On May 5, 2016, the Court of Appeals, New York's highest court, unanimously affirmed the November 2014 Appellate Division decision dismissing all claims arising from the purchase of all outstanding shares of Kenneth Cole Productions, Inc. (KCP) by the company's founder and controlling shareholder, Kenneth Cole. This opinion treats a matter of first impression under New York law. It firmly establishes the applicability of the business judgment rule to the actions of directors in connection with a transaction with a controlling shareholder, as long as certain protections for minority shareholders are in place. Significantly, the New York Court of Appeals agreed that dismissal of the complaint, before discovery, was appropriate.1
The Going-Private Transaction
On February 24, 2012, KCP's board of directors announced that Mr. Cole—who held approximately 46 percent of the company’s common stock and 89 percent of the voting power—offered to purchase the publicly traded shares of common stock that he did not already own for $15 per share. The acquisition was conditioned on approval by both an independent special committee and the company's public shareholders unaffiliated with Mr. Cole. Immediately upon receiving Mr. Cole's proposal, the board of directors formed a special committee of four independent directors.
Within days of the announcement of Mr. Cole's proposal, a number of shareholder class action lawsuits were filed against the company, the members of the board and Mr. Cole alleging breaches of fiduciary duties in connection with the proposed transaction. The special committee spent several months evaluating Mr. Cole's proposal and negotiating with Mr. Cole. Mr. Cole ultimately agreed to increase his price to $15.25 per share, and the special committee approved the acquisition at that price. On September 24, 2012, the public shareholders unaffiliated with Mr. Cole voted overwhelmingly in favor of the acquisition: more than eight million public shares voted in favor while fewer than 19,000 voted against or abstained, a 99.8 percent approval mark. The transaction closed the next day.
The New York Court of Appeals Holding
The New York Court of Appeals' holding is particularly significant because the Court expressly adopted the standard of review for challenges to going-private mergers announced in 2014 by the Delaware Supreme Court in Kahn v M & F Worldwide Corp. In announcing the new standard, the Court emphasized the longstanding recognition that "courts are ill equipped to evaluate what are essentially business judgments."At the same time, the Court looked to balance this principle with appropriate protections for minority shareholders.
Thus, the Court held that "the business judgment rule should be applied as long as the corporation's directors establish that certain shareholder-protective conditions are met; however, if those conditions are not met, the entire fairness standard should be applied." Adopting the same six criteria set forth in M & F Worldwide, the Court held that "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."
The Court held that the Kenneth Cole complaint properly was dismissed because the plaintiff failed to sufficiently allege that any of the six enumerated shareholder-protective conditions did not exist. First, the plaintiff conceded that Mr. Cole conditioned the merger, from the outset, upon approval by both a special committee of independent directors and a majority of the minority shareholders. Second, the plaintiff's allegations, such as that Mr. Cole was responsible for nominating and electing the committee members to KCP's board, did not indicate that any of the members of the special committee engaged in fraud, had a conflict of interest or divided loyalties, or were otherwise incapable of reaching an unbiased decision regarding the proposed merger. Third, the Court found the plaintiff's speculation that the committee merely submitted to Cole’s wishes insufficient, noting that it was undisputed "that the committee did, in fact, select its own financial advisors and legal counsel" and that Mr. Cole had stated at the time of his initial proposal that, "if the committee did not recommend approval or the minority shareholders did not vote in favor of the proposed transaction, such a determination 'would not adversely affect [his] . . . relationship' with KCP." Fourth, the Court found that allegations that the special committee could have been more effective in negotiating a higher buy-out price provided no more than "conclusory assertions the committee failed to meet its duty of care in negotiating a fair price," noting, among other things, that the final price of $15.25 per share was higher than the stock price prior to Mr. Cole’s announcement that he intended to take the company private. Fifth, the complaint failed to specifically challenge information contained in the proxy statement provided to minority shareholders prior to the vote, "such that it could be said that the shareholders were not informed." Sixth, "plaintiff did not allege any coercion of the minority shareholders in relation to the vote."
Accordingly, because the plaintiff did not sufficiently allege the absence of any of the six enumerated conditions, the New York Court of Appeals held, the business judgment standard of review applied to the transaction at issue. Under that standard, "absent fraud or bad faith, we defer to the determinations of the special committee and the KCP board of directors in recommending and approving the merger." Thus, the Court concluded, "the complaint was properly dismissed" and "the Appellate Division order should be affirmed."
A New Standard Balancing the Interests of All Constituents
Before the Kenneth Cole decision, no New York court had squarely addressed whether the business judgment rule could apply to a going-private transaction with a controlling shareholder. The general rule was that transactions with controlling shareholders are subject to entire fairness review because the controlling shareholder effectively stands on both sides of the transaction.
The Court of Appeals addressed the authority on which minority shareholders typically rely—the court’s 32-year-old decision in Alpert v. 28 Williams St. Corp. In that case, the Court of Appeals had applied the so-called "entire fairness" standard to a merger transaction with a company’s controlling shareholder. "Entire fairness" is a particularly fact-intensive standard that has made it virtually impossible to obtain dismissal of such a claim at the pleading stage, regardless of the merits. The Court in Kenneth Cole, however, agreed with the defendants that Alpert was 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 also distinguishable because, in Alpert, "there was no independent committee and no minority shareholder vote."
Instead, the Court adopted the Delaware standard for New York, finding that it properly balances "the rights of minority shareholders" against "the interests of directors and controlling shareholders in avoiding frivolous litigation and protecting independently-made business decisions from unwarranted judicial interference." As the Delaware courts have reasoned, the presence of both of these requirements provides substantial safeguards to minority shareholders, and the application of the business judgment rule to such transactions benefits minority shareholders by encouraging controlling shareholders and boards to empower independent directors and minority shareholders through these requirements.
Kenneth Cole provides a roadmap for independent directors who are considering transactions proposed by controlling shareholders of New York corporations. Importantly, the decision should incentivize controllers to condition their offers from the outset on approval by disinterested directors and shareholders. When a process is designed and run in a manner that provides these protections for minority shareholders, the parties to these transactions should be able to reduce the "litigation tax" that has plagued M&A transactions for years.
Sidley represented the special committee of independent directors in the transaction and also in the litigation that ended with the decision of the Court of Appeals. Sidley partners Andrew W. Stern and Nicholas P. Crowell argued the case before the Court of Appeals and the lower courts. Our Updates on the trial court and Appellate Division decisions can be found here and here.