Recent Judge Rakoff Decision May Curb Private Equity Leverage Abuses By Pinning Liability on Directors of Selling Company


For decades, authorities and experts have tried restricting excessive borrowing by private equity investors, since it’s been repeatedly shown that they leave lots of bankruptcies in their wake. And these abuses continue because private equity looting fee structures result in general partners making out handsomely whether or not the business does well. In 1987 (no typo), the Treasury proposed limiting the deduction of interest on highly leveraged transactions. That idea went by the wayside thanks to the 1987 crash. Other proposals to restrict debt levels have similarly not gone anywhere. Yet now an important ruling looks set to deliver where regulators and legislators have failed.

The decision is related to bankruptcy ruling, In re Nine West LBO Securities Litigation, in early December. I’m late to it; several readers called it to my attention via a William S. Cohan op ed in the New York Times, The Private Equity Party Might Be Ending. It’s About Time. I think Cohan is overstating its significance; investment bankers and lawyers are prone to howling loudly about anything that might reduce the size of their meal tickets while working full bore to preserve them. But Nine West does appear likely to restrict very highly leveraged deals by pinning the liability tail for likely insolvencies on the directors and officers of the selling company.

The very short version of this story is that the directors of the selling company approved a sale transaction that they knew would saddle the company, renamed Nine West, with more debt than its own bankers had said it could support while removing its best assets. They sat pat as the buyer revised the deal to load even more borrowings on the acquisition, despite having a fiduciary “out” clause.

Author(s): Yves Smith

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Publication Site: naked capitalism