$55 million suit against Paul Hastings over acquisition loan goes forward

A $55 million lawsuit by a unit of Cerberus Capital Management L.P. can proceed against Paul, Hastings, Janofsky & Walker over allegations the firm gave faulty advice on a loan made in connection with a private equity firm's 2008 acquisition of bankrupt retailer Steve & Barry's.

In a decision filed last week, Manhattan Supreme Court Justice Shirley Kornreich said Paul Hastings had "conclusively rebutted" Cerberus' lending arm's claim that it would not have made a $125 million loan if it knew the recipient, an affiliate of Bay Harbour Management L.C., was acquiring less than all of Steve & Barry's inventory. But the judge said the law firm had not shown that it accurately advised the Cerberus affiliate on acquisition documents and their impact on the loan's security.

"Any negligence on the part of [Cerberus] in reviewing the underlying documents is merely a factor to be assessed in mitigation of damages," Kornreich wrote.

She called other allegations of negligence by the Cerberus finance unit, Ableco Finance LLC, sufficient for the suit to move forward. The judge said submitted documents do not answer whether Paul Hastings negligently failed to advise Ableco of potential risks arising from the loan in the event of a bankruptcy by the Bay Harbour affiliate.

Paul Spagnoletti of Davis Polk & Wardwell, who represents Paul Hastings, said his client would appeal. Stuart L. Shapiro, a lawyer for Ableco at Shapiro Forman Allen & Sava, declined to comment.

The suit against Paul Hastings in particular paints a picture of the perils of deal financing in the financial crisis of 2008.

Ableco, a financing affiliate of private equity giant Cerberus with more than $6 billion under management, turned to Paul Hastings partners John F. Hilson and Mario J. Ippolito in August 2008 to advise it on providing a $125 million secured loan to a company established by Bay Harbour called BH S&B Holdings.

The Bay Harbour affiliate was looking to buy most of the assets of S&B Industries Inc., which operated clothing retailer Steve & Barry's, which was in bankruptcy. Ableco said Hilson had advised it on hundreds of transactions over 14 years.

At the time the thinly capitalized BH S&B Holdings made the $163 million acquisition of the Steve & Barry's assets, the housing and credit markets had caused major problems in the economy. Ableco said it told Paul Hastings it would need a perfected first priority lien on Steve & Barry's entire inventory, which was worth $183.7 million.

But the purchase agreement the Bay Harbour affiliate entered into for Steve & Barry's instead provided that S&B Industries would retain inventory in more than half of the retailer's stores. S&B Industries' rights to the inventory and sales proceeds would also take priority over the Bay Harbour company's lien on the assets in those stores.

In November 2008, BH S&B Holdings also filed for Chapter 11 bankruptcy, in the Southern District of New York. Ableco claimed it did not realize it did not have a perfected priority lien on all of Steve & Barry's inventory until the bankruptcy.

Ableco claims it lost $55 million on the loan transaction, which it said it would not have entered into had Paul Hastings provided a copy of documents between S&B Industries and Bay Harbour and advised that it would not have first priority on the loan. Ableco also alleged Paul Hastings failed to advise on the legal risks it faced by entering the deal.

In its motion to dismiss, Paul Hastings submitted a series of e-mails between the firm and Ableco discussing the loan terms and deal documents and various bankruptcy documents to show that the firm did not act negligently in its representation.

Kornreich, in Ableco Finance LLC v. Hilson, 650618/2009, said the e-mails conclusively showed that Paul Hastings provided a copy of the documents that Ableco said it never received. As a result, Paul Hastings had "conclusively rebutted" Ableco's claim it would not have issued the loan had it realized the Bay Harbour affiliate was acquiring less than all of Steve & Barry's inventory.

But the judge said Paul Hastings had not provided conclusive documentary evidence to show it accurately advised Ableco on the terms of the acquisition documents. Ableco had alleged it believed it would have first priority liens on all of Steve & Barry's inventory, regardless of whether the Bay Harbour company was acquiring all of the retailer's assets.

Kornreich noted an e-mail exchange after the Bay Harbour affiliate declared bankruptcy seemed to support Ableco's claim that it still believed it would have first priority liens on all of Steve & Barry's inventory.

(Published by Law - August 16, 2010)