December 11, 2020

LBOs: Seller’s Directors on the Hook for Post-Closing Insolvency

Every now and again there’s a decision on director or shareholder liability in a bankruptcy that just fills corporate lawyers with dread – and you can usually count on it coming from the Southern District of New York.  Just in time for the holidays, this Ropes & Gray memo reports that we can add another SDNY decision to that list.  Here’s an excerpt:

The United States District Court for the Southern District of New York has delivered a sobering punctuation mark to a sobering year through In re Nine West LBO Securities Litigation, Case No. 20-2941 (S.D.N.Y. Dec. 4, 2020) (Rakoff, J.). Nine West holds that directors approving the sale of a company as part of a leveraged buyout can be liable for breach of fiduciary duties in the seller’s subsequent, post-sale bankruptcy where those directors failed to adequately assess the seller’s post-sale solvency. In particular, Nine West determined that:

– the business judgment rule does not even apply where directors fail to adequately assess the selling company’s post-sale solvency;

– directors may be deemed to have acted recklessly by failing to adequately assess the selling company’s post-sale solvency; and

– selling directors can also be held liable on an “aiding and abetting” theory for subsequent but related post-sale asset dispositions undertaken by the buyer.

Nine West should be viewed as a serious warning for corporate decision-makers. Although they may be exiting, the directors of a corporate seller cannot ignore the selling company’s post-transaction balance sheet without also risking their protections under business judgment rule.

The seller was a Pennsylvania corporation, and the court’s determination that the board acted “recklessly” had profound consequences – it meant that their conduct was not protected by the business judgment rule or by the seller’s exculpatory charter provision.  In other words, these directors are looking at personal liability for their actions.

The memo acknowledges that the court’s directive seems to conflict with the board’s duty to maximize value for their shareholders in a sale, but “rightly or wrongly, Nine West’s message is that directors should prudently assess the post-transaction capitalization of the selling company and related transactions taken (or proposed to be taken) by the buyer, regardless of the fact that the seller in question will be ‘under new management’.”

John Jenkins