On May 5, 2016, the New York Court of Appeals in Matter of Kenneth Cole Productions, Inc., Shareholder Litigation, 2016 WL 2350133 (N.Y. May 5, 2016) (Matter of Kenneth Cole), adopted the approach of the Supreme Court of Delaware in Kahn v. M & F Worldwide Corp., 88 A. 3d 635 (Del. 2014) (MFW), and ruled that lower courts may apply the business judgment rule when evaluating challenges to a controlling shareholder’s proposal to take a publicly-traded company private in a “going-private merger.” Writing on behalf of a unanimous court, Judge Leslie E. Stein applied the MFW standard and affirmed the dismissal of a shareholder class action challenging Kenneth Cole’s 2012 purchase of the outstanding shares in Kenneth Cole Productions, Inc. (KCP). This case marks the first time that New York’s high court has explicitly addressed the standard of review that applies to challenges to going-private mergers by controlling shareholders.
The Going-Private Merger and Plaintiff’s Claims
In February 2012, defendant Kenneth Cole, owner of 46 percent of KCP’s publicly-traded common stock, informed KCP’s board of directors that he intended to make an offer to purchase the remainder of the company’s outstanding shares and take KCP private. The board thereafter formed a special committee of several directors to review Cole’s forthcoming proposal and negotiate a merger. On February 23, 2012, Cole offered to purchase the outstanding shares for $15.00 per share, subject to approval by (1) the special committee and (2) a majority of the minority shareholders. The special committee subsequently engaged in several months of negotiations with Cole, with Cole ultimately agreeing to purchase each outstanding share for $15.25. The special committee approved Cole’s offer, and recommended it to KCP’s minority shareholders. Although several shareholders, including plaintiff, had previously filed class actions against the special committee and Cole challenging the proposal, on September 24, 2012, 99.8% of minority shareholders approved Cole’s offer. The parties closed on the transaction the following day.
In its complaint, plaintiff Erie County Employment Retirement System sought, inter alia, (1) a declaration that Cole and the special committee had breached their fiduciary duties to the minority shareholders; (2) an award of damages to the class; and (3) an injunction against the merger. Defendants, in turn, sought dismissal of the action for failure to state a cause of action.
The Lower Court Rulings
The New York Supreme Court granted defendants’ motion to dismiss, finding that plaintiff had failed to allege facts showing that any of the defendants lacked independence. The court also determined that plaintiff had insufficiently alleged any facts that could prove that the special committee had breached its fiduciary duty by not seeking other bids, as “plaintiff acknowledge[d] that the special committee negotiated with Cole over a period of months and obtained an increase in the price he would pay,” and because Cole’s original $15.00 per share offer represented a premium over the then-market value of KCP’s shares. Applying the business judgment rule, the court declined to review the special committee’s endorsement of Cole’s offer “absent a showing of specific unfair conduct by the [special] committee.” Separately, the court held that plaintiff had not adequately pleaded facts demonstrating Cole’s breach of his fiduciary duty. Plaintiff appealed on behalf of itself and the class, and the Appellate Division affirmed.
The Court of Appeals Decision
On appeal, plaintiff argued that courts reviewing a going-private merger should apply the “entire fairness” standard established by the Court of Appeals in Alpert v. 28 Williams St. Corp., 63 N.Y. 2d 557 (1984), which requires that interested directors prove that they engaged in a fair process and obtained a fair price. In a case of first impression, Judge Stein disagreed, holding that the business judgment rule is the proper standard for reviewing such transactions, and that courts should defer to the decisions of a company’s directors provided certain protections for minority shareholders are present. However, if such protections are absent, the courts are instructed to apply the “entire fairness” standard and shift the burden to a company’s directors to prove good faith and the entire fairness of the merger.
In reaching this conclusion, Judge Stein first stressed the general principle embodied in New York jurisprudence that courts should respect the business judgment of corporate boards absent the presence of fraud or bad faith. However, courts “may inquire as to the disinterested independence of the members of [a committee of directors] and as to the appropriateness and sufficiency of the investigative procedures chosen and pursued by the committee.” (Quoting from Auerbach v. Bennett, 47 N.Y. 2d 619, 623-24 (1979).)
Turning to plaintiff’s entire fairness argument, Judge Stein acknowledged that a going-private merger, like the two-step merger at issue in Alpert, is a type of freeze-out merger1 that could divide or compromise a director’s loyalty so as to warrant judicial review. However, she noted that the court in Alpert explicitly stated that it was not deciding whether the conditions that it identified as sufficient to satisfy fiduciary duties in a two-step merger applied to other types of mergers. Moreover, she observed that the Alpert case, unlike Matter of Kenneth Cole, involved neither an independent committee nor a minority shareholder vote. Accordingly, the Alpert court’s decision to review a two-step merger under the entire fairness standard was not controlling in the instant case.
In weighing the merits of the approaches advanced by plaintiff (the entire fairness standard) and defendants (the business judgment rule, with or without certain conditions), Judge Stein found the Supreme Court of Delaware’s decision in the MFW case to be instructive. As a preliminary matter, the circumstances in MFW closely mirrored those in the instant case: a controlling shareholder had offered to purchase all outstanding shares of a company’s stock and take the company private upon (1) negotiation and approval by a special committee of independent directors; and (2) approval by a majority of shareholders unaffiliated with the offeror. Further, the approach ultimately adopted by the Supreme Court of Delaware – application of the business judgment rule conditioned upon the presence of certain minority shareholder protections – “created a strong incentive for controlling shareholders to provide a structure for freeze-out mergers that is most likely to protect the interests of minority shareholders, because when both protections [approval by an independent committee and a majority of minority shareholders] are in place, the situation replicates an arm’s length transaction and supports the integrity of the process .…”
Quoting MFW, Judge Stein set forth the applicable standard of review for going private mergers:
[I]n controller buyouts, the business judgment standard of review will be applied if and only if: (i) the controller conditions the procession of the transaction on the approval of both a Special Committee and a majority of the minority stockholders; (ii) the Special Committee is independent; (iii) the Special Committee is empowered to freely select its own advisors and to say no definitively; (iv) the Special Committee meets its duty of care in negotiating a fair price; (v) the vote of the minority is informed; and (vi) there is no coercion of the minority.
Upon application of this standard, Judge Stein found that plaintiff had failed to “specifically and sufficiently” allege facts that could demonstrate an absence of any of the six MFW conditions. First, plaintiff conceded that Cole had conditioned the merger on the approval of the special committee and a majority of the minority shareholders. Second, plaintiff failed to allege that any members of the special committee were incapable of reaching an unbiased decision regarding the merger. Third, plaintiff failed to allege that the special committee could not reject Cole’s proposal or hire its own advisors. Fourth, plaintiff failed to allege any grounds for concluding that the special committee was inclined to accept an inadequate price or that it had engaged in unfair conduct. Fifth, plaintiff failed to raise any specific challenges to the minority shareholders’ proxy statement so as to call into question whether their vote was informed. Finally, plaintiff failed to plead that such vote had been coerced.
Accordingly, Judge Stein held that: (i) the business judgment rule applied to Cole’s going-private merger; (ii) absent fraud or bad faith, the court would defer to the special committee’s approval of Cole’s offer; and (iii) the lower courts had properly dismissed plaintiff’s claims.
There are several important takeaways from the Matter of Kenneth Cole decision, and companies and controlling shareholders would be well-advised to review the Court’s guidance prior to commencing negotiations on a going-private merger.
First, the central issue in the case is one of burden, and the determination of whether a minority shareholder plaintiff has alleged “a reasonably conceivable set of facts” to demonstrate the absence of any of the six shareholder-protective conditions. If a plaintiff can demonstrate that at least one of these conditions did not exist, the burden will shift to the interested directors or controlling shareholder to prove good faith and the entire fairness of the merger. The Court’s decision to apply the business judgment rule, with some conditions, clearly weighs in favor of corporate boards and controlling shareholders, and reflects the traditional deference of New York courts to the business decisions of corporate directors and officers.
Second, Judge Stein’s opinion is notable because it provides a detailed blueprint of what plaintiffs must do in order to ensure that their claims survive a motion to dismiss. While plaintiff in Matter of Kenneth Cole did allege certain facts that called into question the competency of KCP’s special committee, the complaint ultimately fell far short of suggesting the absence of any of the six shareholder-protective conditions¬ – the necessary element for carrying its evidentiary burden under the MFW doctrine.
Finally, it is notable that the Court of Appeals decided Matter of Kenneth Cole on the pleadings and prior to any discovery by either party. This distinguishes the case from MFW, where the Supreme Court of Delaware ruled on defendants’ motion for summary judgment. In this sense, the Court’s decision is somewhat bolder than that of the MFW court, and signals that plaintiffs should not expect much leeway to further develop their arguments through discovery in the absence of a well-pled complaint.
The Court of Appeals decision in Matter of Kenneth Cole can be found here.
1. A freeze-out merger involves an attempt by a majority shareholder or group in control to “freeze out” the interests of minority shareholders.