On November 20, 2014, New York’s Appellate Division, First Department, unanimously affirmed the September 2013 trial court decision dismissing all claims arising from the purchase of all outstanding shares in Kenneth Cole Productions, Inc. (KCP) by the company’s founder and controlling shareholder, Kenneth Cole. (Our report on the trial court decision ishere.) This opinion on a matter of first impression under New York law firmly establishes the applicability of the business judgment rule to the actions of directors in connection with a transaction with a controlling shareholder so long as certain protections for minority shareholders are in place. Just as significant, the Appellate Division agreed that pre-discovery dismissal on the pleadings was appropriate. Andrew Stern, in Sidley’s New York office, argued the case on behalf of the special committee of four independent directors of KCP at the trial and appellate courts.
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. The special committee retained Joe Armbrust and Gabe Saltarelli of Sidley as its legal advisors on the transaction.
Within days of the announcement of Mr. Cole’s proposal, a number of shareholder 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 carefully evaluating Mr. Cole’s proposal and negotiating with Mr. Cole, with the active assistance of the special committee’s financial advisor and the Sidley transaction team. 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 minority public shareholders voted overwhelmingly in favor of the acquisition – more than 8 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 Appellate Division Holding
The Appellate Division’s holding is particularly significant because the Court squarely addressed the authority on which minority shareholders typically rely – the 1984 Court of Appeals decision in Alpert v. 28 Williams St. Corp. In that case, New York’s highest court 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 Appellate Division, however, agreed with the defendants thatAlpert did not apply because, unlike in Alpert, the Kenneth Cole transaction “required the approval of the majority of the minority (i.e., non-Cole) shareholders.” Just as significant, the Appellate Division concluded that the plaintiffs’ allegations that the special committee of independent directors was “controlled” by Mr. Cole were insufficient because “it is not enough to charge that a director was nominated by or elected at the behest of those controlling the outcome of a corporate election.” Because there were no allegations sufficient to demonstrate that, “the special committee did not act in good faith or were otherwise interested” in the transaction, the appellate court held that the claims for breach of fiduciary duty were correctly dismissed.
The Changed Legal Landscape
Before the Kenneth Cole decisions, 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.
This appellate decision interprets New York law consistently with recent Delaware cases applying the business judgment rule to going-private transactions that are conditioned on the two key procedural protections that were present in the KCP transaction: (i) approval by an independent special committee fully empowered to negotiate with the controlling shareholder and, if warranted, to reject the transaction, and (ii) approval by a majority of the shareholders unaffiliated with the controlling shareholder. 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.
The appellate affirmation of this reasoning bodes well for directors of New York companies who take appropriate steps to protect minority shareholders but still find themselves in the crosshairs of the shareholder lawsuits that inevitably are filed in the wake of a merger announcement. Most important, it provides controlling precedent for the dismissal of such lawsuits at the pleadings stage, before the burden and distractions of discovery.