While there has been much fuss over the recent ruling by the United States District Court for the Southern District of New York in In re Nine West LBO Securities Litigation1 due to its potential ramifications for director liability, as we explored in Part I of our series on this case here, court watchers have paid less attention to the court’s treatment of officer liability and the interesting and important ways in which the court distinguished between liability for directors versus officers. Although officers may take some comfort from the court’s discussion of fiduciary duty liability, the decision highlighted a different type of risk officers may face in connection with a change of control transaction — the threat of having to return their change of control payments, which may be voided as fraudulent conveyances.
Background and Executive Summary
A brief recap of the facts (which are described in more detail in our original post): In 2014, the Jones Group engaged in a leveraged buyout (LBO) transaction, with private equity firm Sycamore Partners purchasing the company, and became Nine West. The LBO, which put substantial additional debt on the company, and related transfers of valuable assets out of Nine West shortly following the LBO ultimately led to Nine West’s bankruptcy a few years later. Garnering headlines, Judge Rakoff of the Southern District of New York ruled that directors of the Jones Group at the time of the LBO could be liable for breach of fiduciary duty under Pennsylvania law (and aiding and abetting the Nine West directors’ breaches of fiduciary duties under Delaware law) for failing to assess the post-sale solvency of the selling company, taking into account contemplated post-sale transactions, and that the business judgment rule would not apply in such situations.
Yet the ruling did not stop there, as the trustee for the litigation trust created under the chapter 11 plan (the “Litigation Trustee”) also went after the officers of the selling company. The Litigation Trustee alleged the same claims of breach of fiduciary duty and aiding and abetting a breach of fiduciary duty, as well as fraudulent transfer claims relating to the change of control payments the officers received due to the LBO. The court found that the officers could not be held to the same standard as the directors on a breach of fiduciary duty theory because the officers did not have the power to prevent the transaction. Similarly, the court determined that the officers could not be held liable on an aiding and abetting a breach of fiduciary duty theory because the officers provided merely tangential assistance to the approval of the LBO, unlike the directors, who were alleged to have provided substantial assistance.
The officers did not escape unblemished, however, as the court held that the fraudulent conveyance claims regarding the change of control payments made to the officers could proceed beyond the motion to dismiss stage. The court found that the complaint adequately alleged both a constructive fraudulent conveyance, because the company may have been insolvent at the time of the transfer, and an intentional fraudulent conveyance, as the plaintiff alleged details of the transfers with sufficient particularity and the complaint included allegations sufficient to support an inference of fraudulent intent.
This ruling highlights who has ultimate responsibility for the actions of companies and provides guidance as to how individuals in positions of responsibility ought to think about key decisions in the lifespan of a company. Those who are the final arbiters on decisions such as whether to engage in an LBO may face potential liability as to the post-sale solvency of the company, while those who cannot execute or influence a decision may not. Although the court here made a bright-line distinction between directors and officers, that may not always be the case.
In addition, the potential for change of control payments to be deemed fraudulent transfers may have the effect of causing officers to look more deeply into change of control transactions. While officers, unlike directors, may be able to avert fiduciary duty liability for misguided transactions that ultimately result in the company’s bankruptcy, the potential of having to return change of control payments in bankruptcy may serve as an incentive for officers to engage in more thorough due diligence prior to the consummation of a transaction.
A more detailed analysis of the court’s ruling is below, or readers can jump to the takeaway here.
Breach of Fiduciary Duty
Under Pennsylvania law, which governed the transaction because the Jones Group was a Pennsylvania corporation, officers owe a duty to act in good faith, in the best interests of the corporation, and with such care as an ordinary prudent person in similar circumstances.2 Officers do not “owe fiduciary duties to a corporation regarding aspects of the management that are not within their responsibility or are within the exclusive province of the board,” but “may be held liable for breach of fiduciary duty to the extent that they have discretionary authority over, and the power to prevent, the complained of transactions, in which case they will be held to the same standards as a director.”3
Here, the court held that, given the allegations in the complaint that the directors had ignored various “red flags” concerning the transaction, it was “not plausible” that the transaction could have been prevented if the officers had “investigated, communicated, and acted upon” their knowledge about the “danger and unfairness” of the transaction and brought these issues to the board’s attention.4 The court added that although the officers may have helped carry out certain actions that facilitated the transaction, such as participating in rating agency presentations to syndicate the company’s acquisition of debt, that assistance was insufficient to establish that the officers’ actions could have prevented the transactions from occurring. As a result, the court dismissed the breach of fiduciary duty claims against the officers.
Aiding and Abetting Breach of Fiduciary Duty
The Litigation Trustee also brought forth claims against the officers on an aiding and abetting a breach of fiduciary duty theory, arguing that they, like the selling company’s directors, aided and abetted the new directors’ breach of fiduciary duties under Delaware law (which governed the new directors’ fiduciary duties). To sustain such a claim beyond the motion to dismiss stage, “a plaintiff must plead facts making it reasonably conceivable that the defendant knowingly supported a breach of duty and that his [sic] resulting assistance to the primary actor constituted substantial assistance in causing the breach.”5
The court ruled that participating in presentations to rating agencies and failing to encourage the Jones Group board to stop the transaction showed that the officers had, “at most, participated in certain actions that helped the 2014 transaction along,” but that these actions were insufficient to support the aiding and abetting a breach of fiduciary duty claim.6 Specifically, unlike the selling company’s directors, whose actions constituted a “substantial factor” in causing the breach by the new Nine West directors with regard to the transaction, the officers provided only “tangential” assistance “at best.”7 Moreover, the officers could not have proximately caused the fiduciary breaches because they could not have prevented the transaction from occurring.8
Constructive Fraudulent Transfer
The Litigation Trustee also sought to avoid, as fraudulent transfers, the ‘change in control’ payments, ranging from $425,000 to $3 million, made to certain officer and employee defendants upon the closing of the transaction and termination of their employment. The Litigation Trustee pursued both a constructive fraudulent conveyance claim and an intentional (actual) fraudulent conveyance claim under section 544(b) of the Bankruptcy Code, which grants a trustee the authority to bring state law avoidance claims (here New York law).9
A constructive fraudulent transfer claim under the then-existing New York law10 (the “DCL”) requires a showing both that the transferor did not receive “fair consideration” and that one of the following three solvency tests have been satisfied: “(i) the transferor is insolvent or will be rendered insolvent by the transfer in question; (ii) the transferor is engaged in or is about to engage in a business transaction for which its remaining property constitutes unreasonably small capital; or (iii) the transferor believes that it will incur debt beyond its ability to pay.”11 The defendant officers did not seek to dismiss based on the fair consideration element, but argued that none of the solvency tests could be satisfied.
The court determined that the Litigation Trustee alleged facts sufficient to support an inference of insolvency at the time of the change in control payments and, therefore, denied the motion to dismiss the constructive fraudulent conveyance claims.12 The court cited a valuation demonstrating that the company’s total assets were worth less than the company’s total debt post-transaction under a simple balance sheet test.13 It also cited to the complaint’s reference to a discounted cash flow test that would show the value of the assets was less than the debt and rejected the argument that such a “forward-looking” test was inappropriate for determining the present value at the time of the transaction.14
In a minor victory, the court did sustain the arguments that the complaint did not sufficiently allege facts under the other two tests. The “unreasonably small capital” test “reaches entities that are technically solvent but doomed to fail.”15 Under this test, the court examines a number of different factors, including “the transferor’s debt to equity ratio, historic capital cushion, and the need for working capital in the transferor’s industry.”16 The court found that although Sycamore only provided an equity contribution constituting 8% of Nine West’s total capitalization, the complaints did not allege that this amount comprised the entirety of Nine West’s equity, meaning that the court could not evaluate the propriety of its equity position. The complaints also did not provide facts about the company’s historical capital cushion or working capital needs.17 Similarly, as to the “ability to pay” test, a plaintiff must allege that the defendant made the conveyance with the “inten[t] or belie[f] that [it] will incur debts beyond [its] ability to pay as they mature.”18 The debts at issue in this inquiry are not old debts that might become due after the transfer but, instead, new debts that the transferor intended to incur after the transfer. Because the complaints did not allege such facts, they failed to state a claim under the “ability to pay” test as well.19
Intentional (Actual) Fraudulent Transfer
Finally, the Litigation Trustee alleged that the change in control payments constituted intentional fraudulent conveyances (also known as actual fraudulent transfers). The court noted that to withstand a motion to dismiss with regard to an intentional fraudulent conveyance claim, a plaintiff must meet the heightened pleading standard requirements under Rule 9(b) and must demonstrate that the facts support an inference of fraudulent intent. The first requirement requires that plaintiffs plead facts with sufficient particularity, although courts take “a more liberal view” when a bankruptcy trustee pleads actual fraud given that such a trustee is “an outsider to the transaction who must plead fraud from second-hand knowledge.”20 The court held that the Litigation Trustee met the sufficient particularity standard here because the complaints provided details regarding the change in control payments and broadly outlined the circumstances under which they occurred.21
In addition, the court found that the facts supported an inference of fraudulent intent. To support such an inference under the DCL, “allegations of circumstantial evidence are sufficient,” and in reaching its conclusion, the court will analyze whether any of a long list of “badges of fraud” are present in the case.22 Here, the court determined that the alleged facts regarding the “nature of the close relationship between the officers and the Company…, the Company’s financial condition at the time of the transfer, and…the general chronology of the events in question” were sufficient to permit an inference of fraudulent intent.23
Importantly, the court reached a different conclusion regarding the non-officer employee defendants who also received change of control payments. Unlike the close relationships described in the complaint among the officers and the company, the complaint included mere “threadbare allegations” about the non-officer employees; they were “simply identified as having received a payment, without any context as to who they are or the nature of their relationship to the Company.”24 This suggests that there are gradations of particularity when it comes to change in control payments, and that while a broad relationship of some kind with the company is insufficient to state a claim, a close relationship with the company can lead to the avoidance of change in control payments in connection with a major transaction.
Takeaways from SDNY Decision for Officers
While the news from Nine West may be distressing for directors, the holdings are decidedly more mixed for officers (and perhaps even promising for employees). On the positive side of the ledger, officers will not be held to the same high standard as directors in terms of their potential liability for the post-sale insolvency of the company. Instead, as long as officers do not have decision-making power over a transaction or the power to prevent the transaction, they may avoid liability. In most cases, being an officer, as opposed to a director, may be enough to satisfy this rule. This does not mean that officers should shirk responsibility over the decision-making process – and it may be prudent to bring up any potential hesitations regarding a transaction beforehand. However, when the transaction backfires and officers helped the transaction along in ministerial ways without voicing an objection, officers will be relieved to know that they may not face liability for their silence, unlike their director friends.
Alternatively, greater cause for concern exists for officers in connection with change of control payments. This decision confirms that change of control payments may be avoided as fraudulent conveyances if the company is deemed insolvent at the time of the transfer and if the trustee can also prove lack of fair consideration (or reasonably equivalent value, as it is more often described). The implications of this element of the ruling could be far-reaching in that officers may now scrutinize potential transactions more carefully prior to advancing them up the corporate ladder. Perhaps this will have the effect of preventing unwise deals, as officers grow to fear the potential of losing payments for which they negotiated.
Finally, it is worth reiterating the procedural posture of the case. The court here was only ruling on whether or not to dismiss the claims brought by the Litigation Trustee. This means that the court had to take all of the facts alleged by the Litigation Trustee as true, and see if such pleadings were sufficient to justify a claim under the particular statutes implicated. The court’s decision not to dismiss some of these claims merely means that the claims can now go through discovery to see what the facts ultimately reveal. To be sure, discovery and further litigation will likely be costly, and the parties may decide to settle, but this ruling in no way means that any party has been found liable as to any claim alleged.