Recent Judge Rakoff Decision May Curb Private Equity Leverage Abuses By Pinning Liability on Directors of Selling Company

For decades, authorities and experts have tried restricting excessive borrowing by private equity investors, since it’s been repeatedly shown that they leave lots of bankruptcies in their wake. And these abuses continue because private equity looting fee structures result in general partners making out handsomely whether or not the business does well. In 1987 (no typo), the Treasury proposed limiting the deduction of interest on highly leveraged transactions. That idea went by the wayside thanks to the 1987 crash. Other proposals to restrict debt levels have similarly not gone anywhere. Yet now an important ruling looks set to deliver where regulators and legislators have failed.

The decision is related to bankruptcy ruling, In re Nine West LBO Securities Litigation, in early December. I’m late to it; several readers called it to my attention via a William S. Cohan op ed in the New York Times, The Private Equity Party Might Be Ending. It’s About Time. I think Cohan is overstating its significance; investment bankers and lawyers are prone to howling loudly about anything that might reduce the size of their meal tickets while working full bore to preserve them. But Nine West does appear likely to restrict very highly leveraged deals by pinning the liability tail for likely insolvencies on the directors and officers of the selling company.

The very short version of this story is that the directors of the selling company approved a sale transaction that they knew would saddle the company, renamed Nine West, with more debt than its own bankers had said it could support while removing its best assets. They sat pat as the buyer revised the deal to load even more borrowings on the acquisition, despite having a fiduciary “out” clause.

The directors and officers lost a motion to dismiss litigation filed by the creditors of the Nine West alleging breach of fiduciary duty. Judge Jed Rakoff accepted some of the creditors motions, , because the board had a duty to creditors and approved actions that would render the company insolvent.

As Ropes & Gray, counsel to Bain among many others, put it (emphasis theirs):

Under Nine West, directors of a selling corporation face a serious risk of personal liability where they do not assess a buyer’s post-transaction viability.

Given its potentially drastic implications, Nine West should be carefully reviewed by corporate directors and market participants.

Now to unpack the facts and reasoning a bit more (the opinion is embedded at the end of the post).

The Jones Company owned a series of clothing and shoe brands including Nine West. Most were flagging save two recently-purchased, outperforming stars: Stuart Weitzman and Kurt Geiger.

The directors decided to explore a sale of the company in 2012. Their banker, Citigroup, said the business could support up to 5.1x its then estimated 2013 EBITDA.

In 2013, private equity firm Sycamore responded to Citi’s shopping of the company and offered a $15 a share deal, with four additional things happening more or less simultaneously with the purchase of shares from the current owners:

1. Merging Jones Company into a new entity to be called Nine West

2. Contributing $395 million in new equity to the company

3. Increasing debt from $1 billion to $1.2 billion

4. Stuart Weitzman, Kurt Geiger and one other business would be sold to other Sycamore entities for less than their fair value

The board tried to have it both ways. It approved the Merger Agreement but postured that it was nixing the extra debt and the sale of the prime assets. But the Merger Agreement obligated the seller to assist Sycamore with both activities.

Sycamore made more changes before the deal closed, namely increasing the additional debt by $355 million and reducing the equity addition from $395 million to $120 million.

Notice how even before you get to raiding the best assets, the deal walks and quacks like a cash out? The buyers are providing only $120 million in equity but adding $550 billion in debt…which they could easily partly or fully dividend out.

The ruling also describes how Sycamore provided obviously false financial forecasts to Duff &= Phelps to get them to provide an inflated value “RemainCo”, meaning Nine West after the best bits were spun out. Duff & Phelps came up with $1.58 billion. That means even with not-credibly rosy forecasts, Sycamore planned to put debt on the company that was virtually equal to its total value. The board chose to ignore the clearly dodgy forecasts even as the performance of the company kept decaying before closing.

Needless to say, this structure also gave RemainCo, soon to be Nine West, a higher leverage ratio that the seller’s bankers had said the company could support even if it had retained its prize businesses.

Before the transaction closed, some shareholders sued, arguing the $15 a share was too low and therefore a breach of fiduciary duty. After some jousting, the claims were dismissed with prejudice.

When the deal closed, key executives and board members received golden parachute payments ranging from $425,000 to $3 million.

Nine West went bankrupt in 2018. Nine West settled with Sycamore but not with the former officers and directors of the seller, Jones Group. Those claims were transferred to a Litigation Trust for the benefit of the bankrupt estate, as in the creditors.

The Jones Group defendants made the usual handwaves: the resolution of the shareholder litigation these claims, and the directors were entitled to “business judgment” protection under Pennsylvania law and the company’s by-laws. They landed like duds, hence the alarm across Corporate America.

The matter of the dismissed shareholder suit doesn’t have big significance precedent-wise, but it still gave the opportunity for a delicious shellacking by Judge Rakoff:

The 2014 Settlement extends only to claims that could have been brought by the shareholder plaintiffs “in their capacity as shareholders.”… Fraudulent conveyance claims, however, can be brought only by or on behalf of creditors…. Because the shareholder plaintiffs could not have brought these fraudulent conveyance claims “in their capacity as shareholders,” the claims are not barred by the 2014 Settlement.

As for the related question of res judicata (emphasis original):

It is well-established that a judgment rendered in derivative action “brought on behalf of the corporation by one shareholder will generally be effective to preclude other actions predicated on the same wrong brought by other shareholders.”…

Whereas the shareholder plaintiffs argued that the directors and officers breached their fiduciary duty by failing to generate enough money for the shareholders, the Litigation Trustee now argues that the directors and officers breached their fiduciary duty by distributing too muchmoney to shareholders, thereby rendering the Company insolvent. While the two sets of claims challenge the same one transaction, the incentives of the shareholder plaintiffs — to generate more money for the shareholders — were directly opposed to those of the Litigation Trustee, who seeks in this very action, for example, to claw back money paid to the shareholders as fraudulent conveyances

Now to the meatier part, the rejection of the notion that the directors can hide behind their assertion that they exercised “business judgement,” too bad about the smoldering wreck the left behind.

Turning the mike over to Governance & Securities Watch:

The headline issue that has people up in arms is the court’s holding that directors of a selling corporation may lose the benefit of the business judgment rule and be held liable, under a breach of fiduciary duty theory, for not undertaking a reasonable investigation into the company’s post-sale solvency and the propriety and effect of any contemplated post-closing transactions that could be considered part of the same overall transaction when such transactions may affect the post-sale solvency of the company. In other words, according to the court, a director may be liable for not taking into account transactions expected to occur after the sale closes, the company’s shareholders receive the sale consideration, and new ownership and directors take over. The court similarly determined that directors of the selling corporation may be liable, on an aiding and abetting a breach of fiduciary duty theory, for actions undertaken by the future board of the buyer corporation if the selling corporation’s directors had actual or constructive knowledge of the fiduciary breach of the buyer’s directors. This liability may attach even if the buyer directors were not yet directors, and therefore owed no duties, at the time of their misconduct. In the eyes of this court, it’s no longer a “my watch, your watch” world.

Even though Jones and Nine West were governed by Pennsylvania law, the relevant provisions of Delaware law are sufficiently similar so as to be causing some consternation.

One troubling element of the legal write-ups I have seen so far (Ropes & Gray, Quinn Emanuel) is that they give prominent play to how this decision complicates the “duty” of a board to “maximize shareholder value”. This sort of blather confirms that the M&A bar has been captured by Wall Street. Directors have duties to the corporation, not to shareholders in particular. As we’ve repeatedly explained, the “maximizing shareholder value” fetish was created by economists, not by statute or precedent, although it saddly has been turbo-charged with equity-linked executive compensation schemes. These lawyers need some brain bleach.

The Harvard Law School Forum on Corporate Governance thinks the alarm about Nine West is overdone but prudent sellers should nevertheless take some precautions, such as:

Based on Nine West, the target board involved in an LBO should evaluate the likelihood of post-closing solvency of the company….

  • The equity and debt being provided for the deal are being provided by sophisticated parties who have negotiating leverage and access to all relevant information.
  • The equity being contributed meaningfully exceeds any value to be distributed to the buyer or its affiliates shortly following closing. 
  • There was more than one bid for the company, with pricing and a capital structure roughly similar to that in the approved transaction..
  • The buyer provides representations and warranties in the merger agreement relating to the post-closing solvency of the company….

If there are “red flags” as to a risk of insolvency post-closing, a broader evaluation may be warranted.

Note that the Nine West asset shuffle did indeed result in Sycamore pulling out more dough at closing than it put in thanks to the grab of the crown jewel businesses.

I haven’t heard a peep as to whether Judge Rakoff’s assessment, that the Jones board was reckless, would void its D&O insurance if confirmed in later rulings, making the directors liable. But even if not, as in the Litigation Trustees prevail, their insurer will get a big bill and D&O insurers generally will be on notice that they actually might have to pay out claims now and again. So expect to see additional behavior changes as this case moves forward.

00 In re Nine W. LBO Sec. Litig
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  1. Chris Herbert

    The ‘shareholder value’ is, in its current definition, a pure dodge and theft.

  2. somethingstinks

    I thought the way to take over a common stock company was to buy at least 51% of the common stock?

    So why in heck are the directors allowed to sell a company unless they have pre-approval by at least 51% of the shares to do so?

    And btw, logically, the board and officers are to do the WILL of the OWNERS of the company, what a majority of the share owners desire, within the law, and that may or may not be to maximize shareholder value.

  3. none

    Is this decision likely to get appealed, and could it stand? Would the Roberts court immediately want to shoot it down, based on ideology of letting corporate raiders do whatever they want?

    1. Yves Smith Post author

      This part is not likely to be appealed, it’s just a knockdown of some arguments that the suit on behalf of Litigation Trust should be dismissed. The defendants can have a go at it at trial.

  4. LowellHighlander

    As an Economist (trained mostly in heterodox traditions), I just love this insight:

    “Directors have duties to the corporation, not to shareholders in particular. As we’ve repeatedly explained, the ‘maximizing shareholder value’ fetish was created by economists, not by statute or precedent…”

    A corporation is, in law, a person. (This was settled in the preamble of a case sometime in the 1860s or 1870s, which is known, in short, as “Santa Clara”.) This insight clearly captures the reality that Directors have to keep the body (i.e. the corporate “person”) alive, and that consequently shareholders aren’t all there are to a corporate person.

    I feel certain that Institutional Economists, such as Dean Baker and the late Robert Prasch (amongst many others, to be sure), would readily grasp all this, just as I feel equally certain that the vast majority of neo-classicals avoid these realities like the plague.

    Thanks much for the posting. I am currently studying for a Master’s in Forensic Accounting, and I will be able to use the insights from your posting here in my required on-line discussions.

  5. chuck roast

    “…directors and officers breached their fiduciary duty…” Holy mackrel Andy! I never thought that I would see that. Around 2002-3 the Fiduciary Rule was ‘modernized’. I don’t know if we are still operating under that Fiduciary Rule, but my layman’s interpretation was that a Board of Directors would have to be caught snoozing in order that a fiduciary violation occur. It was an absolute toothless tiger as my retirement fund board of directors demonstrates from time to time. And try to charge the CalPERS board with a fiduciary violation…yeah, a real laugh riot. Well, I truly love old Jed, but he is more likely to expose the rule as the infinitely malleable word-smithing it is than a trusty signpost. Now if he can make the link between fraudulent conveyance and the Fiduciary Rule stick there may be chance.

    Incidentally, I have been trying for years to find an investment advisor that will take care of my wife’s affairs when I croak. My first question is, “Will you sign a contract becoming her fiduciary agent?” The answer is always, “No.”

  6. Matthew G. Saroff

    There was a study a few years back about how increased personal liability led to more responsible practices in finance.

    Short version: In the early 1800s a so called Married Women’s Property Acts (MWPAs) were adopted by different states at different times.

    The MPWA allowed married women to own property of their own, things like family jewels, a family home, etc.

    Bank presidents with rich wives therefore had a significant portion of family assets protected from debts incurred by bank failures because of this law, and it correlated directly and strongly with reckless behavior.

    I believe that corporate bankruptcy laws should be restructured to make it much more personally painful for those who loot their companies.

  7. somethingstinks

    A question I have is what if 51% of the shares of Jones Co. had been acquired by Sycamore without the knowledge or approval of the directors and officers of Jones Co by simply buying them in the Stock Market?

    How then could the sellers of Jones Co. be held liable for what the buyer latter did simply for selling some stock? Wouldn’t limited liability laws protect them?

    1. Yves Smith Post author

      You can’t acquire 51% without anyone’s knowledge. You have to file a 13-D when you get to 5%.

      As to the rest, you don’t understand enough even to be asking useful questions. Please study up. Or read the opinion, which very clearly explains the judge’s reasoning.

      I don’t mean to sound harsh, but this is a finance and economics site. I am not in the business of providing tutorials to readers who present themselves as less knowledgeable than a casual reader of the business press.

      1. somethingstinks

        You can’t acquire 51% without anyone’s knowledge. You have to file a 13-D when you get to 5%. Yves

        Thanks very much.

        I have been reading the Opinion and now that I know that loophole doesn’t exist, I shall continue reading with much more interest.

  8. Susan the other

    Thanks for this evidence that excellent logic still exists. I’m so pleased to see it is wielded by Judge Rakoff. Who else? This is such good news, I’m pretty sure spring is coming.

  9. Sound of the Suburbs

    The neoliberals are following an ideology, but don’t know how economies really work and neoclassical economics doesn’t help.

    We released the power of finance, which is the power of debt.

    I am a banker and my only real product is debt.
    Who can I load up with my debt products?
    You’ll do.

    Bankers loaded up economies with their debt products until they got financial crises.
    At 25.30 mins you can see the super imposed private debt-to-GDP ratios.

    No one realises the problems that are building up in the economy as they use an economics that doesn’t look at debt, neoclassical economics.
    As you head towards the financial crisis, the economy booms due to the money creation of bank loans, as it did in the 1920s in the US.
    The financial crisis appears to come out of a clear blue sky when you use an economics that doesn’t consider debt, like neoclassical economics, as it did in 1929.

    1929 – US
    1991 – Japan
    2008 – US, UK and Euro-zone
    The PBoC saw the Chinese Minsky Moment coming and you can too by looking at the chart above.
    The Chinese were lucky; it was very late in the day.

    The Chinese have worked out the problem and know they are on the verge of a financial crisis.
    They have been making all the classic mistakes everyone has been making during globalisation.

    What’s wrong with neoclassical economics?
    1)   It makes you think you are creating wealth by inflating asset prices
    2)   Bank credit flows into inflating asset prices, debt rises faster than GDP and you eventually get a financial crisis.
    3)   No one notices the private debt building up in the economy (apart from the Chinese) as neoclassical economics doesn’t consider debt.
    4) It confuses making money with creating wealth so everyone thinks the bankers are doing really well as they try and drive your economy into a Great Depression.

    The Chinese understand the problem they have, unlike anyone in the West.

    1. Sound of the Suburbs

      Western experts investigated after 2008.
      After a thorough and comprehensive investigation they reached their conclusion.
      “It was a black swan mate; no one could have seen it coming, honest”

      I don’t think they really put any effort in at all.
      I worked it out, but I am no one of any significance.
      I have been posting this in comments sections for years, but no one has really taken any notice.
      The Chinese have now worked it out too, and to keep up with the Chinese we are going to have to take it on board.

      Davos 2018 – The Chinese know financial crises come from the private debt-to-GDP ratio and inflated asset prices
      The black swan flies in under our policymakers’ radar.
      They are looking at public debt and consumer price inflation, while the problems are developing in private debt and asset price inflation.
      The PBoC knew how to spot a Minsky Moment coming, unlike the FED, BoE, ECB and BoJ.

      A year later, and they had made further progress.

      Davos 2019 – The Chinese know bank lending needs to be directed into areas that grow the economy and that their earlier stimulus went into the wrong places.
      They had pumped bank credit into areas that don’t grow GDP, and the private debt-to-GDP had risen to a level they were on the verge of a financial crisis.
      Everyone does that with neoclassical economics, but they don’t usually see the financial crisis coming, like the US in 1929, Japan 1991 and US, UK and Euro-zone in 2008.

      To compete with China we will need to learn the same lessons as they have.

    2. Sound of the Suburbs

      What’s gone wrong?

      Neoclassical economics is a pseudo economics that hides the inconvenient truths discovered by the classical economists.
      The classical economists identified the constructive “earned” income and the parasitic “unearned” income.
      Most of the people at the top lived off the parasitic “unearned” income and they now had a big problem.
      This problem was solved with neoclassical economics, which hides this distinction.
      It confuses making money and creating wealth so all rich people look good.

      There are other inconvenient truths that also had to be buried, elsewhere.

      Our knowledge of banking has been going backwards since 1856.
      Credit creation theory -> fractional reserve theory -> financial intermediation theory
      “A lost century in economics: Three theories of banking and the conclusive evidence” Richard A. Werner

      This was a recipe for disaster.
      They developed the neoliberal ideology from what they knew, which wasn’t nearly enough.

      William White (BIS, OECD) talks about how economics really changed over one hundred years ago as classical economics was replaced by neoclassical economics.
      He thinks we have been on the wrong path for one hundred years.
      Small state, unregulated capitalism was where it all started and it’s rather different to today’s expectations.

      The corruptions to economics came after the classical economists.
      We need to go back there to find out what small state, unregulated capitalism really looks like.
      They could observe it in the world around them.

      The truth about banks has now been revealed.
      It was too late for globalisation and the development of the neoliberal ideology.

    3. LowellHighlander

      Dear Sound-of-the-Suburbs,

      Sorry for the late reply, but I was just reading your post and I might be able to help steer you into a direction of economics that will comfort you in your thinking here. Regarding these statements you made:

      “No one realises the problems that are building up in the economy as they use an economics that doesn’t look at debt, neoclassical economics.
      “As you head towards the financial crisis, the economy booms due to the money creation of bank loans, as it did in the 1920s in the US.”

      Do you realize that you are echoing the economics of the towerig Post-Keynsian scholar Hyman Minsky? I’m certainly no authority on Post-Keysnian economics, so you should check out their academic journal (I believe it’s entitled the Journal of Post-Keynsian Economics) to find economists publishing in that paradigm. Of course, you might wish to start with Professor Minsky’s magnum opus, Stabilizing an Unstable Economy. I believe you will find that this book both validates and expands your worldview [on debt and macro-economic] performance here. And my apologies in advance if you are already aware of all this.

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