The Nine West Decision: A New Twist on an Old Cause of Action

by Kenneth A Rosen

When a company files for Chapter 11 bankruptcy, unsecured creditors often face the risk of receiving little or no recovery for their claims. This is especially true when the company has undergone a leveraged buyout (LBO) or a merger that left it with a heavy debt load and reduced its value. In such cases, unsecured creditors may wonder whether the directors of the company acted in their best interests or breached their fiduciary duties.

Under US law, directors of a corporation owe fiduciary duties of care and loyalty to the corporation and its shareholders. These duties require directors to act in good faith, with due diligence, and in the best interests of the corporation. However, when a corporation becomes insolvent or is in the zone of insolvency, some courts have held that the directors’ fiduciary duties expand to include the interests of creditors, who become the residual claimants of the corporation’s assets.

This means that directors may be liable to creditors for breach of fiduciary duty if they engage in transactions that harm the creditors’ interests, such as fraudulent transfers, preferential payments, or self-dealing. However, proving such liability is not easy, as creditors must overcome several hurdles, such as:

• The business judgment rule, which presumes that directors acted in good faith and with reasonable care, unless there is evidence of fraud, illegality, or gross negligence.

• The exculpation clauses, which limit or eliminate the directors’ personal liability for monetary damages for breach of the duty of care, as permitted by many state laws.

• The releases and injunctions, which bar creditors from suing the directors for pre-bankruptcy actions, as provided by many Chapter 11 plans of reorganization.

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A recent decision by the US District Court for the Southern District of New York in In re Nine West LBO Securities Litigation1 may offer some hope to unsecured creditors who seek to challenge director liability in Chapter 11 cases. The case involved a lawsuit by a litigation trust, representing the unsecured creditors of Nine West Holdings, Inc., against the former directors and officers of Jones Group Inc., the predecessor of Nine West. The trust alleged that the directors and officers breached their fiduciary duties by approving a $2.2 billion LBO of Jones Group by Sycamore Partners in 2014, which resulted in the transfer of Jones Group’s most valuable assets to Sycamore and its affiliates, and left Nine West with insufficient capital and unsustainable debt. Nine West filed for Chapter 11 bankruptcy in 2018, and its unsecured creditors received only 2.5% recovery on their claims.

The court denied the defendants’ motion to dismiss the complaint, finding that the trust had sufficiently alleged that the directors and officers acted in bad faith and with gross negligence in approving the LBO, and that the exculpation clauses and the releases in the Chapter 11 plan did not apply to them. The court also rejected the defendants’ argument that the creditors’ claims were derivative of the corporation’s claims, and thus belonged to the bankruptcy estate, not to the creditors. The court held that the creditors’ claims were direct, as they suffered a unique injury that was not shared by the corporation or its shareholders.

The decision in Nine West is significant, as it shows that unsecured creditors may have a viable cause of action against directors and officers for breach of fiduciary duty in Chapter 11 cases, even if they are not given the right to vote on the plan of reorganization or to challenge the releases. However, the decision is not binding on other courts, and it may be subject to appeal or reversal. Therefore, unsecured creditors should consult with experienced bankruptcy lawyers and carefully evaluate the facts and circumstances of each case before pursuing such claims.