New York’s highest court earlier this month adopted a more lenient standard for reviewing certain types of corporate transactions between companies and controlling shareholders, similar to that adopted two years ago by Delaware’s highest court. The decision provides companies and directors with a roadmap as to how to structure transactions in order to achieve deferential business judgment review, rather than face the more searching entire fairness standard.
The decision by the New York Court of Appeals dismissed a putative class-action suit filed by a minority shareholder of Kenneth Cole Productions, Inc. (“KCP”). In re Kenneth Cole Productions, Inc., Shareholder Litigation, No. 54, 2016 N.Y. Slip Op. 03545 (May 5, 2016). The court held that the transaction merited review under the business judgment standard because certain key conditions were met, including that: (1) the deal was negotiated and approved for the company by a special committee of independent directors and (2) it was approved by a majority of minority shareholders.
The standard of review a court applies to corporate transactions is important. Under the entire fairness standard, defendants generally must show the fairness of both the deal process and the purchase price. But under the business judgment standard, the inquiry is focused on whether the decision makers on the transaction were not acting in good faith. Cases decided under the business judgment standard are much more prone to dismissal at an early stage and often allow defendants to avoid discovery, as happened in Cole. Cases under an entire fairness standard usually do not get decided until after discovery or trial.
Because the transaction in Cole involved a controlling shareholder, Kenneth Cole, buying out the remainder of the publicly held stock of the company, the shareholder’s counsel argued that it should be subjected to the entire fairness standard. Such interested-party transactions between a controlling shareholder and the controlled company have been held subject to entire fairness review in some earlier decisions.
In 2014, however, the Delaware Supreme Court decided Kahn v. M & F Worldwide Corp., 88 A.3d 648 (Del. 2014) (“MFW”). It held that when certain protections are in place, the inherent conflicts of interest in such going-private mergers were effectively mitigated. The court found that a functioning special committee of independents, coupled with approval by a majority of the minority shareholders, replicates an arm’s length transaction, meriting a more deferential standard of review.
In the Cole case, the New York Court of Appeals echoed that view. There, Kenneth Cole was clearly a controller – he held 89% of the voting power of the company and approximately 46% of its economic interest. After he proposed a going-private merger of KCP, in which he would purchase the remaining public stock, the KCP board established a special committee to consider the proposal and to negotiate any potential merger. Cole made an initial offer of $15.00 for the outstanding shares, conditioned on approval of both (1) a special committee of independent directors and (2) a majority of the minority shareholders. After months of negotiations, the special committee finally approved an offer of $15.25 per share, which it recommended to the minority shareholders. Of the minority shareholders, 99.8% voted to approve the transaction.
Within days of Cole’s initial announcement, plaintiff Erie County Employee’s Retirement System commenced a putative class action alleging, among other things, breach of fiduciary duty by Cole and the other KCP directors.
The Court of Appeals Decision
In opposition to defendants’ motions to dismiss the complaint, plaintiff argued that the court must apply the entire fairness standard of review to the KCP transaction, which would require discovery into the process and final price of the transaction. But the trial court granted defendants’ motions, declining to second-guess the special committee’s decision absent an allegation of unfair conduct or lack of independence. Following affirmance of that decision by the Appellate Division, Plaintiff was granted leave to appeal the matter to the Court of Appeals.
The Court of Appeals focused on what standard should apply where a going-private merger is subject from the outset to approval by both a special committee of independent directors and a majority of minority shareholders.
The court distinguished its earlier decision in Alpert v. 28 Williams St. Corp., 63 N.Y.2d 557 (1984), in which it held that the entire fairness standard should generally apply in mergers involving inherent conflicts of interest, as is the case in most mergers where a controlling shareholder seeks to eliminate the interests of minority shareholders. Adopting the Delaware approach taken in MFW, however, the court found that such inherent conflicts of interest were allayed where the following conditions protecting minority shareholder interests were present in going-private mergers, thus permitting review under the business judgment standard:
(i) the controlling shareholder 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.
Where these conditions are not met, however, the entire fairness standard will apply. The court further elaborated that, in order to survive a motion to dismiss, a complaint must allege “a reasonably conceivable set of facts” showing that any of these six enumerated shareholder conditions did not exist.
The Court of Appeals’ adoption of the Delaware reasoning of MFW is likely to signal a greater acceptance of this conditional business judgment standard in going-private mergers in the remainder of the nation. Many jurisdictions turn to Delaware corporate law to fill in gaps in their own jurisprudence, and the adoption of the MFW approach by another state will only enhance its appeal in additional jurisdictions. Thus, parties contemplating controlling shareholder transactions should pay careful attention to this line of authority, as it may provide a way to avoid, or at least cut short, the deal-challenge litigation that follows nearly every M&A transaction.