The recent success in Claire’s Stores’ $2.1 billion restructuring reinforces the importance of a proactive approach to corporate governance for closely held or sponsor-owned portfolio companies.
- Through its restructuring, Claire’s, the leading mall-based retailer for teens and young girls, successfully reorganized in a high profile restructuring completed in October 2018.
- Claire’s eliminated nearly $1.9 billion of debt through its reorganization, while also providing substantial recoveries to its secured creditors, unsecured creditors, and equity sponsor.
- Claire’s’ proactive approach to disinterested governance was an essential component of this result.
- Weil, Gotshal & Manges LLP advised Claire’s during this process.
Claire’s and other high profile restructurings have seen instances where stakeholders, rightly or wrongly, will attempt to thwart a particular transaction or “leverage the process” principally by challenging the governance in place at the affected portfolio company. Under this line of attack, stakeholders will not simply challenge the substance of a business decision or strategy but, instead, will attack the process by which the corporate decisionmakers have undertaken a particular course of action.
As a baseline matter, corporate directors are generally subject to two primary fiduciary duties: (i) the duty of care; and (ii) the duty of loyalty.
- the duty of care generally requires directors to act in an informed manner with the requisite level of care appropriate to the decision at issue; and
- the duty of loyalty generally requires directors to act in the best interest of the corporation—as opposed to representing any particular constituency or personal interest.
Where the duties of care and loyalty are satisfied, corporate decisionmakers will be protected from ex post “second guessing” through application of the business judgment rule—i.e., disinterested and duly careful directors will not be personally liable for unsuccessful business strategies or decisions. But where the business judgment rule does not apply, corporate decisionmakers must defend a particular strategy or transaction under the more severe “entire fairness” standard.
Under the “entire fairness” standard, decisionmakers can be held liable (and pay the cost) for corporate losses if the challenged transaction is not “entirely fair” in terms of both process and substance. Litigious stakeholders will therefore view an entire fairness line of attack as a preferred path to obtain access to an equity sponsor’s deep pocket on the theory that “under entire fairness, you lose.”1
The importance of disinterested corporate governance is heightened still where a corporation approaches financial distress or seeks bankruptcy protection. In bankruptcy, baseline principles of corporate law are amplified by the Bankruptcy Code’s fundamental commitment to transparency, namely, that “[t]he conduct of bankruptcy proceedings not only should be right but must seem right.” In re Ira Haupt & Co., 361 F.2d 164, 168 (2d Cir. 1966) (Friendly, J.).
Litigious stakeholders have increasingly focused on (or will search for) some aspect of a particular transaction that, at least arguably, uniquely benefits the sponsor rather than the particular portfolio company. Board members affiliated with, or appointed by, the equity sponsor cannot satisfy their duty of loyalty and then lose the benefit of the business judgment rule—or so the argument goes.
As a result, the evaluation of key transactions by disinterested fiduciaries, the process for that evaluation, and establishing a record memorializing that review, is critically important to successfully implementing a value-maximizing transaction.
Claire’s Stores, Inc.
Claire’s’ restructuring involved the reorganization of that leading mall-based retailer with approximately 7,500 worldwide locations and that employed more than 17,000 men and women across the globe. By late 2017, Claire’s was looking ahead to upcoming liquidity issues and a potential Q1 “going concern” default in connection with its approximately $2.1 billion of debt. At that time, Claire’s was a privately-held business following a 2007 leveraged buyout. Claire’s private equity sponsor also held approximately $52 million in indebtedness issued by Claire’s and its affiliates following a 2016 liability management transaction.
Recognizing that potentially difficult decisions might lie ahead, Claire’s’ board of directors formed a Finance Committee consisting of its Chief Executive Officer and its lead independent director. The Finance Committee was then tasked with evaluating, developing, and, ultimately, making recommendations to Claire’s’ board with respect to restructuring alternatives. And, under the Finance Committee’s supervision, Claire’s ultimately filed chapter 11 in March 2018 having entered into a recapitalization transaction supported by the substantial majority of its first lien and unsecured debt, which itself resulted from vigorous negotiation.2
Following its chapter 11 filing, however, Claire’s’ majority second lien creditor challenged Claire’s’ restructuring plan. In particular, the creditor took aim at the propriety of corporate decisionmaking by alleging that Claire’s restructuring was, in effect, wrongly engineered to benefit its equity sponsor to the detriment of more senior stakeholders. More broadly, Claire’s’ bankruptcy case was characterized by hard-fought litigation through almost the entirety of its 6 month process.
In response to this challenge, and to further ensure the integrity of its restructuring process, Claire’s added an additional independent director to its Finance Committee in June 2018 and further delegated complete decisionmaking authority to the Finance Committee with respect to its restructuring process for the duration of its chapter 11 proceeding.
This proactive, disinterested governance was a key step towards positioning Claire’s to strike a global compromise on highly favorable terms that was approved by the bankruptcy court in September 2018. Claire’s subsequently emerged from chapter 11 on October 19, 2018 in a reorganization that provided substantial distributions to its secured creditors, unsecured creditors, and equityholders, and facilitated Claire’s reorganization as a substantially delevered going concern.
Sponsors should be vigilant when assessing governance where portfolio companies may be approaching financial stress. Sponsors should also bear in mind that governance-based attacks are increasingly common, and it will be keenly important to thoroughly document a process that is not only right in substance but also in form.
To this end, a number of factors should be considered, including:
- Timing: Be proactive. Disinterested governance should not wait until a transaction is at hand and should remain the subject of ongoing review. Having disinterested directors already in place that are familiar with a particular portfolio company’s needs and goals can help the company respond quickly to challenges or as they arise. We also recommend that sponsors continuously evaluate the processes that may be in place to handle the evaluation and review of key decisions—not just a portfolio company’s upcoming decision matrix.
- Location: Identify the right entity within the corporate structure where disinterested directors are appointed. For example, does the corporate structure include different layers of debt? Does this debt sit at different entities? Will corporate affiliates potentially have overlapping or conflicting interests? Do local law subsidiaries have their own requirements for nationality or residence requirements for directors? These questions and others should be asked (and answered) as governance is assessed and implemented or modified.
- Scope: How much authority is delegated to a corporation’s disinterested directors? Should disinterested directors be tasked with providing recommendations to the full board or delegated with decisionmaking authority? Should a special committee be formed? Should a committee’s role be limited to particular aspects of a transaction or a other corporate action, such as specific litigation or transactional analysis, or should it reach more broadly? The scope of appropriate responsibility may also evolve over time, but the delegation and scope of authority should be regularly assessed in light of the transaction posture and potential outcomes.
- Experience: Board duties in a stressed or distressed context can quickly escalate above and beyond ordinary course responsibilities or demands; having directors experienced with these often unpredictable demands can be invaluable. Disinterested directors with experience with the specialized legal and financial considerations applicable in a restructuring will provide substantial value, in addition to relevant industry or company-specific experience.
At the same time, each situation and company will be different. The facts on the ground will matter a great deal, and a “one size fits all” approach to corporate governance is unlikely to be successful. A proactive approach to disinterested governance for distressed portfolio companies must reflect the facts on the ground and goals at issue in a particular situation—recognizing that each step may be heavily scrutinized by stakeholders looking to obtain a strategic advantage by attacking corporate governance along the way.
In this regard, Claire’s’ successful reorganization clearly demonstrates how a proactive, thoughtful approach to governance can facilitate positive outcomes for the portfolio company and its stakeholders.
- Whether the Bankruptcy Code preempts more general principles of state corporate law may be open to debate. Compare In re Zenith Elecs. Corp., 241 B.R. 92, 108 (Bankr. D. Del. 1999) (“We agree that section 1129(a)(3) [of the Bankruptcy Code] does incorporate Delaware law (as well as any other applicable nonbankruptcy law).”), with In re Horsehead Holding Corp., Case No. 16-0287 (Bankr. D. Del. Sept. 2, 2016), Hr’g Tr. 9:15–19 (“To the extent that’s inconsistent with what state law fiduciary duty would require in a change-of-control transaction, I believe that the Bankruptcy Code alters that or supersedes that in the context of what reorganizations actually require under the Code.”). Given that many transactions undertaken by a stressed or distressed portfolio company may occur outside of chapter 11, however, both the Bankruptcy Code and general corporate law should inform a proactive governance approach.↵
- See In re Claire’s Stores, Inc., Case No. 18-0584 (Bankr. D. Del. March 19, 2018).↵