New York Court of Appeals adopts Delaware Standard of Review in Private Mergers.

In a recent decision, Matter of Kenneth Cole Prods., Inc. Shareholder Liig., (2016 N.Y. Slip Op 354, May 5th, 2016), the New Court of Appeals adopted the standard of review decided in Kahn v. M&F Worldwide Corp., 88 A.3d. 635 (MFW) with respect to going private mergers.  The Court went on to affirm the application of the business judgment rule where shareholder-protective conditions are present.  In contrast, the Court further held that in the absence of such conditions, the entire fairness standard shall apply, drawing from MFW standard.

Kenneth Cole Productions, Inc. (KCP) had two classes of common stock: (1) Class A stock which was traded on the New York stock exchange and (2) Class B stock, which was held entirely by  the defendant Kenneth Cole himself.  There were 10,706,723 outstanding shares of Class A stock and each shareholder was entitled to one vote.  Kenneth Cole owned 46% of Class A stock.  With respect to Class B, there were 7,890,497 shares and each share was entitled ten votes.  The overall voting structure meant that Kenneth Cole had 89% of the voting power of KCP.

In February 2012, Cole had informed the Board that he wished to proceed with a going private merger and intended to submit an offer to purchase the remaining Class A shares.  The Board established a special committee consisting of Michael J. Blitzer, Philip R. Peller, Denis F. Kelly, and Robert Grayson to review the proposal and negotiate the merger.  Kenneth Cole was not present when the committee was formed.

On February 23rd, 2012, Kenneth Cole proposed to to buy the Class A shares at $15 per share.  Among the conditions of the offer, (1) the special committee had to approve the offer and (2) in addition, the majority of the minority shareholders need to approve the offer as well.  On a rather personal note, Kenneth Cole also stated that if the offer was not approved, “his relationship with KCP would not adversely be affected”.

After the announcement of Cole’s offer, various shareholders commenced class actions  against Cole and KCP.  During their review, the special committee asked Cole to increase his offer and Cole ultimately raised his offer to $15.50 and then $16.  However, Cole reduced his offer back to $15 stating the issues with the company and general economy.  Further negotiations ultimately settled for a price of $15.25 for each outstanding share of Class A stock.  A shareholder vote was held and 99.8% of minority shareholders voted in favor of the merger.

Plaintiffs in an amended complaint alleged: (1) Cole and the directors breached their fiduciary duty they owed to minority shareholders; (2) award of damages to the class; and (3) a judgment enjoining the merger.  The defendants filed a motion to dismiss the complaint on the grounds that it failed to state a cause of action.

The Supreme Court granted defendants’ motion to dismiss the complaint citing that complaint failed to “demonstrate a lack of independence on the part of any of the…individual defendants.”  The Supreme Court also pointed out that the directors engaged in negotiations with Cole over the period of months and the the price offered was a premium over the last selling price of the stock.  Furthermore, the plaintiffs had failed to show any specific unfair conduct by the committee and thus, there was no reason to second guess the committee’s business decisions.

Upon appeal, the Appellate Division affirmed the Supreme Court holding that the “the motion court was not required to apply the “entire fairness’ standard to the transaction”(internal citations omitted).  The Appellate Division distinguished this case from the seminal case, Alpert v. 28 Williams St. Corp., 63 N.Y.2d 557 (1984) in that the current merger required the “approval of the majority of the minority shareholders.”  Furthermore, the Appellate division pointed that Cole himself did not participate in the board’s vote on the merger and the plaintiffs failed to demonstrate any self-interest on the part of the remaining board members.

The Court of Appeals adopted a “middle ground” with respect to the standard that should be applied to a going private merger.  Plaintiff had argued that an entire fairness standard should be used which places a burden on the directors that they “engaged in a fair process and obtained a fair price.”  On the other hand, the defendants argued that the business judgment rule should apply.

The Court began to re-affirm the principle that “courts should…avoid interfering with the internal management of business corporations”.  Thus, in the application of the business judgment rule, as long as the directors and officers of a company exercise unbiased judgment in good faith, the courts will defer to those determinations.  40 W. 67th St. v. Pullman, 100 N.Y.2d 147, 153 (2003).  In expounding the business judgment rule, the Court also observed that courts are ill equipped to evaluate business judgments and there was no objective standard by which one could evaluate any corporate decisions.  Auerbach v. Bennett, 47 N.Y.2d 619 (1979).  The Court further emphasized that under the business judgment rule, “courts may inquire as to the disinterested independence of the members of that committee and as to the appropriateness and sufficiency of the investigative procedures chosen and pursued by the committee” citing Auerbach at 623-624.

The opinion also distinguished the different types of freeze-out mergers: (1) two-step mergers whereby an investor purchases the majority of the shares of the company and then uses said control to merge the target with a second company, compromising minority shareholders; (2)  parent-subsidiary mergers and (3) going-private mergers, whereby the majority shareholder of a public company buys the shares of the remaining investors.

In the  Court’s analysis, the leading case in freeze-out mergers is Alpert v. 28 Williams St. Corp., 63 N.Y.2d. 557 (1984).  With respect to a two step merger, in the event of an “inherent conflict of interest and the potential for self-dealing, careful scrutiny of the transaction is required.” citing Alpert, 570.   The burden falls on the interested directors or shareholders to prove good faith and the entire fairness of the merger citing Chelrob, Inc. v. Barrett, 293 N.Y 442, 461 (1944).

Under Alpert, In order to determine fairness, two elements must be considered: (1) fair process and (2) fair price.  The fair process is comprised of factors such as “timing, structure, disclosure of information to independent directors and shareholders, how approvals were obtained” (internal citation omitted).   In contrast, the fair price can be determined whether “independent advisors rendered an opinion or other bids were considered in order to determine an arms-length negotiation.  These two elements are then considered as a whole to determine fairness to the minority shareholders.

Despite reiterating the standard used in Alpert, the Court nevertheless distinguished the case by stating that in Alpert there was no independent committee formed or a minority shareholder vote.  The question still remained whether the fiduciary standard set above would apply to mergers other than a two-step merger.

The Court considered the holding in the Delaware case of Kahn v. M&F Worldwide Corp., 88 A.3d. 635 (MFW) where a controlling shareholder proposed to purchase all outstanding shares of stock and thus, take the company private.   Similar to the current case, the shareholder also made the proposal contingent on: (1) approval from a special independent committee and (2) approval of the majority of the shareholders not associated with the controlling shareholder (internal citations omitted).  Furthermore, if the merger was not approved, the controlling shareholder would not bear an adverse relations with the corporation.

The Delaware court preferred the business judgement rule over the entire fairness standard because of the structure it created i.e. (1) an independent special committee and (2) uncoerced, informed vote of the majority of the minority shareholders.  The reasoning behind the adoption of the business judgment rule is that inter alia there are arms-length negotiations; the protection offered to minority shareholders in controller buyouts; there is a deference to the informed decisions of the independent directors and the incentive to protect minority shareholders.

The standard is defined as follows: (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”.  (internal citation omitted).

The Court reasoned that the adoption of the Delaware standard “reinforces the business judgement rule.”  Furthermore, there remains a continued to deference to the disinterested board of directors consistent with Auerbach, and the interests of the minority shareholders are protected sufficiently.

In order to prevail in a complaint for breach of fiduciary duty, the plaintiff may proceed to discovery if it alleges “a reasonably conceivable set of facts” showing that one if the six elements does not exist.  Neither conclusory statements or speculation may support a cause of action for breach of fiduciary duty.  In the event that one of six elements does not exist, the business judgment rule no longer applies, and in its place, the entire fairness standard should be applied instead.

In applying the MFW standard, the Court affirmed the lower courts’ decision granting defendant’s motion to dismiss.  First, the plaintiffs did not allege with any sufficiency or specificity that any of the six elements were absent.  The first element had already been fulfilled as Kenneth Cole had established a special committee of independent directors and in addition, the majority of the minority shareholders.

Although the plaintiffs challenged the independence of some of the directors, the Court applied the MFW standard in that the ties must be “material in the sense that they could affect partiality.  MFW, 69.  Thus, the plaintiffs had failed to provide any evidence of fraud, conflict of interest or that the members lacked the capability of reaching an unbiased decision.

With respect to the third element, the plaintiffs only made speculative allegations that the directors acceded to Kenneth Cole’s demands.  The Court focused on the Cole’s conduct whereby he stated that his relationship with the company would not be adversely affected if the committee or the minority shareholders failed to vote for the transaction.

The plaintiffs also failed to fulfill the fourth condition.  The Court pointed out that mere cursory allegations that the committee failed to meet its duty of care in negotiating a fair price was not sufficient.  The plaintiffs failed to provide substantive instances where the committee engaged in any unfair conduct.  The Court noted that the final offer was higher than the original offer, which in itself was determined by a panel of independent analysts.

With respect to the fifth and sixth elements, the plaintiff failed to plead with any specificity that the minority shareholders were less than informed when they voted for the transaction or that they were coerced in any manner.

Essentially, the Court has held that unless the six conditions are met, the Court will continue to apply the business judgment rule.  The case stands as a re-affirmation to the deference to the board of directors with respect to corporate decisions to mergers.


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