New York Adopts Business Judgment Rule in Reviewing Certain Going-Private Transactions
The New York Court of Appeals dealt a blow to plaintiffs on May 5, 2016 when it issued its first decision addressing the appropriate standard for analyzing going-private merger transactions. In In re: Kenneth Cole Productions, Inc., Shareholder Litigation, the New York Court of Appeals held that New York courts should apply the more deferential business judgment rule, rather than the stricter entire fairness standard, in reviewing going-private mergers, as long as certain “shareholder-protective conditions” are implemented.
Plaintiffs often challenge proposed going-private transactions before the ink is dry in a race to the courthouse to file a merger strike suit, no matter how weak the merits of their case are, in the hopes of surviving a motion to dismiss and forcing a settlement. Recent decisions of the Delaware courts indicate an increasing intolerance of this behavior and the resultant “tax” on merger transactions. The Kenneth Cole decision suggests that the New York courts are turning in the same direction.
The case involved a proposed going-private transaction by Kenneth D. Cole of his namesake apparel, footwear, handbag and accessories company, of which he was majority shareholder. The offer was conditioned upon the approval by a special committee of independent directors formed to consider and negotiate the proposal and by a majority of the minority shareholders. After months of negotiations, the special committee approved the proposal and 99.8 percent of the minority shareholders voted in favor of the merger.
As is commonplace in merger transactions, plaintiffs’ attorneys filed a merger strike suit as soon as the offer was announced publicly. The case was dismissed on the pleadings and the Appellate Division, First Department, affirmed the dismissal. On appeal, the New York Court of Appeals decided the standard of review for going-private mergers, which had been an open question under New York law. Plaintiffs argued for the “entire fairness” standard to apply, which would have required defendants to demonstrate the merger was the result of a fair process and was at a fair price, thereby making it difficult to obtain a dismissal at the pleadings stage. Defendants advocated for the application of the much more deferential business judgment rule, which warrants dismissal unless a plaintiff pleads specific facts indicating that the special committee did not act in good faith or was otherwise interested.
The court, in recognition of the competing interests of not interfering with the internal management of corporations and “avoiding frivolous litigation” and that of protecting minority shareholders in freeze-out mergers, adopted a middle ground, following the Delaware Supreme court’s decision in Kahn v. M & F Worldwide Corp. The court held that a going-private merger would be entitled to review under the business judgment rule rather than the entire fairness test if six “shareholder-protective conditions” were met: (1) if the transaction is conditioned on the approval of both a special committee and a majority of the minority shareholders; (2) if the special committee is independent; (3) if the special committee is empowered to select its own advisors and to say no definitively; (4) if the special committee meets it duty of care in negotiating a fair price; (5) if the vote of the minority is informed; and (6) if there is no coercion of the minority.
The court went further and held that a merger strike suit would be subject to dismissal unless it alleges “a reasonably conceivable set of facts” showing that one of the six conditions did not exist, and that conclusory or unsupported legal assertions are not sufficient. In particular, with respect to the special committee’s independence and care in negotiating a fair price—two conditions likely to face challenges by plaintiffs—the court set a high bar, requiring a plaintiff to allege the special committee engaged in fraud or unfair conduct, or had a conflict of interest or other incentive to accept an inadequate price without meaningful negotiations. Since the plaintiffs only attempted to meet their burden with conclusory allegations, the court affirmed the dismissal of the complaint.
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Parties contemplating a going-private transaction should condition it on the approval of a properly formed special committee and of a majority of minority shareholders in order to satisfy the six conditions laid out in In re: Kenneth Cole Productions, Inc., Shareholder Litigation. Merger strike suits are more susceptible to dismissal under the deferential business judgment rule, which may allow for the avoidance of costly discovery and litigation.
Kaye Scholer represented the former CEO of Kenneth Cole Productions, Inc. and Kenneth Cole Productions, Inc. in this action.