A recent decision by Judge Jed Rakoff of the Southern District of New York highlights the risks faced by directors and officers of companies in financial distress who fail to undertake properly their duties to the company and its stakeholders. In mostly denying a motion to dismiss claims brought against former directors and officers of Nine West Holdings and Jones Group, its predecessor company, Judge Rakoff's opinion highlights the limits of protective legal doctrines such as the business judgment rule, which typically shields from subsequent inquiry corporate decisions made in good faith and with appropriate care, and prophylactic measures such as the delivery of solvency opinions.
In 2014, Jones Group, the financially distressed owner of footwear and apparel brands such as Nine West, Anne Klein, and Gloria Vanderbilt, was taken private in a leveraged buyout by private equity firm Sycamore Partners and became Nine West Holdings. When Nine West Holdings filed for bankruptcy in 2018, creditors unsurprisingly began scrutinizing the acquisition effectuated four years earlier. Potential claims against Sycamore in connection with the 2014 transactions were resolved as part of the chapter 11 case. Claims against former directors and officers of Jones Group were not settled and were given over to a litigation trust for prosecution on behalf of Nine West Holdings' creditors following the confirmation of the chapter 11 plan.
Broadly stated, the 2014 acquisition of Jones Group was initially proposed to involve five separate transactions:
- Jones Group was first to merge with a Sycamore affiliate to become Nine West Holdings.
- Sycamore committed to contribute $395 million in equity to Nine West Holdings.
- Following the merger of Jones Group with the Sycamore affiliate, Nine West Holdings, which already had $1 billion in debt on its balance sheet, would take on additional debt of $200 million.
- The former Jones Group shareholders would receive $1.2 billion ($15 per share).
- Also following the merger, certain valuable brands would subsequently be carved out of Nine West Holdings and sold to a separate Sycamore affiliate for less than fair market value.
The claims brought by the litigation trustee primarily focused on alleged breaches of fiduciary duty by Jones Group's former directors and alleged fraudulent transfers to Jones Group's former officers. Certain key facts considered by Judge Rakoff:
- The terms of the transactions changed prior to the closing of the merger and became much less favorable for Nine West Holdings. Sycamore's equity commitment was reduced to $120 million, and Nine West Holdings' debt load increased by an additional $350 million, to $1.55 billion.
- An investment banker engaged by the Jones Group's board in 2012 had advised that the company could support a debt ratio of 5.1 times its projected 2013 earnings. However, the changed terms meant that Nine West Holdings would have a debt ratio of 7.8 times its projected earnings. Moreover, Nine West Holdings' earnings would no longer include revenue from the brands being carved out and sold to Sycamore separately.
- The Jones Group directors went forward with the merger despite the change in terms, even though they had the right to terminate the transactions under a "fiduciary out" clause in the agreements. Although the vote to approve the merger did not include approval of the increase in debt for Nine West Holdings and the sale of the carved-out brands, the Jones Group directors were aware that those transactions were expressly contemplated as part of the overall deal structure.
- Following the merger, new directors were appointed for Nine West Holdings, and the new directors approved the transactions to increase the debt and to sell the carved-out brands.
- In connection with the separate sale of the carved out brands, Sycamore engaged an investment bank to provide a solvency opinion for Nine West Holdings. The opinion concluded that Nine West Holdings had an enterprise value in excess of its contemplated debt load of $1.55 billion and was therefore solvent. However, the investment bank used earnings projections expressly provided by Sycamore and did not undertake an independent analysis.
- Following the merger, Jones Group officers received "change of control" payments from Nine West Holdings ranging from $450,000 to $3 million.
The former Jones Group directors requested dismissal of the claims that they breached their fiduciary duties to the company and its stakeholders on the basis of the business judgment rule. Corporate laws vary from state to state, but the business judgment rule, as described by Judge Rakoff, typically protects decisions made by corporate directors and officers that were made (i) in good faith, (ii) by persons who have no financial interest in the subject of the decision, (iii) by persons reasonably and properly informed with respect to the subject of the decision, and (iv) with a reasonable basis for the belief that the decision was in the best interests of the corporation. The directors further sought the dismissal of claims with respect to the increase in debt and sale of the carved-out brands transactions undertaken by Nine West Holdings following the merger.
The former officers sought dismissal of the claims that the change of control payments constituted constructive fraudulent transfers which could be recovered by the litigation trustee. A constructive fraudulent transfer requires a showing that the transferor was insolvent at the time of the transfer was made and did not receive reasonably equivalent value in return. The former officers contended that the solvency opinion obtained by Sycamore for Nine West Holdings established that Nine West Holdings was not insolvent at the time that the payments were made, and that one of the necessary elements of a constructive fraudulent transfer therefore could not be shown.
Judge Rakoff declined to dismiss most of the claims. In determining that the former Jones Group directors were not shielded by the business judgment rule, he concluded that they had failed to undertake an appropriate investigation into whether the five transactions, taken as a whole, would damage the company by rendering it insolvent, particularly after the deal terms were unfavorably changed. He further ruled that the directors could not escape potential liability for the post-merger debt and sale transactions even though they were approved by a subsequent board of directors. Noting that the former Jones Group directors had expressly disclaimed undertaking any independent investigation of those transactions, he pointedly observed that "the business judgment rule presupposes that directors [actually] made a business judgment[.]" Those directors, he held, even after having been expressly informed that the debt ratio of the post-merger company would substantially exceed the maximum recommended limit, ignored numerous "red flags" as to the potential negative impact of the post-merger transactions, and therefore could not claim the protections of the business judgment rule.
The fraudulent transfer claims against the former Jones Group officers also mostly survived dismissal. Judge Rakoff gave short shrift to the officers' contentions that the solvency opinion obtained by the investment bank engaged by Sycamore provided any protection in this regard, referencing the litigation trustee's allegations that it was based on "Sycamore's allegedly bloated enterprise value, which was alleged to have been specifically engineered to be 'just above the $1.55 billion of debt.'" He particularly noted the impact of the loss to Nine West Holdings of the value of the carved-out brands in ruling that insolvency could readily be inferred from the litigation trustee's allegations, and that the trustee could therefore proceed to trial on those claims.
The rulings in the Nine West D&O litigation serve as an important reminder to corporate directors and officers that there are limits to the protection from liability that legal doctrines such as the business judgment rule, and transactional protections such as solvency opinions, can provide when major decisions regarding a company in financial distress are being made. Given the extensive review that will be undertaken if a company subsequently falls into bankruptcy, extra care must be taken to show that potential red flags have been properly considered and weighed, and that any relied-upon work product provided by professional advisors is derived from genuinely independent analysis.
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