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Directors & leveraged buyouts: Liability a greater risk than originally thought.

The acquisition of another company using a significant portion of borrowed funds, or a leveraged buyout, is a common business growth strategy. When done wisely, the director’s decision to take on a surge in debt can translate to growth and ultimately lead to financial rewards. When the board makes an error, the result of a leveraged buyout can be catastrophic.

In a recent example, the Board of Directors for Nine West was discussing the sale of the company. At the time, a private equity firm expressed interest in a deal. The proposed agreement included a merger, contribution by the private equity firm, an increase in Nine West’s debt, Nine West’s predecessor would get cashed out at $15/share, and the sale of some of Nine West’s profitable businesses to the private equity firm for “substantially less than fair market value.” Nine West’s board approved the proposal, which contained a provision that allowed the board to withdraw if the board found that agreeing to the deal would be in violation of its fiduciary duties to Nine West.

Shortly afterwards, the private equity firm changed the deal — increasing the debt to more than 7 times the original proposed calculation. After the merger was complete, a group of Nine West stockholders filed suit stating that the board had violated their fiduciary duties to Nine West when they agreed to the updated deal.

The board fought back. Two of its primary arguments included the following.

Strategy #1: Business judgement rule.

This rule essentially allows business leaders to dismiss a lawsuit because it presumes the leaders were acting in the interests of the company. It essentially places the burden on those who are making the claims to have some evidence to support the allegations before the claim can move forward.

In this case, the court stated the shareholders were able to show the board failed to investigate the impact of the updated proposal and that this evidence was sufficient to support the possibility of a successful claim. As such the court allowed the case to move forward.

Strategy #2: Limitations on director liability.

Nine West’s bylaws include a provision that limited the liability of directors to apply in cases that involved self-dealing and recklessness, referred to as exculpatory by-laws. Although the court agreed that the director’s conduct did not rise to self-dealing, it found the board’s disregard of the updated merger reckless. As such, it allowed the case against the board to move forward.

Lessons from this case

The case provides an example of the risks faced by directors even when transactions include provisions that limit liability like disclaimers and exculpatory by-laws. It serves as a reminder that those who are considering or currently navigating similar transactions are wise to have legal counsel review the proposals and discuss any potential issues, mitigating the risk of surprises after the deal is finalized.

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