A fiduciary is a person or entity that is required to act in the best interests of another person, entity, or group of persons. Typically, a fiduciary will manage assets on behalf of a beneficiary. In, corporate law, a fiduciary can be a) a member of the board of directors; b) an officer of the company; or c) a controlling shareholder. Fiduciaries owe duties to other people or entities. Corporate law outlines two primary fiduciary duties: the duty of care and the duty of loyalty. Most states have adopted the Delaware approach given the state’s large number of companies and robust corporate law; as such, this post will focus on the Delaware approach.
Who owes fiduciary duties to whom?
The directors of a corporation owe fiduciary duties to the corporation and its shareholders. The directors also owe fiduciary duties to common stockholders in preference to preferred stockholders. A corporation’s directors may also owe fiduciary duties to the corporation’s creditors when the corporation is insolvent. A controlling stockholder (>50% ownership) owes fiduciary duties to the minority stockholders. The officers of a corporation also owe fiduciary duties to the corporation and its stockholders. This post will focus primarily on the fiduciary duties of a corporation’s board of directors.
Duty of Care
The duty of care requires the corporation’s directors to inform themselves of all material information reasonably available to them when making a business decision. The duty of care requires a director to use the amount of care which an ordinarily careful and prudent person would use in similar circumstances. Directors’ decisions are scrutinized for their reasonableness, but courts have been careful not to impose liability on directors when a decision seems wrong only with the benefit of hindsight. Additionally, Section 102(b)(7) of the Delaware General Corporation Law allows corporations to include an exculpatory provision in their charters. This allows corporations to exculpate their directors for breaches of the duty of care.
Duty of Loyalty
The duty of loyalty requires a corporation’s directors to act in good faith and in the best interests of the corporation and its stockholders and not for their own personal interest. The duty of loyalty is associated with conflicts of interest and corporate opportunities, both of which are explained below.
- Conflicts of Interest
- A conflict of interest usually exists when a director has a personal or financial interest in a transaction or other corporate matter. Some scenarios that implicate a conflict of interest are when the director stands on both sides of a transaction (i.e. when a director is a party to the transaction with the corporation or serves both parties or has an ownership interest in a party). When a director appears on both sides of a transaction, this is known as self-dealing.
- Corporate Opportunity
- Corporate directors breach the duty of loyalty when they usurp a corporate opportunity. Courts assess several factors to determine whether a corporate opportunity belongs to the corporation:
- Whether the opportunity is in the same line of business as that of the corporation
- Whether the corporation has an interest or expectancy in the opportunity
- Whether the corporation has the financial ability to take the opportunity presented
- Whether the opportunity would present a conflict of interest or would be a breach of fiduciary duties for a director or officer
- Corporate directors breach the duty of loyalty when they usurp a corporate opportunity. Courts assess several factors to determine whether a corporate opportunity belongs to the corporation:
Standards of Review
There are three standards of review that courts employ to assess whether directors have breached their fiduciary duties:
- Business Judgment Rule
- Courts tend to avoid substituting their business judgment for that of the directors and they hesitate to question business decisions when they have the benefit of hindsight unless the board’s decision cannot be attributed to any rational business purpose. The business judgment rule is essentially the presumption that the board was informed and honestly believed that its action was taken in the best interest of the corporation. In a lawsuit involving an alleged breach of the duty of care, a court will make this presumption unless the plaintiff shows that a majority of the board of directors failed to meet the following elements:
- Informed Decision. Before making a business decision, the board of directors must inform itself of all material information reasonably available. The board of directors should complete the following tasks in order to properly inform itself: attend board meetings, carefully review materials and reports prepared for the board, ask questions at board meetings, and make good-faith determinations of the competence of the persons producing the reports/analyses on which the board relies.
- Good Faith. The board of directors must act in good faith, which courts define as the absence of bad faith. An action done in bad faith means that the conduct was “motivated by an actual intent to do harm or when there is an intentional dereliction of duty, a conscious disregard for one’s responsibilities.”
- Take Action in the Corporation’s Best Interest. The board of directors must reasonably believe that its action or a particular transaction was made in the best interest of the corporation. If a majority of the board has a conflict of interest in a transaction, the conflicted directors do not receive the presumption of the business judgment rule.
- Courts tend to avoid substituting their business judgment for that of the directors and they hesitate to question business decisions when they have the benefit of hindsight unless the board’s decision cannot be attributed to any rational business purpose. The business judgment rule is essentially the presumption that the board was informed and honestly believed that its action was taken in the best interest of the corporation. In a lawsuit involving an alleged breach of the duty of care, a court will make this presumption unless the plaintiff shows that a majority of the board of directors failed to meet the following elements:
1. Courts have reiterated that “under the business judgment rule director liability is predicated upon concepts of gross negligence.”
- Entire Fairness
- Entire fairness is the standard of review employed by courts when an actual conflict of interest exists. This is the highest standard courts use in evaluating a breach of fiduciary duty. When entire fairness is the applicable standard, the defendant directors must establish both of the following:
- Fair dealing. Fair dealing involves concepts of how a transaction was timed, structured, negotiated, disclosed to the board, and approved by the board/stockholders.
- Fair price. Fair price involves the economic considerations of a transaction, including the following factors: assets, market value, earnings, future prospects, and any other elements that affect the intrinsic value of the corporation’s stock.
- Enhanced Scrutiny
- Enhanced scrutiny is an intermediate test employed by the courts in certain situations (e.g. when a board of directors adopts anti-takeover measures or approves a sale of control).
- Anti-takeover measures. Corporate directors often try to entrench themselves in order to save their seats on the board. Therefore, boards sometimes adopt anti-takeover measures to prevent a hostile takeover. In this situation the “Unocal test” is applied to the anti-takeover measure. When implementing a defensive measure, the board must prove two elements:
- The board had reasonable grounds for believing a threat existed to the operation and/or policies of the corporation.
- The defensive measures were reasonable in relation to the threat imposed.
- Sale of Control. When there is a sale of control or a break-up of the organization, courts will apply the enhanced scrutiny standard. These situations implicate what are known as “Revlon duties.” Revlon duties require a board of directors to obtain the highest possible value reasonably available to stockholders when selling the corporation. Usually, the highest possible value implies the highest possible purchase price, but other factors are relevant such as certainty of deal completion given required financing and consent from government authorities.
Fiduciary Duties in the Post-Transaction Period: A Case Study
Do directors’ fiduciary duties extend after the directors have sold the corporation and no longer serve on the corporation’s board? In other words, can directors be liable for actions taken by the subsequent directors in the post-transaction period? A recent case out of the Southern District of New York suggests that directors could be liable in this scenario.
The Facts. Prior to 2014, Jones Group was a publicly-traded global apparel and footwear company and owned brands such as Nine West, Anne Klein, and Gloria Vanderbilt. It sold its products to retailers such as Macy’s, Lord & Taylor, and Walmart. Jones Group was struggling in the years leading up to 2014, except for two of the company’s brands, Stuart Weitzman and Kurt Geiger. In July 2012, the Jones Group board of directors began exploring options for the company, including selling all or part of the company. The Jones Group board hired the investment bank, Citigroup, to advise it in the matter. Citigroup advised the Jones Group board that the entire business, including the promising brands, could support debt to EBITDA (earnings before interest, taxes, depreciation, and amortization) ratio of 5.1 times the estimated 2013 Jones Group EBITDA.
In April 2013, a private equity firm, Sycamore Partners Management, L.P. (“Sycamore”), offered to buy Jones Group for $15 per share, which implied an enterprise value of $2.15 billion. The merger agreement included five integrated components that would occur essentially concurrently.:
- Jones Group was to merge with a Sycamore affiliate and the surviving corporation would be renamed “Nine West.”
- Sycamore was to contribute equity of $395 million to Nine West.
- Nine West’s debt would increase from $1 billion to $1.2 billion.
- The Jones Group shareholders would be cashed out at $15 per share (totaling approximately $1.2 billion).
- The Stuart Weitzman and Kurt Geiger brands, along with Jones Apparel (a separate business unit) were to be sold to other Sycamore affiliates for below fair market value (the “Carve-out Transactions”).
In December 2013, the Jones Group board voted unanimously to approve the merger agreement. Though the board’s approval did not include the additional debt and Carve-out Transactions, the merger agreement did include covenants whereby the Company agreed to assist Sycamore in planning the Carve-out Transactions and in syndicating the additional debt. The merger agreement also included a “fiduciary out” clause, “which allowed the Jones Group directors to withdraw their recommendation in favor of the 2014 Transaction if they determined, after consultation with counsel, that withdrawal could be required by the directors’ fiduciary duties under applicable law.”
Before closing, Sycamore made changes to the terms of the transaction. Sycamore reduced its equity contribution to $120 million from $395 million and arranged new financing that increased the company’s debt by approximately $350 million (from $1.2 billion to $1.55 billion). This new financing structure implied a new debt to EBITDA ratio of 7.8 times the adjusted EBITDA calculated by Jones Group management. This was likely to be an unsustainable debt level.
The merger closed in April 2014. Upon closing, Sycamore’s principals became the sole directors of Nine West. The new directors caused Nine West to enter into the Carve-out Transactions, whereby the promising and top-performing brands would be sold to newly formed Sycamore affiliates for $641 million, which was below their fair market value of $1 billion and below the $800 million that Jones Group paid for them a few years earlier.
Four years later, in April 2018, the remaining Nine West entity filed for chapter 11 bankruptcy. The bankruptcy court approved Nine West’s chapter 11 restructuring plan in February 2019. A litigation trust was created in order to pursue claims related to the 2014 transaction for the benefit of unsecured creditors. In early to mid-2020, the litigation trustee brought claims against the Jones Group directors for breach of fiduciary duties (among other claims) arising out of the bankruptcy and in connection with the 2014 transaction.
The case came before the United States District Court for the Southern District of New York and was decided on December 4, 2020. The director defendants moved to dismiss the breach of fiduciary duty claims on the grounds that the business judgment rule applied to this transaction and even if the business judgment rule is not applied, the directors are exculpated from liability due to the provisions in the Jones Group bylaws. In order to be granted business judgment rule protection from liability, the directors must make decisions in good faith and where the directors are disinterested, informed with respect to the transaction to the extent they reasonably believe is appropriate under the circumstances, and rationally believe that the transaction is in the best interests of the corporation. The directors argued that they were not obligated to investigate or consider the solvency of Jones Group after the additional debt and Carve-out Transactions, because these components of the 2014 transaction were carried out after they ceased to be directors of Jones Group. The Court disagreed and treated the multi-step transaction as a single, integrated plan where the subsequent transactions were foreseeable. The Court ruled that the directors “cannot take cover behind the business judgment rule with respect to those components of the 2014 [t]ransaction.”
The Court, applying Pennsylvania law, then ruled on the exculpatory provision in the Jones Group bylaws. Pennsylvania law permits shareholders to adopt bylaws exculpating directors from liability, except in situations where the breach of fiduciary duty constitutes self-dealing, willful misconduct, or recklessness. The Court ruled that the directors were reckless because the directors failed to make a reasonable investigation, or any investigation, into the additional debt and Carve-out Transactions, even in the face of red flags that suggested the 2014 transaction would cause the company to become insolvent. Therefore, the Court said, the directors were not entitled to the protection of either the business judgment rule or the exculpatory provisions in the Jones Group bylaws, and their motion to dismiss was denied. The parties ultimately agreed to a settlement of the claims.
Implications
The Nine West ruling has the potential for widespread repercussions for corporate directors and private equity firms. How can corporate directors see into the future to assess whether buyers will engage in “financial engineering”?
Private equity has been often criticized for its use of one form of financial engineering: “dividend recapitalizations.” Dividend recapitalizations usually involve the private equity firm saddling a portfolio company with excessive debt in order to pay itself a large dividend, thereby extracting much of the value from the portfolio company and leaving it at risk of bankruptcy. In effect, the Jones Group transaction was virtually a dividend recapitalization, except that instead of paying itself a cash dividend from Nine West, the private equity firm (Sycamore) extracted value through the Carve-out Transactions, which involved one of Sycamore’s affiliates paying less than fair market value for the top-performing brands and leaving the remaining company burdened by a massive debt load. Sycamore got what it wanted through cheap debt and subsequently bankrupted what remained of Nine West in 2018. Who foots the bill for this massive transfer of wealth? The holders of the Nine West debt, most of which essentially became worthless after Sycamore extracted the valuable brands from Nine West at a steep discount and effectively forced Nine West into bankruptcy. Nine West was able to reduce its pre-bankruptcy debt obligations by more than $1 billion. That means the debt investors (lenders) essentially lost a billion dollars. Think about that one for a second. Sycamore invested only $120 million in purchasing Nine West (Jones Group) and bought the promising brands for $641 million when they were worth well over $1 billion. This implies that in one integrated transaction, Sycamore paid some $761 million for assets worth in excess of $1 billion. The following year, Sycamore sold the brands Stuart Weitzman to Coach for $574 million, Kurt Geiger to Cinven for $372 million, and Jones Apparel (Jones New York) to Authentic Brands for an undisclosed sum (likely in the hundreds of millions of dollars). In 2016, Sycamore sold another brand, Easy Spirit, to Marc Fisher for an undisclosed sum. Sycamore appears to have doubled its investment within two years while simultaneously bankrupting the company it purchased as part of that investment. This is not an uncommon occurrence in private equity, and the Nine West ruling could put this to bed.
Will corporate directors be willing to sell a corporation to financial buyers such as private equity firms in the future now knowing that they may be subject to liability for a financial buyer’s post-transaction financial engineering even if they no longer serve on the corporation’s board? It’s a risky proposition, to say the least. Corporate directors should be especially careful when evaluating strategic options for a company.
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