Seller's Directors Beware: You May Be Liable When the Buyer's Leveraged Buyout Goes Bad

Alerts / May 18, 2021

For the past two decades, courts have afforded directors and officers considerable protection for a good-faith decision to proceed with a highly leveraged sale that ultimately led to bankruptcy or liquidation. Courts are generally reluctant to second-guess directors’ and officers’ decisions to enter into potentially risky transactions. State legislatures have also protected directors and officers, passing laws to protect them from liability for their good-faith “business judgment” decisions – even very risky ones.

But a recent decision by New York Federal District Court Judge Jed Rakoff, whose opinions on controversial issues have often attracted national attention, may signal a change in the lenient approach to directors and officers (D&O) liability.

In 2014, Nine West, once a leading fashion retailer, sold itself in a highly leveraged transaction. Nine West’s own projections showed the buyer was taking on far more debt than could be serviced. But Nine West’s directors decided to ignore the issue. Nine West was profitable, and the directors felt it was their duty to get the highest value for their shareholders regardless of the risk to the buyer and the company’s creditors.

Nine West, as predicted, was unable to pay its loans and filed a bankruptcy case four years later. The bankruptcy trustee brought D&O lawsuits against the presale directors and officers of Nine West.

Last December, Rakoff held the seller’s board of directors, and only they, may be liable for breach of their fiduciary duties to Nine West. The judge ordered that they proceed to trial. Because Rakoff felt the officers of Nine West did not have the responsibility to approve the sale, he dismissed the claims against them.

But even though the seller’s directors had no role whatsoever and the company survived for nearly four years after the sale closed, Rakoff determined that the seller’s directors knew or should have known that the buyer was taking on too much debt to survive the transaction. This, said the judge, can mean the directors acted recklessly or with reckless disregard for the consequences of the overleveraged sale. And recklessness can overcome the directors’ argument that state laws and the corporate governing documents protect them from business judgment decisions taken in good faith. Rakoff noted the directors had substantial information showing them the buyer was incurring debt beyond its ability to pay and was using flawed projections of earnings before interest, tax, depreciation and amortization. Knowing that and proceeding to sell did not constitute good faith.

For private equity and other M&A parties, this decision is notable, and BakerHostetler will monitor further developments closely. There are many reasons this decision may not change matters significantly. For one thing, Rakoff relied on a difference between Pennsylvania law, which governed the Nine West decision, and Delaware law, which governs the great majority of businesses. And the judge has only ordered that a trial occur – he has not ruled on the merits. The parties may settle or a jury may decide the directors were not at fault for selling to the highest bidder. The opinion may also be overturned on appeal, so the final determination of liability remains uncertain.

But there is no escaping the very real concerns this ruling presents – the directors of the seller may be potentially liable when the buyer fails many years after a sale. Directors clearly must remain well informed throughout the entirety of a highly leveraged sale process and be aware of the possibility the buyer may fail. Given the prevalence of highly leveraged sales in M&A and the seemingly conflicting duties of the seller’s directors to (i) get the best return possible for shareholders and (ii) concern themselves with the survival of the buyer years down the road, Rakoff’s decision must be seen as a corrective to the prevailing deference to the decision by a seller’s directors to proceed with a highly leveraged sale.

Authorship Credit: Matt Goldman and Scott Prince

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