Deal lawyers in the US are warning that leveraged buyouts could become much more difficult to do, after a court said creditors could go after a company’s former directors if a private equity buyer saddles the business with an unsustainable amount of debt.
A recent ruling — in the case of the bankruptcy of retailer Nine West — by Judge Jed Rakoff of the Southern District of New York said creditors can pursue misconduct charges against the previous board of directors, which approved a $2bn leveraged buyout to Sycamore Partners in 2014. The business went bankrupt four years later.
The board had been “reckless” in failing to assess how the LBO debt could leave the new company insolvent, the federal judge wrote in the December 4 ruling.
“Requiring boards to be liable for the results years after a sale would put board members in a position of conflict between what is best for shareholders in the short run versus what is best for directors over the next few years following a transaction,” said Brian Quinn, a corporate law professor at Boston College. “It could be a gamestopper for the private equity business.”
[The] direction to corporate decision makers is seemingly at odds with their concurrent duty to maximise value for corporate stakeholders
Ropes & Gray
The ruling in the Nine West case is preliminary and the specific situation will now be resolved in a fully-fledged trial or a settlement, but the judge’s statement of legal theory could have long-lasting consequences, said Ryan Preston Dahl, a partner at Ropes & Gray.
“Even a trial and ‘vindication on the facts’ will still leave this preliminary ruling out there stating that a board acts ‘recklessly’ by failing to adequately assess an LBO-buyer’s post-transaction solvency,” he said.
Ropes & Gray found the ruling to be so consequential that it put out a public bulletin to clients last week.
The ruling’s “direction to corporate decision makers is seemingly at odds with their concurrent duty to maximise value for corporate stakeholders — typically satisfied by obtaining the highest possible price from a putative buyer”, the law firm wrote.
The Nine West bankruptcy has been contentious, with its private equity owner facing accusations of asset-stripping. As part of the 2014 buyout, it sold two of the company’s top brands, Stuart Weitzman and Kurt Geiger, to a Sycamore affiliate in a side deal at what creditors later argued was too low a price, leaving the remaining Nine West brands unable to shoulder the LBO debt.
Junior creditors argued the Nine West board had been told by investment bankers that the company could only withstand a debt to cash flow ratio of 5.1 times, but the Sycamore LBO they approved raised leverage to 7.8 times.
The board argued that it had specifically not opined on the propriety of the side deal and LBO financing, which together had sent leverage skyrocketing. The court, however, said all components of the transaction should have been considered.
Since the board had been “reckless” in not investigating Nine West’s solvency, it “cannot take cover behind the business judgment rule”, Judge Rakoff wrote, referring to the legal doctrine that keeps directors’ past actions from being second-guessed later. 
Lawyers for the Nine West directors did not respond to a request for comment.
Elizabeth Tabas Carson, a partner at Reed Smith, said selling companies have typically assisted private equity firms in raising deal financing, but at the very least may become less keen to do this.
“If sellers are ultimately going to be liable for the buyers’ actions, then you can expect to see much more push back on seller syndication co-operation provisions,” she said.
A leading deal lawyer said: “If Bank of America or Goldman Sachs or whoever is willing to underwrite a deal and the company gives a solvency certification and the market buys the debt what more should the selling directors do?”