A Lesson In What Not To Do When Selling Your Company To Yourself

Ever since Michelle Obama wore J.Crew on The Tonight Show with Jay Leno, the company’s sales have skyrocketed.

Under the leadership of my personal style hero Jenna Lyons (who is currently at the centre of a ridiculous controversy over painting her son’s toenails…side note: I heart Jon Stewart), J.Crew sales went up 14%, even during the economic downturn. I can neither confirm nor deny reports that my personal purchases from J.Crew accounted for 13.9% of that increase.

So what did Micky Drexler, CEO of J.Crew, decide to do with these booming sales? Sell, of course! Only, some shareholders accused him of selling at below market value (a mere $3 billion). AND he sold it to J.Crew’s own former parent company. AND he waited 7 weeks to tell the Board of Directors about the deal. AND he said he would not work for anyone besides the buyers with whom he negotiated the deal (TPG Capital and Leonard Green & Partners). Whoops.

Not surprisingly, lawsuits ensued.

Shortly after the announcement of the J.Crew sale to TPG Capital and Leonard Green & Partners, shareholders filed a lawsuit against J.Crew, its Board of Directors, and TPG for breaching their fiduciary duties. The parties eventually settled for $10 million, netting each shareholder 15 cents per share, and each lawyer about $500 per hour (who exactly “won” this lawsuit again?). But the fight is far from over, as the plaintiffs’ lawyers now accuse J.Crew of violating the settlement agreement. And, even though corporate governance advisory firm Institutional Shareholder Services advised J.Crew’s shareholders to vote against the sale, the shareholders nevertheless approved the $3 billion buyout last month.

Although Mickey Drexler has publicly said he would conduct the sale the exact same way (I’m sure), the whole situation is basically a lesson on what not to do in a management-led buyout.

The shareholder lawsuit alleged that Drexler and the Board of Directors breached their fiduciary duties, a special class of legal duties that exist only between persons and entities in special relationships of trust or confidence — trustees and beneficiaries, partners and partners, agents and principals, stockbrokers and clients, and, unfortunately for Drexler, corporations and their corporate executives. One of these duties is the duty of loyalty, which prohibits corporate directors from receiving an unfair benefit at the expense of the corporation or its shareholders.

The shareholders who sued J.Crew accused Micky Drexler and the Board of engaging in self-dealing (receiving an unfair benefit in a transaction with their own corporation). One of the Board members, James Coulter, is also the founder of TPG Capital, who is paying for most of this deal. TPG owned J.Crew in the 90s, taking the company private in 1997 and then selling its shares after a public offering in 2009, but leaving Mr. Coulter on the Board. The shareholders also believe that the $3 billion price tag ($43.50 a share compared to its 52-week high of $50.96) undervalued the brand (they argued for $45 per share; at the time the shareholders approved the buyout, the stock was trading at $43.72). It doesn’t take a very cynical (or creative) mind to imagine that a billion-dollar sale arranged between two companies with the same decision-makers, between long-standing business associates who probably have a weekly golf game, might not be negotiated on the best or fairest of terms (at least for the poor schlub who bought 100 shares of J.Crew for his 401(k) because his wife thought their dresses were cute).

Shareholders also accused Drexler of diluting the offer price by refusing to work with anyone except TPG. Indeed, Drexler’s effectively told the Board to forgo searching for any other potential buyers, and only did that after keeping the entire deal a secret for 7 weeks before speaking with the Board of Directors in the first place. Far from maximizing the value of the sale of the company, Drexler’s actions seemed to depress the value that J.Crew could command from buyers, who couldn’t get in on the action in any event because Drexler had effectively locked them out. Probably made for a great laugh between Drexler and Coulter on the 9th tee too.

Of course, shareholders could very well decide to be happy with the 15 cents a share they managed to squeeze out of the settlement. Shareholder lawsuits generally have a success rate somewhere between slim and none because of a legal doctrine called the “business judgment rule.” Stated legally, the business judgment rule means that the law presumes that Directors manage a corporation in good faith and in the best interests of the corporation and shareholders, and should be protected from liability for colossal mistakes in business judgment, as long as they were acting in good faith. Stated practically, the business judgment means that shareholders lose. (Unless, perhaps they can find a “smoking gun” email that reads something like, “Wasn’t it really fun how we colluded and screwed over the shareholders in this deal that was totally against their interests?” And even then it, might be a close call.)

Despite all the drama surround the J.Crew buyout, J.Crew has assured its customers that nothing is going to change. We’ll still get the same preppy/modern clothes they’ve become so popular for, and they’ll still get to go on awesome design trips to Italy.

This post originally appeared at Law Law Land.