fiduciary was aware of the actions that would result in a breach prior to those duties terminating.   This decision has potentially wide-ranging ramifications for fiduciaries in multiple contexts, including private equity-appointed directors.