Yesterday, New York’s highest court adopted the Delaware standard of review for certain going-private mergers, further reinforcing the roadmap for avoiding protracted litigation where particular shareholder-protective measures are present.
Adopting the standard set forth by the Delaware Supreme Court in Kahn v. M&F Worldwide, 88 A.3d 607 (Del. 2014), the New York Court of Appeals held that the deferential business judgment standard of review applies to controlling shareholder buyouts if made expressly contingent, from the outset, upon approval by an independent, adequately empowered special committee that fulfills its duty of care and an uncoerced and informed vote of the majority of the minority stockholders.
The issue addressed in Kenneth Cole was the proper standard of review to apply -- the entire fairness standard or the business judgment standard. When the entire fairness standard applies, the burden is on the directors to prove that both the process and the price were entirely fair to the minority stockholders. As a practical matter, it is very difficult to get dismissals or even summary judgment in cases governed by entire fairness. When the business judgment standard applies, the burden is on the shareholder to prove that the board’s decision was so egregious or irrational that it could not have been based upon a valid assessment of the company’s best interests. Suits governed by business judgment frequently fail to survive motions to dismiss. For the business judgment standard to apply in a controlling shareholder buyout, there are six necessary conditions: (1) the controlling shareholder conditions procession of the transaction on the approval of both a special committee and a majority of the minority stockholders; (2) the special committee is independent; (3) the special committee is empowered to freely select its own advisors and to say no to the transaction definitively; (4) the special committee meets its duty of care in negotiating a fair price; (5) the vote of the minority is informed; and (6) there is no coercion of the minority. If a plaintiff alleges a reasonably conceivable set of facts showing that any of those conditions are not met, then the case will proceed to discovery. But if these conditions are met, then the court will not second-guess the decision of the special committee, and the case may be dismissed on the pleadings.
Although this was an issue of first impression for the New York Court of Appeals, the Kenneth Cole decision represents a shift from the general rule that transactions involving a controlling shareholder are subject to the “entire fairness” standard because of the concern that the controlling shareholder effectively stands on both sides of the transaction. The Court of Appeals agreed with the Delaware Supreme Court that the involvement of both an independent committee and an informed, uncoerced vote of the minority shareholders replicates an arm’s-length transaction and warrants the application of the business judgment rule.
At issue was a transaction proposed by Kenneth Cole, the controlling shareholder of Kenneth Cole Productions (KCP), to take the company private by purchasing all of the outstanding common stock that he did not already own. Mr. Cole made a non-binding offer of $15.00 per share which represented a premium over KCP’s stock price. This proposal was conditioned on the approval of an independent special committee formed by the board and the approval of a majority vote of the minority stockholders. Mr. Cole indicated that he had no desire to seek any other type of merger and that if the stockholders voted against the transaction his relationship with KCP would not be adversely affected. Shareholders initiated suit, alleging that Mr. Cole and the directors breached their fiduciary duties to the minority shareholders in approving the transaction at $15.25 a share. The trial court granted defendants’ motion to dismiss, and the Appellate Division affirmed.
On appeal to New York’s highest court, the Court found the reasoning in Kahn persuasive because it reinforced the general rule that courts do not review corporate management decisions and do not inquire into the substantive decisions made by committees of disinterested directors. The Court noted that the Kahn standard balanced the rights of minority shareholders to seek judicial relief of transactions involving interested parties against the interests of directors and the controlling shareholder to avoid frivolous lawsuits and judicial inquiry into independently made business decisions.
Applying Kahn, the Court held that plaintiffs failed to allege a “reasonably conceivable set of facts” showing that any of the six necessary conditions were not met and affirmed the dismissal of the complaint. Regarding the independence of the committee, the Court held that plaintiffs failed to allege any members of the 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.” The allegations did not demonstrate the committee lacked proper empowerment, as the committee hired its own financial advisors and legal counsel, and Mr. Cole stated that an adverse determination by the committee would not adversely affect his relationship with KCP. The final price accepted by the committee was higher than the asking price and was within a range of value determined to be fair by the committee’s financial advisors , demonstrating that the committee met its duty of care in negotiating a fair price. Finally, plaintiffs failed to specifically challenge any information contained in or allegedly omitted from the proxy statement which would have rendered the minority shareholders uninformed.
This ruling levels the playing field for companies incorporated in New York with those incorporated in Delaware, as breach of fiduciary lawsuits against corporate directors are decided under the law of the state of incorporation. Now New York and Delaware offer a common playbook for controlling shareholder buyouts that wish to avoid the shareholder-friendly entire fairness standard of review.