In In the Matter of Kenneth Cole Productions, Inc., Shareholder Litigation (In re KCP), New York State’s highest court applied the business judgment rule in a challenge to a one-step, controlling shareholder going-private merger transaction where certain protections for the minority shareholders were present from the outset. The decision brings New York in line with the Delaware Supreme Court’s decision in Kahn v. M&F Worldwide Corp., 88 A3d 635 (Del. 2014) (MFW), which adopted the same business judgment rule standard of review for controlling shareholder going-private mergers where the same protections are present. In re KCP offers guidance as to how controlling shareholders can opt into a structure for freeze-out going-private mergers in New York to avoid the heightened scrutiny of the entire fairness standard of review and thereby improve the likelihood of winning dismissal of minority shareholder challenges at an early stage of litigation.
Background of KCP Going-Private Transaction
In re KCP stemmed from a proposal by Kenneth Cole (Cole) in 2012 to take Kenneth Cole Productions, Inc. (KCP) private by offering to acquire the remainder of the outstanding shares of Class A stock that he did not already own. Cole held approximately 46% of the outstanding Class A shares, which were traded on the New York Stock Exchange, and all of the outstanding Class B shares, giving him 89% of the total voting power. Cole’s initial offer was for $15 per Class A share, which represented a 17% premium over KCP’s closing stock price the day before Cole’s offer. From the outset, Cole’s offer was conditioned on approval by (1) a special committee that was established to consider and negotiate the merger and (2) a majority vote of the minority shareholders. After months of negotiations with the special committee and its legal and financial advisors, Cole ultimately made an offer of $15.25 per share, which the special committee approved and recommended to the minority shareholders. The merger was subsequently approved by 99.8% of the shares held by minority shareholders. Shortly after Cole made his initial offer, and before the minority shareholders approved the merger, several shareholders filed separate class actions against KCP, Cole and the other directors for, among other things, breach of fiduciary duty.1 The New York trial court dismissed the complaint and the intermediate appellate court affirmed, holding that “there [were] no allegations sufficient to demonstrate that the members of the board or the special committee did not act in good faith or were otherwise interested.” (In re KCP at 5-6).
New York State’s Highest Court Adopts Delaware’s MFW Standard
On appeal, the New York Court of Appeals considered “what standard of review should apply to a going private merger conditioned upfront by the controlling stockholder on approval by both a properly empowered, independent committee and an informed, uncoerced majority-of-the-minority vote.” (In re KCP at 10, quoting MFW at 639). Faced with competing arguments from the plaintiffs to apply the entire fairness standard, which the Court had applied to a two-step controlling shareholder freeze-out merger in Alpert v. 28 Williams St. Corp., 63 NY2nd 557 (NY 1984) (Alpert), and from the defendants to apply the business judgment rule as the Delaware Supreme Court had done in MFW,2 the New York Court of Appeals decided to apply the business judgment rule, for substantially the same reasons that the Delaware Supreme Court discussed in MFW. Quoting the six conditions stated in MFW, the New York Court of Appeals 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 re KCP at 12, quoting MFW at 645 (emphasis in original)). In deciding to apply the MFW standard of review to controlling shareholder going-private mergers of New York corporations, the Court of Appeals determined that Alpert was (1) inapplicable because in Alpert "we specifically stated that we were not deciding whether the circumstances that would satisfy fiduciary duties in a two-step merger would be the same for other types of mergers," and (2) distinguishable because "there was no independent committee and no minority shareholder vote." (In re KCP at 9). The Court of Appeals cautioned, however, that applying the business judgment rule to transactions structured like the KCP buyout still allows courts to question the independence of the disinterested directors of the special committee and whether their consideration and negotiation of the purchase price and merger process were appropriate and sufficient. Accordingly, a case could still proceed to trial where, for example, there is evidence that the disinterested directors were not truly independent or the minority shareholders were not informed or were subject to coercion when they voted.
KCP Complaint Fails Under Business Judgment Rule
In affirming dismissal of the complaint, the New York Court of Appeals followed the Delaware Supreme Court’s reasoning that a “complaint is sufficient to state a cause of action for breach of fiduciary duty … if it alleges ‘a reasonably conceivable set of facts’ showing that any of the six enumerated shareholder-protective conditions did not exist.” (In re KCP at 13 (citing MFW at 645)). “Conclusory allegations,” “bare legal assertions without specificity” and “mere speculation” are not sufficient. If the pleading requirements are met, in order to defeat a motion for summary judgment, the plaintiff must demonstrate that there is a question of fact as to the absence of at least one of the six conditions. If the evidence confirms such absence, the entire fairness standard, rather than the business judgment rule, applies. (In re KCP at 13-14). The New York Court of Appeals agreed with the lower courts that the complaint’s allegations could not survive the motion to dismiss because “plaintiff did not sufficiently and specifically allege that any of MFW's six enumerated conditions were absent from the merger here.” (In re KCP at 14 (emphasis in original)). The Court held that the business judgment rule applied, and since there were no allegations of fraud or bad faith that would support a claim under this standard of review, the Court affirmed dismissal of the complaint.
As in Delaware, controlling shareholders and boards of New York corporations now have a procedural framework permitting them to achieve a business judgment rule standard of review in one-step going-private mergers by structuring the transaction to satisfy the six MFW/In re KCP conditions. In New York as in Delaware, this approach should reduce the incentive for minority shareholder plaintiffs to bring lawsuits challenging such mergers because controlling shareholders will have a significantly greater likelihood of winning dismissal at an earlier stage under a business judgment rule review, as plaintiffs may face a significant hurdle in stating a case on the pleadings alone. Since far fewer corporations are incorporated in New York than in Delaware, the direct consequences of In re KCP might not be as extensive as the impact of MFW. Nevertheless, in combination with MFW, In re KCP can be expected to have implications beyond its application to New York mergers:
- With the highest courts in these two major business-law jurisdictions now having adopted the business judgment rule for one-step going-private mergers conditioned on the minority shareholder protection procedures described above, controlling shareholders have stronger grounds for arguing that this standard of review should be applied to similarly structured transactions in other states that have not yet adopted a uniform standard of review.
- For similar reasons, controlling shareholders contemplating going-private mergers in other jurisdictions may be more likely to incorporate the MFW/In re KCP minority shareholder protections in their initial offers, in order to fend off, and bolster their chances of winning dismissal of, challenges by minority shareholders to one-step going-private mergers.
- This trend may also benefit minority shareholders. Quoting MFW, the Court in In re KCP observed that the business judgment rule “create[s] 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 are in place, the situation replicates an arm’s length transaction and supports the integrity of the process.” (In re KCP at 11 (emphasis in original), also quoting from MFW that “the dual procedural protection merger structure optimally protects the minority stockholders in controller buyouts” (Id.))
- For the latter reason, however, the availability of business judgment rule review through compliance with the MFW/In re KCP conditions may not result in a uniform change in controlling shareholders’ approaches to these situations, particularly where a “majority of the minority” voting condition creates substantial transaction risk. Whether substantial transaction risk exists will depend on the circumstances of each transaction. In particular, the size of the controlling shareholders’ initial position, as well as the ownership of and market for the minority shareholdings, will need to be carefully evaluated, as a smaller minority stake may make it easier for one or more shareholders (such as activist shareholders or hedge funds) to attempt to wage a blocking effort, potentially forcing the controlling shareholder to pay a higher price.
In view of the foregoing, where application of the business judgment rule depends on satisfaction of the MFW/In re KCP conditions, a controlling shareholder should consider, based on the particular circumstances, whether an entire fairness review is ultimately less costly and/or risky than accepting the additional conditions required to achieve the application of the business judgment rule. Thus, controlling shareholders seeking to effect one-step going-private mergers of New York or Delaware corporations should continue to evaluate the circumstances of each transaction, including with respect to the target’s shareholder base, the number and percentage of minority shares outstanding, and the likelihood of involvement by activist shareholders.