Director’s Liability in Leveraged Buyout Transactions

Impairment of Safe Harbor under Business Judgment Rule in Sight?

 

Directors of a German stock corporation (Aktiengesellschaft) or limited liability company (GmbH) may benefit from a safe harbor protecting them against liability as a consequence of damages incurred by their respective company due to business decisions made by the directors. The so-called Business Judgment Rule has its roots in U.S. rules of law. Based on its U.S. role model, this safe harbor was also implemented into applicable German law. Although German corporation law principles always marked the cornerstones and fundamentals of directors' liability (and its limitation), U.S. law plays a particular role in further developing and shaping these principle. The prerequisites of the Business Judgment Rule under German law include, inter alia, the requirement that the directors are acting based on reasonably sufficient basis of information, taking into account the particularities of the respective decision. The details of each requirement are subject to constant discussion and continuous development and are shaped and tailored by both, legal scholars and courts.

Given its historic roots, U.S. developments may also today provide valuable guidance and indications on potential future trends in applying the Business Judgment Rule under German law. The US District Court for the Southern District of New York (Court) has recently made it to the headlines of financial and legal publications with its decision in In re: Nine West Leveraged Buyout Securities Litigation which was widely echoed and in some instances even seen as the end of Leveraged Buyout transactions. This ruling may also impact the way the German Business Judgment Rule is interpreted and shaped in the future, in particular when it comes to M&A transactions.

The Background: Directors' Decisions in an Leveraged Buyout Transaction as Breach of Fiduciary Duties

A publicly traded fashion retailer Jones Group received a taking-private bid from private equity sponsor Sycamore Group. The merger agreement comprised several transaction components which are in the Courts' view of relevance, including: (i) merger of Jones Group into a newly formed Sycamore affiliate to be renamed Nine West (Merger); (ii) Contribution of equity by Sycamore (with another private equity firm) which was pre-closing however reduced to one third of the initially planned only (Equity Contribution); (iii) Post-closing substantial increase of Nine West's debt (Additional Debt); (iv) Cashing out of Jones Group shareholders in the Merger; and (v) Post-closing carve-out of two brands of Jones Group (Stuart Weitzman and Kurt Geiger) and one other business unit to Sycamore Group at about half the price of fair market value of these business and less than their acquisition cost two years earlier (Carve-Out Transactions).

Prior to Closing, the board of Jones Group – which at that time was compiled entirely of persons unaffiliated with Sycamore – unanimously approved the Merger while expressly disclaiming any approval of (or view as to) the Additional Debt and the Carve-Out Transactions. However, the merger agreements contained obligations of Jones Group to plan for the incurrence of the Additional Debt and the consummation of the Carve-out Transactions pursuant to which many directors participated in according meetings.

Following Closing, the board's composition was changed entirely by removing the Sycamore unaffiliated directors (who previously approved the Merger) and appointing two Sycamore principals to office. These new directors initiated the post-closing integration which in particular required Jones Group (now Nine West) to incur the Additional Debt and enter into the Carve-out Transactions.

Four years down the road, Nine West filed for bankruptcy. The bankruptcy trustee brought forward litigation against the former Sycamore unaffiliated directors claiming that the directors breached their fiduciary duties to Nine West by not investigating whether the transactions contemplated in connection with the Merger as a whole would cause the bankruptcy of Nine West post-closing.

The Business Judgment Rule and its Safe Harbor

The Court did not yet finally rule on the director's liability based on the alleged breaches of their fiduciary duties but rather denied motions to dismiss of the former directors.

There are selected corporate law arguments noteworthy in this respect:

• Business Judgment Rule Impacts: The Court held that while directors may in principle benefit from the safe harbor of the Business Judgment Rule, such limitation of liability requires a thorough analysis of the requirements of the Business Judgment Rule, in particular that the directors are informed with respect to the subject of the business judgment to the extent they reasonable believe to be appropriate under the circumstances and that they rationally believes that the business judgment in question is in the best interest of the corporation.
  
  In its ruling, the Court particularly focuses on the question whether the former directors did indeed conduct a reasonable investigation into facts of the transaction and, in particular, whether the transaction could impose a risk of the company falling into insolvency post-closing.
  
  Importantly, the Court held that multistep transactions can be treated as one integrated transaction where the transactions "reasonably collapse into a single integrated plan" and where a cause of action is alleged which constitutes a breach of a fiduciary duty based on the foreseeability of the alleged harm. In the Nine West case, the Court assumes that the former directors failed to conduct a reasonable investigation in the post-closing transactions and that therefore the directors may not rely on the benefits of the business judgment rule in respect of these parts of the overall transaction.
  
  Even further, the Court clearly points out that the behavior of the former directors was reckless by ignoring certain red flags which were presented to the directors. In particular, financial advisors to the company had previously assessed that the company could bear a 5.1 times debt to EBITDA ratio. The revised transaction structure as amended prior to closing constituted, however, a debt to EBITDA ratio of at least 6.6 times (depending on numbers even as much as 7.8 times). Also, the purchase price for the "crown jewels" of Nine West was significantly below their fair market value and even significantly below the price paid by Nine West just some years ago.
  
  
• Aiding and Abetting Breach of Fiduciary Duties: In addition to their own breach of fiduciary duties, the Court held that the former directors aided and abetted the breach of fiduciary duties of the newly appointed directors. For purposes of its ruling, the Courts is of the opinion that the former directors had actual or constructive knowledge that the newly appointed directors would consummate the contemplated incurrence of the Additional Debt and the Carve-out Transaction which would leave Nine West insolvent.

While this decision is not yet determining whether or not the defendants are actually liable for a breach of fiduciary duties, the ruling indicates a potential liability of board members.

The Transatlantic Angle

In U.S. publications, the Court's ruling was largely echoed as a specification of director's duties and the requirements of the business judgment rule as well as guidelines on proper process in connection with Leveraged Buyout transactions.

What does that mean for German transactions? As stated above, the German legislator has adopted the Anglo-American approach of a safe harbor for management in business decisions situations and introduced the business judgement rule in statutory law. History of corporate law in Germany shows a tendency that new developments in the U.S. are carefully reviewed, analyzed and – in some parts like the business judgment rule – are copied and implemented into German law rules.

Hence, lessons learned from the Nine West case for German management may be summarized as follows:

• It all falls into one place: Management facing multi-step transactions might be required to expand the basis of information to cover all parts of the contemplated deal, including those aspects which are to be implemented only after closing (and potentially also only after such management has resigned from office in the course of the transaction). It should be noted that courts might not accept carve-outs of certain transaction parts from management's overall business decision and judgment but require that directors collect information covering the entire transaction and its impact to the company – also post-closing and even post-revocation of the directors' term. Directors may not take cover in the Business Judgment Rule's safe harbor by simply excluding certain parts of a multi-step transaction in their decision and opinion.
  
  
• Process matters: More than usually it is recommended to keep track of the discussions and underlying information. Independent expert opinions need to be diligently monitored and management should keep track of all information which forms the basis for their decision. This holds in particular true if red flags appear throughout the fact finding: Expert opinions and indications on imposed threats to the company need to be monitored, analyzed and the directors' view on these should be carefully documented evidencing the process of weighing arguments in favor and against the multistep transaction.
  
  
• Leveraged Buyout is not dead: Last but not least and on a side note, the ruling tightens the duties of management but does not end Leveraged Buyout However, target management will likely analyze the transactions more carefully and comprehensively.