According to the authors of the following article, Southern District of New York Judge Jed Rakoff’s December 2020 decision in the Nine West LBO Securities Litigation could have important implications for the structure of LBO deals and the due diligence conducted in connection with the transaction, particularly in light of the current economic conditions. The article was written by Travis A. Knobbe, Partner at Freeman Mathis & Gary, LLP and Sarah Abrams, Head of Professional Liability Claims at Bowhead Specialty Underwriters. I would like to thank Travis and Sarah for allowing me to publish their article as a guest post on this site. I welcome guest post submissions from responsible authors on topics of interest to this blog’s readers. Please contact me directly if you would like to submit a guest post. Here is the authors’ article.
The continued acceleration of leveraged buy-out (LBO) structures in Private Equity mergers and acquisitions presents a variety of litigation and director and officer challenges for insurers. In fact, a relatively recent court decision should provide reason for PE firm partners to reconsider the structure of LBO deals and the due diligence conducted along the way.
In December 2020, the United States District Court for the Southern District of New York rendered an instructive decision in the Nine West bankruptcy filing, In re Nine West LBO Sec. Litig., 505 F. Supp. 3d 382 (2020). While the factual and procedural history is complex, the 2018 Nine West bankruptcy stemmed from the Jones Company (“Jones”) and Sycamore Partners Management, L.P. (“Sycamore”) merger forming Nine West Holdings, Inc. (“Nine West” or “the Company”).
Sycamore altered the terms of the initial merger in a way that reduced equity contributions from $395 million to $120 million and increased Nine West’s debt from $1 billion to $1.55 billion. This resulted in an EBITDA debt to equity ratio between 6.6 and 7.8, even though Citigroup Global Markets (“Citigroup”) advised the board that the Company could only support a ratio of 5.1. Ultimately, this led to the Nine West bankruptcy.
In the In re Nine West case, the liquidating trustee sought to hold the Company’s directors and officers liable, pleading various claims of breach of fiduciary duties, aiding and abetting, fraudulent conveyances, and unjust enrichment. While the Court dismissed many of the direct claims plead against the officers due to lack of evidence that the officers could have prevented the transaction, the Court denied motions to dismiss the breach of fiduciary duty and aiding and abetting claims against the Company’s directors.
The ruling came as a surprise because it essentially overlooked the otherwise powerful tool in the business judgment rule and provisions in the bylaws in favor of the directors. The Court found persuasive the fact that the directors had enough information to determine that the complex series of mergers and related transactions would render Nine West insolvent. As a result, the order held the pleadings sufficiently demonstrated that the directors were “reckless” in their approval of the transaction.
While there has not yet been a flood of decisions citing In re Nine West approvingly, as the economy begins a more tumultuous period, there is an expectation that bankruptcy trustees and plaintiff’s counsel will look to hold directors responsible for PE portfolio bankruptcies under similar theories. Directors and PE firms alike must understand the lessons from In re Nine West for its own and directors and officer insurers’ benefit.
In particular, there must be heavy reliance on due diligence obtained from third parties on the front of the LBO transaction. In the case of In re Nine West, had the parties involved simply structured the transaction as initially agreed, they would have had the full support of the Citigroup report the directors commissioned. Direct reliance on the Citigroup report would have made it exceedingly difficult, if not impossible, to demonstrate “reckless” approval by the directors.
Additional transaction costs incurred by involving restructuring professionals early in the transaction would have further diluted the surviving claims against the Nine West officer and directors. Obtaining the blessing of a sale that essentially sheds debt from valuable assets is, after all, the primary purpose of most larger Chapter 11 bankruptcy filings. Thus, in evaluating PE and PE portfolio risks, director and officer underwriters should consider questions surrounding use of lawyers, accountants and other professionals to conduct due diligence in LBO transactions to prevent a result similar to In Re Nine West holding in a case of resulting bankruptcy.