Failure to investigate the solvency of a company after a leveraged buyout may place a director in breach of their Fiduciary Duty.
In suits alleging a corporation’s director violated his duty of care to the company, courts will evaluate the case based on the business judgment rule. Under this standard, a court will uphold the decisions of a director as long as they are made (1) in good faith, (2) with the care that a reasonably prudent person would use, and (3) with the reasonable belief that the director is acting in the best interest of the corporation. In In re Nine West LBO Securities Litigation, 505 F. Supp. 3d 292 (S.D.N.Y. 2020) (Rakoff, J.), the United States District Court, for the Southern District of New York held that when a company is sold based on a leveraged buyout (“LBO”), directors may not be entitled to the benefit of the “business judgment rule,” and may be liable for breach of fiduciary duty for failing to undertake a reasonable investigation regarding the company’s solvency post-closing and the effect it may have on future contemplated transactions. In other words, this case stands for the proposition that liability may attach to the company’s old board of directors even though they are not members of the new board and were not involved in any of the alleged misconduct.
Post-Closing Duty for Boards of Directors
There appears to be a new duty for the old board members to consider post-closing-contemplated transactions of the new company and its new ownership. They can now be held liable for aiding and abetting a breach of fiduciary duty for actions undertaken by future board members. This should send a chill down any board member’s back. Perhaps this is an outgrowth of the number of LBOs that ultimately end up in bankruptcy, with creditors bearing the brunt of an unscrupulous transaction.
That said, this opinion may relate solely to the district court’s interpretation of Pennsylvania corporate law, but it sends a message to other courts and should send a message to board members that potential liability remains, even after the company is sold. It also appears that there were some bad facts relating to the sale of Nine West and, as we all know or should know, bad facts make for bad laws/rulings. (In addition, this case involved a motion to dismiss and was not a trial on the merits.) Nevertheless, in its findings, the court found that there were sufficient allegations supporting a cause of action against these members of the old board.
The Nine West LBO Post-Closing Activities
This article focuses on the facts pertinent to the breach and period post-closing. Before closing, the PE group acquiring the stock changed the merger agreement by considerably reducing its equity contribution and increasing the debt load. The old board could have terminated the agreement but chose not to. Following the closing, Nine West sold its most lucrative business to the PE firm’s affiliates at a price substantially below fair market value of at least $1 billion.
In denying the right of the old board to rely on the “business judgment rule,” the Court pointed out that the board should have investigated the deal as “as a whole” transaction and not just a) the merger plus b) the consideration to be paid — as a single transaction. By instead of viewing the deal as a “whole,” the Court considered that the old board allowed the deal to proceed even though it would render the company insolvent. Not only was the PE firm allowed to reduce its equity contribution pre-closing, but it was foreseeable that the company would sell its most lucrative business. It did not matter that the old board had nothing to do with subsequent transactions.
So, in finding that the post-closing transactions could be collapsed into one transaction as a whole as opposed to treating it as multi-step transaction, the court focused on In re Hechinger Investment Co. of Delaware, 274 B.R. 71 (D. Del. 2002), and noted that it is appropriate to treat multi-step transactions as a single integrated plan when the alleged harm is foreseeable. Here, the Court pointed out that the old board could have terminated the merger when prior to closing the equity contribution would be decreased and the debt load would be increased. Just as crucial, the court found that the old board had actual and constructive knowledge of the subsequent sale of the lucrative business, even though it occurred post-closing. Thus: the old board breached its fiduciary duty to the corporation.
The PE firm ultimately settled by paying $120 million to the estate and agreeing that one of its portfolio companies would make certain required minimum purchases of product from Nine West post-bankruptcy.
Assuming other courts follow this decision, the takeaway is that directors of a selling corporation may be charged with actual or constructive knowledge of subsequent actions or contemplated actions of the acquiring entity that could render the company insolvent. Therefore, it may be necessary for directors to conduct some form of investigation and no longer turn a blind eye when the company is left insolvent after an LBO.
