On May 5, in a case of first impression, the New York Court of Appeals in Matter of Kenneth Cole Productions Inc. Shareholder Litigation, 2016 N.Y. LEXIS 1059 (2016), relied upon the venerable “business judgment” rule in dismissing minority shareholders’ claims against a board of directors in connection with a going-private transaction. This decision represents an important shift from the courts’ longstanding propensity to mechanically apply the “entire fairness” standard to mergers and other freeze-out transactions involving controlling stockholders, who effectively stand on both sides of a deal.
While the Kenneth Cole decision is a significant win for the corporate boardroom, there may be a silver lining for investors in freeze-out transactions.
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In February 2012, Kenneth Cole, who owned approximately 46 percent of the publicly traded shares of Kenneth Cole Productions, Inc. (KCP), advised the KCP board of directors that he intended to submit an offer to purchase the remaining outstanding shares and, in effect, cash out the public stockholders. The board thereafter established a special committee of directors in order to consider the proposal. Cole submitted an initial offer to purchase the public shares for $15 per share, and this offer was conditioned on approval by the special committee and a majority of the minority shareholders. With legal and financial advisors, the special committee negotiated the merger terms over the course of several months. The special committee and Cole eventually agreed on a $15.25 share price, and almost all of the minority stockholders voted in favor of the merger. The KCP minority shareholders that brought suit alleged that the $279 million acquisition was unfair because the directors did not pursue bidders other than Cole.
The determinative issue in Kenneth Cole was whether the court should apply the business judgment rule or the entire fairness standard. Year after year, corporations embroiled in merger litigation have resisted application of the entire fairness standard, instead reflexively urging use of the business judgment rule.
The century-old business judgment rule is premised upon the fundamental precept that courts should endeavor to avoid interfering with the internal management of corporate boards, which ordinarily are clothed with the legal presumption that they are acting in good faith. Under the business judgment rule, courts should not substitute their own judgment for the determination of a corporate board of directors absent proof of bad faith or self-dealing. Not surprisingly, the business judgment rule is a formidable obstacle in shareholder litigation and was the defense-of-choice by KCP’s corporate board.
Under the more exacting entire fairness test, courts generally require defendants in freeze-out transactions to demonstrate that the process used to approve the merger was entirely fair to the minority shareholders, both in price and process. With this framework, defendants have the onus to show that the merger was approved by a special commit¬tee of independent directors and by an informed vote of the majority of the disinterested shareholders. In a seminal decision, Alpert v. 28 Williams Street Corp., 63 N.Y.2d 557 (1984), the Court of Appeals recognized that where there are common directors or majority ownership between the parties involved in a transaction, “the inherent conflict of interest” requires that “the burden of proving that the merger violated the duty of fairness … shift[ ] to the interested directors or shareholders to prove good faith and the entire fairness of the merger.” Practically, it is exceedingly difficult for a corporation to obtain dismissal of a complaint, or to obtain summary judgment, when the case is governed by the entire fairness standard.
The KCP shareholders argued that the trial court should have applied the entire fairness standard when evaluating the freeze-out transaction. The Court of Appeals in Kenneth Cole disagreed and expressly adopted the holding of the Delaware Supreme Court in Kahn v. M&F Worldwide, 88 A.3d 635 (Del. Sup. Ct. 2014), which held that “in 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[.]”
In Kenneth Cole, the Court of Appeals concluded that the shareholder-plaintiffs failed to “specifically and sufficiently” allege facts demonstrating an absence of any of the foregoing conditions. In dismissing the lawsuit, the Court of Appeals squarely held that the business judgment rule, and not entire fairness, is the appropriate standard where a merger has been conditioned on approval by a disinterested special committee of directors and a majority of the minority shareholders and on other shareholder protections.
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There are numerous important takeaways from the Kenneth Cole decision:
• The Court of Appeals’ holding reinforces the presumption that the business judgment rule is New York’s general standard of review of corporate management decisions, and that the substantive determination of a committee of disinterested directors will likely be beyond judicial inquiry in the New York courts.
• The Court of Appeals’ decision was made based on review of only the pleadings, prior to discovery. Going forward, plaintiffs may not have more than one bite at the apple to amend the complaint and to develop their factual allegations.
• The Kenneth Cole ruling shows that New York courts may rely upon Delaware case law in adjudicating corporate disputes, benefitting corporations organized under the law of New York since fiduciary duty lawsuits typically are decided under the law of the state of incorporation.
Although the Kenneth Cole decision weighs heavily in favor of corporate boards, it is not all gloom and doom for shareholder-plaintiffs. The Kenneth Cole paradigm creates a strong incentive for controlling shareholders to provide a merger structure that replicates an arm’s-length transaction and that protects the interests of minority shareholders. Absent strong shareholder protections, plaintiffs in freeze-out litigation are well-positioned to survive a pre-answer motion to dismiss, and to throw the corporation and its directors into protracted, expensive and unpredictable discovery. Of course, to the extent buyers accept a majority-of-the-minority requirement, activists and other shareholders may have the opportunity to extract additional value in the transaction.
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While the defendant-friendly Kenneth Cole decision certainly increases the difficulty of shareholders bringing challenges to any going-private transaction where the requisite shareholder-protection measures are present, this ruling should not stand in the way of challenges to biased or bad faith management decisions.