Challenges to Going-Private Mergers in New York

Jason M. Halper is a partner in the Securities Litigation & Regulatory Enforcement Practice Group at Orrick, Herrington & Sutcliffe LLP. This post is based on an Orrick publication by Mr. Halper, Richard V. Smith, and Gregory Beaman.

In a landmark decision on May 5, 2016, the New York Court of Appeals held that challenges to going-private mergers where there is a controlling stockholder must be reviewed under the deferential business judgment rule rather than the more exacting “entire fairness” standard of review, as long as certain protections for minority stockholders are in place from the time the transaction is proposed. See In the Matter of Kenneth Cole Productions, Inc., S’holder Litig.,—N.E.3d—, 2016 WL 2350133 (N.Y. 2016). In so holding, New York’s highest court adopted the same standard of review announced by the Delaware Supreme Court in Kahn v. M&F Worldwide Corp., 88 A.3d 635, 648-49 (Del. 2014).

New York now joins Delaware in its view that going-private mergers with a controlling stockholder will be insulated from “entire fairness” review as long as the transaction is, at the time an offer is first made, conditioned on approval by (1) a truly independent and empowered special committee, and (2) an informed majority of the minority stockholders.

Such a rule made sense, according to the Kenneth Cole Court, because (adopting the rationale articulated in MFW) “review under the business judgment rule—as opposed to the entire fairness standard—creates[] a strong incentive for controlling shareholders to provide a structure for freeze-out mergers that is most likely to protect the interests of minority shareholders, because when both protections are in place, the situation replicates an arm’s length transaction and supports the integrity of the process.”

Background

Kenneth Cole Productions, the American fashion house founded by Kenneth D. Cole, was organized with two classes of common stock: publicly traded Class A shares (46% of which were held by Cole), and Class B shares (all of which were held by Cole and entitled to 10 votes/share, with the result that Cole exercised 89% voting power over the company). In addition to being the company’s founder and controlling stockholder, Cole sat on its board.

In February 2012, Cole proposed a going-private merger whereby he would acquire the remaining 54% of the Class A shares. The board formed a special committee of four directors to consider the proposal and, on February 23, 2012, Cole made an initial offer of $15.00 per share, which was conditioned on approval first by the special committee and then by a majority of the company’s minority shareholders. Cole also informed the board that (1) he had no desire to seek any other type of merger and, as majority stockholder, would not approve of one, and (2) if the special committee or the majority of the minority stockholders voted against the merger, his relationship with the company would not be adversely affected. After months of negotiations, the special committee, which had been advised by independent legal and financial advisors, approved the merger at $15.25 per share and 99.8% of the company’s minority stockholders voted in favor of the deal.

One of the minority stockholders, however, sought to enjoin the merger on the ground that the Kenneth Cole directors who approved the deal breached their fiduciary duties to the minority stockholders in doing so. The New York Supreme Court dismissed the complaint because the plaintiff had failed to allege any facts showing “specific unfair conduct by the special committee,” and absent such a showing, “the Court will not second guess the [special] committee’s business decisions in negotiating the terms of [the] transaction.” The Appellate Division affirmed, holding that the trial court was not required to review the transaction under the “entire fairness” standard of review because the merger was conditioned on sufficient protections for minority stockholders, which were satisfied.

The New York Court of Appeals also affirmed, adopting the standard of review announced by the Delaware Supreme Court in MFW. Specifically, the Court of Appeals held that, when reviewing challenges to going-private mergers, “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.”

Takeaways

Under New York law, a going-private merger with a controlling stockholder will be eligible for deferential business judgment rule judicial review as long as the transaction proposal is conditioned at the outset on approval by both a truly independent and informed special committee that is free to “say no,” and a majority of the minority stockholders who have been informed and are also free, without coercion, to “say no.”

Adopting and quoting the standard of review announced in MFW, the Court of Appeals stated: “[I]n controller buyouts, 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.” If all six of these conditions are met, New York courts will, absent fraud or bad faith, defer to the determination of the special committee and the board of directors. However, if any one of these six conditions is not met, New York courts will not give deference to the committee’s decisions, but rather will apply “entire fairness” review.

Here, the Court of Appeals explained that the six MFW conditions were met because: (i) the transaction was conditioned at the outset on approval by the special committee and a majority of the minority stockholders; (ii) there was no evidence that “any 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”; (iii) the special committee was empowered to, and in fact did, retain its own independent legal and financial advisors and was free to reject the deal without adverse consequences for the company; (iv) the special committee was informed, negotiated firmly with Cole for several months, obtained a premium price for minority stockholders that was within the value range suggested by its financial advisors and higher than the originally proposed price, and there was no allegation that “the committee had an incentive to accept an inadequate price without meaningful negotiations or that it engaged in any unfair conduct”; (v) there were no challenges to the information included or omitted from the proxy statement provided to minority shareholders; and (vi) there was no allegation that the minority stockholders were coerced into approving the deal.

Because all of the six MFW factors were satisfied, the business judgment rule applied such that the Court would defer to the special committee’s judgment absent fraud or bad faith, neither of which was alleged in the complaint. As a result, the Court of Appeals upheld the dismissal of the complaint.

This decision reaffirms the importance of having empowered committees of independent directors diligently evaluating interested director and controlling stockholder transactions, and of the need for adequate minority shareholder protections if companies wish to get the benefit of a deferential standard of review after the fact.

The Court of Appeals again endorsed the importance of, and rationale for, the business judgment rule as the appropriate standard of review for situations, including change of control transactions, where directors are not faced with conflicting interests.

  • The Court of Appeals noted that “we have long adhered to the business judgment rule, which provides that, where corporate officers or directors exercise unbiased judgment in determining that certain actions will promote the corporation’s interests, courts will defer to those determinations if they were made in good faith.”
  • The basis for this position is sensible, as the Court of Appeals explained: courts are ill equipped to review or second guess business decisions and cannot rely upon an objective standard for judging the correctness of these business decisions. As a matter of public policy, “corporate directors are charged with the authority to make those decisions.”
  • Ultimately, under New York law, when the business judgment rule applies, unless there is a finding of fraud or bad faith, the New York courts will honor the directors’ business judgment and not make any further judicial inquiry into that judgment.
  • Although not the subject of the Kenneth Cole decision, the decision strongly supports the view that the business judgment rule should apply under New York law to a decision by an independent board of directors approving a change of control transaction where there is no controlling stockholder.

While the potential for deferential business judgment review undoubtedly is attractive, there are pitfalls and potential disadvantages as well to structuring approval of the transaction according to the Kenneth Cole/MFW criteria.

  • The Court of Appeals found that the complaint failed to allege that the special committee was uninformed, did not negotiate appropriately with Cole, or otherwise mishandled its consideration of the transaction. Numerous decisions from Delaware and other jurisdictions, however, establish that courts will carefully review a committee’s conduct and decision making. And, in Kenneth Cole, the Court of Appeals expressly cited prior precedent to the effect that a New York court may inquire into “the appropriateness and sufficiency of the investigation procedures chosen and pursued by the committee.” If a court concludes that directors are not fully informed or sufficiently proactive, deferential business judgment rule review is unlikely to apply. [1]
  • In this case, Cole had voting control over the company and expressed to the special committee that he would not vote for a sale to another purchaser. The special committee nevertheless should not refrain from exploring alternatives, including the willingness of third parties to bid for the company. In MFW, the special committee considered whether other buyers were interested in purchasing the company. This kind of information can be helpful in evaluating the fairness of the price offered by the controller. Of course, the special committee also has to consider how realistic any third party indications of interest might be since it is not likely that any third party will invest a meaningful amount of time or resources in evaluating a company where a controller can block a sale transaction.
  • The Court of Appeals concluded that there was no allegation that the proxy statement soliciting minority stockholder approval of the transaction was false or misleading. To the extent minority stockholders approve a controlling stockholder transaction on the basis of a proxy statement that is alleged and proven to be misleading, business judgment rule review will not apply and the transaction will instead be assessed under the “entire fairness” standard.
  • The timing of conditioning approval of a transaction on the Kenneth Cole/MFW criteria is important. Parties will not be able to obtain business judgment rule review based on Kenneth Cole/MFW where a controller’s initial proposal is not conditioned on special committee and minority stockholder approval. In fact, that is exactly what led to “entire fairness” review in In re Orchard Enterprises, Inc. Stockholder Litigation, 88 A.3d 1 (Del. Ch. 2014). There, the company’s controlling stockholder proposed a squeeze-out merger, but it “did not agree up front, before any negotiations began, that it would not proceed with a self-dealing transaction” without the approval of both an independent and disinterested special committee and the majority of the minority vote. Although the stockholder’s initial proposal contemplated approval by a special committee, it was not conditioned on majority of the minority vote until much later in the negotiations. The Chancery Court therefore held that the transaction was subject to “entire fairness” review and the case ultimately settled out of court.
  • Boards need to consider execution risk. There is always the chance that minority stockholders may not approve the transaction, thereby precluding deferential business judgment review even if the transaction terms are later amended to eliminate such approval as a condition to consummating a deal. Companies need to consider the likelihood of actually satisfying the Kenneth Cole/MFW criteria, especially the minority vote requirement. There may well be instances when, from a cost-benefit perspective, it is better not to condition a transaction on approval by a majority of the minority stockholders.

Importance of Delaware court decisions as to M&A transactions.

  • The Kenneth Cole decision is an important reminder that decisions rendered by the Delaware courts in change of control transactions are influential and, therefore, transaction planners in non-Delaware jurisdictions must consider these decisions in the M&A context.
  • Indeed, it is especially important in this regard to consider the Court of Appeals’ decision to adopt, without qualification, the MFW principles articulated by the Delaware Supreme Court. The legal issues concerning controllers and squeeze out transactions have been the subject of many court decisions across many jurisdictions over many years. And, of course, there have been endless law review and commenter articles on this subject. As a result, the Court of Appeals had many paths open to it when deciding the Kenneth Cole case. Yet, ultimately, the Court of Appeals was persuaded by the reasoning of the Delaware Supreme Court in MFW. Needless to say, this outcome does not mean that New York courts will always follow the reasoning of Delaware courts in change of control transactions: New York courts, and federal courts deciding business cases under New York law, are, and will continue to be, both independent and highly influential in deciding business transaction disputes. But, it does mean that transaction planners for deals involving New York corporations need to pay careful attention to the decisions of the Delaware courts as to M&A transactions.

Endnotes:

[1] Indeed, in an important footnote in the MFW case, the Delaware Supreme Court observed that allegations in the complaint in that case concerning the sufficiency of the price agreed upon called into question the adequacy of the special committee’s negotiations, “thereby necessitating discovery on all of the new prerequisites to the application of the business judgment rule.”
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