Nine West
Background
In 2014, the private equity firm Sycamore Partners Management L.P. (“Sycamore”) completed a highly leveraged buyout of the Jones Group, a publicly traded Pennsylvania apparel company with brands like Nine West. Like many companies targeted by private equity firms, the Jones Group was struggling financially in the years leading up to 2014, although two of its signature brands, Kurt Geiger and Stuart Weitzman, were hitting earnings targets and were showing consistent growth. Due to the struggles of its other brands, however, Jones Group sought to sell the business and retained Citigroup to serve as its advisor. Citigroup advised the Jones Group that it could support a deal resulting in a debt to EBITDA ratio of 5.1 times its 2013 estimated EBITDA.
Sycamore offered to buy Jones Group for $15 per share ($2.15 billion enterprise value), with a Sycamore affiliate (run by Sycamore) acting as the surviving company, to be named Nine West Holdings, Inc. (“Nine West”). As part of the original agreement and plan of merger (“Merger Agreement”), the stockholders of Jones Group would be cashed out at $15 per share and they would thus no longer hold interests in Jones Group nor would they acquire interests in Nine West. Sycamore was to contribute at least $395 million in equity and Nine West would increase its debt from $1 billion (the Jones Group’s pre-merger debt) to $1.2 billion. Nine West’s two successful brands would act as “carve-out businesses” and would be sold separately to other Sycamore affiliates for less than their fair market value. Thus, the struggling non-carve-out brands of Jones Group would become Nine West, while the two successful brands, Kurt Geiger and Stuart Weitzman, would be sold separately as part of a nearly concurrent sale to Sycamore. The Merger Agreement contained a “fiduciary out” which allowed the Jones Group directors to withdraw their recommendation in favor of the deal if they determined doing so was required in order to comply with their fiduciary duties.
The Jones Group board voted unanimously to approve the Merger Agreement. However, before closing, Sycamore changed the deal terms drastically and reduced its planned equity contribution from $395 million to just $120 million. To offset this adjustment, Sycamore arranged for Nine West to increase its debt from $1 billion to $1.55 billion rather than from $1 billion to $1.2 billion as originally planned. These changes resulted in a post-merger debt ratio of 7.8 times Nine West’s EBITDA. Throughout the deal process, the Jones Group board thoroughly investigated and considered the fairness of the proposed offer of $15 per share, concluding that it was a fair price for stockholders, but it allegedly did not consider the fairness or impact of the additional debt that would be taken on by the post-merger company, Nine West. The board also allegedly did not investigate or consider the impact of the sales of the carve-out businesses on Nine West’s solvency or financial state.
To get to a cheaper price for the carve-out businesses, Sycamore allegedly created unjustified EBITDA projections for the non-carve-out remaining businesses, as more value attributed to those businesses would make it easier to justify a discount sale price on the profitable carve-out businesses. The Jones Group board was unaware of Sycamore’s alleged manipulations but did receive consistent updates on the struggles and financial decline of the non-carve-out businesses, along with optimistic projections for the carve-out businesses. After the merger closed in 2014, Sycamore’s principals, Stefan Kaluzny and Peter Morrow, became the sole directors of Nine West. As planned, Kuluzny and Morrow then immediately sold the carve-out businesses to a Sycamore affiliate for $641 million, despite an alleged $1 billion fair market value. In connection with the Sycamore-Jones Group merger, stockholders brought a derivative suit against the Jones Group’s directors and officers. That case settled in 2015.
Four years after the merger with Sycamore closed, Nine West filed for bankruptcy. As part of the Chapter 11 bankruptcy plan, a litigation trust was established, and the litigation trustee (hereinafter, “Plaintiff”) was empowered on behalf of the unsecured creditors to pursue all claims against directors and officers of Jones Group arising out of the 2014 transaction with Sycamore. Plaintiff sued the directors and officers of Jones Group for breach of fiduciary duty and aiding and abetting breach of fiduciary duty, among other claims. At their core, Plaintiff’s claims were based on the premise that the Jones Group directors and officers breached their fiduciary duties by not investigating whether the transaction “as a whole” would lead to the post-merger company’s bankruptcy, and relatedly whether they aided and abetted the subsequent breaches of fiduciary duties by the successor Nine West board (i.e., Sycamore). The former directors of Jones Group moved to dismiss the Plaintiff’s claims for breach of fiduciary duty and aiding and abetting fiduciary duty.
Legal Analysis
The Court denied the directors defendants’ motion to dismiss the breach of fiduciary duty and aiding and abetting claims. In so holding, the Court, applying Pennsylvania law, began by analyzing whether the business judgment rule applied to the challenged transaction. Plaintiff argued that the business judgment rule did not apply because the directors benefited from the deal by cashing out their own shares and were thus not disinterested. The Court rejected this argument and explained that under Pennsylvania law, a director does not stand on both sides of a transaction solely because the director owns shares of the corporation and stands to benefit financially from a challenged transaction as a result of that ownership. Nevertheless, the Court determined that the business judgment rule did not apply for the alternative reason that the director defendants did not (Plaintiff alleged) conduct a reasonable investigation into whether the transaction as a whole would render the surviving company insolvent. The Court rejected the director defendants’ argument that they were not required to consider factors such as the additional debt Nine West would be taking on or the fairness of the sale of the carve-out businesses because such actions were technically completed by a subsequent board after defendants’ tenure as directors ended. In rejecting this argument, the Court explained that multi-step LBO transactions like the one at issue can be treated as a single integrated plan for purposes of a fiduciary duty analysis, and that the director defendants ignored obvious red flags suggesting that the transaction would render Nine West insolvent post-merger. As the business judgment rule presupposes directors made a business judgment, the Court would not afford the director defendants the protection of the rule with respect to matters that they allegedly did not consider.
The Court then determined that the Jones Group’s exculpatory provision did not preclude liability. Pennsylvania law permitted the Jones Group to adopt bylaws limiting director liability except for cases where the breach constituted “self-dealing, willful misconduct, or recklessness.” The Court first confirmed that Plaintiff did not allege self-dealing, adopting the Delaware law approach where self-dealing meant that the director stood on both sides of the transaction. Next, the Court found that Plaintiff alleged that the director defendants acted recklessly, such that the exculpatory bylaw did not shield them from liability. The Court explained that the director defendants were alleged to have consciously disregarded the transactions involving the carve-out businesses and that the director defendants ignored red flags, such as the additional debt taken on and resulting EBITDA ratio, that, if adequately investigated, should have alerted them to the imminent insolvency of Nine West as a result of completing the unified Sycamore deal.
In ultimately holding that Plaintiff adequately pled a claim against the directors for breach of fiduciary duty, the Court focused on (i) the treatment of the Sycamore LBO as a single unified transaction, and (ii) the director defendants’ failure to heed alleged red flags concerning Nine West’s potential post-transaction bankruptcy. The Court explained that the actual merger, the post-merger sale of the carve-out businesses, and the planned increase in additional debt to be taken on by Nine West could be “collapsed” into a “single integrated plan,” essentially opening the door for liability for the directors based on their failure to consider “foreseeable” harm to the post-merger company stemming from the unified deal they approved. Citing a District Court of Delaware case that applied Delaware law, the Court made clear that even if directors do not approve a component of a transaction, they can be liable for the harm that the entire unified transaction causes the post-merger company. The Court then explained that Plaintiff adequately alleged that the director defendants ignored red flags and failed to investigate the impact of the additional debt (and decreased equity) that would be taken on by Nine West due to Sycamore’s last-minute change to the deal structure. Specifically, Plaintiff adequately alleged that the directors ignored the fact that the leverage ratio resulting from the additional debt would far exceed the amount recommended by their financial advisor. The Court also explained that the directors failed to investigate the adequacy of the purchase price for the carve-out businesses and its impact on Nine West’s solvency given the additional debt Nine West was taking on, stating:
The $2.2 billion valuation the company received in the 2014 transaction [with Sycamore], less the company’s $800 million historical purchase price for the carveout businesses, implied that [the non-carve-out businesses were] was worth no more than $1.4 billion. That knowledge should have alerted the director defendants that they needed to investigate [Nine West’s] solvency, given that Sycamore arranged, with their knowledge, for [Nine West’s] debt to be increased to $1.55 billion.
The Court also denied the director defendants’ motion to dismiss the claim for aiding and abetting the Nine West board’s breaches of fiduciary duty. Applying Delaware law to this claim, the Court determined that the director defendants had knowledge that Kaluzny and Morrow, as directors of the post-merger company, would carry out the planned sales of the carve-out businesses, and that these planned transactions were reasonably likely to lead to Nine West’s insolvency. The Court rejected the director defendants’ “senseless” argument that aiding and abetting can only occur when the fiduciary duty exists (i.e., after Kaluzny and Morrow became Nine West’s directors post-merger), thereby suggesting that if breaches of fiduciary duty by a successor board post-merger are foreseeable to the target company’s board pre-merger, and the merger is nevertheless approved by the preceding board, the preceding board can be liable for aiding and abetting the successor board’s breaches of fiduciary duty.
Potential Impact of Nine West on LBOs
While the court in Nine West was only ruling on motions to dismiss (and thus made no factual findings or findings of liability), the decision could nevertheless have a chilling effect on the trend of leveraged buyouts by private equity firms. While the decision is unlikely to change how private equity firms pursue, structure and carry out LBOs, it has the potential of giving directors of target companies pause in approving these kinds of transactions. If directors face liability based on the impact an LBO has on the solvency and financial state of the surviving company, they may be less likely to approve the LBO, as directors’ focus will not be simply on maximizing shareholder value in the short-term, as is customary in a company sale situation. Directors will be inclined to investigate the impact of debt taken on by the surviving company, seek additional fairness opinions, and even inquire into the acquiror’s financing obligations. This could slow down a proposed LBO or cause it to be voted down by a cautious board.
Delaware Courts’ Approach to Reviewing LBOS
A discussion of Delaware courts’ approach to director fiduciary duties in connection with LBO’s must begin with acknowledging the seminal decision, Smith v. Van Gorkom, which was the first decision in which the Delaware Supreme Court had the chance to review an LBO. In Van Gorkom, the Court analyzed the fairness of a leveraged purchase of TransUnion arranged by its CEO, and examined the related fiduciary duty obligations of TransUnion’s directors. The Court held the directors monetarily liable for breaching their fiduciary duty of care as a result of not being fully informed about the transaction and the fairness of the price. The Court then provided guidelines for directors to follow in orchestrating and approving LBOs – a transaction type the Court criticized but did not prohibit. The Delaware Supreme Court focused on the steps a board should take in informing itself of the adequacy of the price per share offered, and implied that a board should seek an outside valuation and fairness opinion in connection with evaluating an LBO. Notably, however, the Court made no mention of a board’s obligation to discuss the impact of the transaction on the surviving company’s solvency or financial state.
Delaware cases reviewing LBOs since Van Gorkom have similarly focused on the adequacy of the cash-out share price, the process in investigating and determining the fairness of the deal to the target stockholders, and the duty that directors have to maximize value for the stockholders. The well-known Revlon decision, for example, involved a hostile takeover attempt by Pantry Pride, and a subsequent bidding war between Pantry Pride and a private equity “white knight.” The Delaware Supreme Court in Revlon explained that once it became clear that the LBO was imminent, “[t]he directors’ role changed from defenders of the corporate bastion to auctioneers charged with getting the best price for the stockholders at a sale of the company.” Similar to the guidelines prescribed in Van Gorkom, the Court articulated context-specific “Revlon duties” which focused on a board’s obligation to maximize stockholder value and become fully informed of the fairness of the merger consideration to be paid to stockholders – again, with no consideration given to the financial state of the surviving company. Years later, the Delaware Supreme Court, reviewing another LBO in Lyondell Chem. Co., confirmed that “directors must engage actively in the sale process, and they must confirm that they have obtained the best available price either by conducting an auction, by conducting a market check, or by demonstrating ‘an impeccable knowledge of the market.’” Again, no considerations were given by Delaware’s high court to the impact that the LBO (and associated assumption of significant debt) would have on the surviving post-merger company.
Based on these cases, it appears there is no Delaware precedent that a Delaware court could rely on in reaching a holding similar to Nine West. Nevertheless, in Time-Warner, the Delaware Supreme Court previewed the potential dueling considerations of a board in approving a deal that it believed aided the long-term interest of the company versus a deal that provided maximum short-term value for stockholders, stating:
First, Delaware law imposes on a board of directors the duty to manage the business and affairs of the corporation. 8 Del. Code § 141(a). This broad mandate includes a conferred authority to set a corporate course of action, including time frame, designed to enhance corporate profitability. Thus, the question of “long-term” versus “short-term” values is largely irrelevant because directors, generally, are obliged to chart a course for a corporation which is in its best interests without regard to a fixed investment horizon. Second, absent a limited set of circumstances as defined under Revlon, a board of directors, while always required to act in an informed manner, is not under any per se duty to maximize shareholder value in the short term, even in the context of a takeover.
This language perhaps suggests that a board might have to consider the long-term solvency of the surviving company in approving a leveraged deal. However, the focus in Time-Warner was again on the fairness of the stock price to the stockholders when they were cashed out, with no focus on the financial state of the surviving company, despite the highly leveraged nature of the transaction at issue.
Indeed, no Delaware decisions appear to have analyzed whether a board has a fiduciary duty to investigate and consider the post-merger solvency of the surviving corporation in orchestrating and approving a transaction. Delaware courts have, however, explored the competing fiduciary duties owed to stockholders versus creditors by directors of struggling companies nearing the “zone of insolvency.” Such cases may shed light on whether directors of a Delaware corporation are required to consider the solvency of the separate, post-merger company, or if instead, they must maximize shareholder value irrespective of the impact that doing so has on the surviving company.
For example, in Trenwick America Litigation Trust, a litigation trustee of the bankrupt Trenwick America Corporation (Trenwick America) and its parent company, asserted claims against the prior directors of both Trenwick America and its parent company for breach of fiduciary duty stemming from several acquisitions and restructurings orchestrated and completed by both Trenwick boards when the companies were still solvent. The Court of Chancery dismissed all claims, and noted that in approving the pre-insolvency transactions, the directors were “expected to seek profit for stockholders, even at risk of failure,” regardless of the organization’s solvency status. The Court also explained that because the company was solvent at the time of these challenged transactions, it owed no fiduciary duties to its parent company or the parent company’s creditors. While much of the decision turned on Delaware law concerning fiduciary duties owed by a subsidiary to a parent, the decision contains dicta suggesting that directors of a then-solvent company may not be held liable retroactively (and post-bankruptcy) for breaching a fiduciary duty to future creditors based on transactions that occurred while the company was solvent (as seen in Nine West). Indeed, the Court stated that “Delaware law does not . . . impose retroactive fiduciary obligations on directors simply because their chosen business strategy did not pan out.”
Predicting how a Delaware court would decide Nine West
Key to the Nine West decision was the New York court’s view that the multi-step LBO at issue ought to be considered as a single unified transaction, such that the impact of the additional debt taken on by the surviving company and the subsequent sales of the carve-out business were reasonably foreseeable by the Jones Group board, and should have thus been investigated and considered. Practically speaking, this view of this particular LBO finds support because the multiple post-merger transactions involving Nine West occurred nearly concurrently with the actual approved Jones Group-Sycamore merger. Moreover, the directors allegedly knew such transactions were certain to occur immediately, as the approved cash out price of $15 per share was expressly dependent on the additional debt and sale of the carve-out businesses. Given the nature and setup of this particular LBO, a Delaware court would likely follow the reasoning in Nine West and likewise view the multi-step LBO as one unified transaction for purposes of a fiduciary duty analysis.
Adopting that view, and given the plaintiff-friendly motion to dismiss standard, a Delaware court may similarly sustain breach of fiduciary duty claims against directors for approving such a unified deal, but it would likely do so with considerable hesitation. Specifically, a Delaware court would struggle with the notion that directors of a solvent company can retroactively owe fiduciary duties to creditors of a successor company, particularly when those directors approved the original deal (while solvent) in adherence with their duty to maximize shareholder value. The Court of Chancery has already hinted at its disapproval of this notion (albeit in a very different context) in Trenwick.
A Delaware court’s possible reluctance to expand the paradigm of fiduciary duties of directors in this broad way is justified given the derivation of a director’s fiduciary duties and the consequences of an LBO on a cashed-out stockholder. A board owes fiduciary duties to a corporation and its stockholders and is charged with acting in the best interest of the stockholders. In doing so, and in acting as an agent of the stockholders, the board must pursue a deal that serves the stockholders’ interests. An LBO like the one completed in Nine West results in the complete cash out and termination of the stockholders’ interests in the target company. It thus follows that the board can only serve the interests of the existing stockholders if it approves a deal that allows them to receive the highest value for their shares. That the private equity acquiror uses large amounts of borrowed money to purchase the company is irrelevant to stockholders, as they receive cash whether the money is borrowed or not. The post-merger transactions of the surviving company (in Nine West, the sale of the carve-out businesses) and their impact on the surviving company (Nine West) are similarly irrelevant to the stockholders, as they are to be cashed out, do not own shares of the surviving company, and thus are not impacted if the surviving company goes bankrupt due to these separate transactions. Thus, the natural question arises: shouldn’t these considerations, which are irrelevant to the stockholders, also be irrelevant to the board charged with acting in the stockholders’ best interests? A Delaware court may worry that requiring a director to account for the solvency of an entirely different, post-merger successor company (rather than simply maximizing shareholder value given that the shareholders are being cashed out) would run counter to the spirit of fiduciary duty law and inappropriately expand the range of fiduciary duties directors owe.
A Delaware court may also take a different approach than the New York court in applying the Jones Group’s exculpation bylaw and analyzing the associated pleading requirements under Delaware law. Unlike Pennsylvania law, Delaware law permits corporations to exculpate its directors for allegedly reckless acts. Plaintiff in Nine West pled recklessness to overcome the business judgment rule and exculpation provision under Pennsylvania law, but would have to plead more under Delaware law – specifically a breach of loyalty or absence of good faith – in order to plead a non-exculpated claim. A Delaware court thus might be more critical of the adequacy of the Plaintiff’s allegations, particularly as they concerned the director defendants’ knowledge and intent. However, one can safely assume that Plaintiff, if before a Delaware court, could have alleged a conscious disregard of duties by the director defendants, amounting to a lack of good faith, thereby pleading a non-exculpated claim that is not shielded by the Jones Group’s exculpatory bylaw.
Finally, a Delaware court would likely allow Plaintiff’s claim for aiding and abetting a breach of fiduciary duty to survive dismissal, just as the New York court did. If the Delaware court, as predicted, viewed the LBO as a unified transaction, then it follows that a Delaware court would view approval of that transaction – which included the additional debt and carve-out business sale nearly concurrently with the merger – as knowingly aiding the Nine West board in breaching their fiduciary duties by completing those transactions and rendering Nine West insolvent. However, a Delaware court would likely make this ruling based on the structure of the LBO and facts of the case, and would likely clarify that a board is not, as a general rule, responsible for “successor acts” of a succeeding board unless such acts were certain to occur if the core transaction was approved, as part of the unified transaction.
Practice Points for Directors
- Price is not everything. Given the Nine West decision, directors of a target company are advised to consider all aspects of a potential transaction, including the impact that the deal will have on the solvency of the post-merger company. Doing so is particularly critical when directors are reasonably certain that the surviving company is taking on considerable debt and is completing potentially detrimental transactions concurrently with the merger or shortly after the merger is complete.
- Directors should continue to seek outside valuations and fairness opinions concerning the merger consideration but are also well-advised to consult with experts concerning the financial impact of the LBO on the post-merger company. Directors should obtain solvency analyses, inquire about the private equity acquiror’s transactional plans post-merger, ask about the buyer’s financing obligations, and adequately document the efforts taken to investigate these matters.
- If the private equity acquiror changes the deal terms late in the process, directors should ask questions, ascertain the reasons for the change, and thoroughly investigate the impact of these changes – particularly increases in the debt that is to be used by the buyer in completing the leveraged purchase.
- Directors should not ignore red flags. The directors in Nine West were alleged to have blindly accepted manipulated EBITDA calculations provided by Sycamore, and failed to investigate several glaring red flags, resulting in potential liability.
- The company and its board should always obtain director and officer liability insurance, particularly in light of the potential increased risk of liability in approving an LBO.
- Directors should consult with outside counsel about fiduciary duty obligations and the fairness of all aspects of the LBO.
