Courts have long applied the exacting “entire fairness” standard to one-step, going-private merger transactions.  In Delaware, after years of agonizing by courts and commentators, this changed in 2013 in Kahn v. M&F Worldwide Corp. (“MFW”).[1]  MFW held that if certain procedural protections were observed in the course of the transaction the far more deferential business judgment standard would be applied.  The required safeguards included, most notably, negotiation and approval of the transaction by a committee of the target’s independent directors and subsequent approval by an informed majority vote of target stockholders unaffiliated with the acquiror.  Last week, the New York Court of Appeals adopted Delaware’s MFW approach in its review of the Kenneth Cole Productions going-private transaction.[2] 

Kenneth Cole Productions, Inc. (“KCP”), a New York corporation, had two classes of common stock.  Mr. Cole owned 46% of the low-vote Class A common stock and 100% of the high-vote Class B common stock, entitling him, in the aggregate, to 89% of the voting power of KCP shareholders.  In February 2012, he made a proposal to acquire the shares of Class A common stock held by the public at $15.00 per share.  The proposal was conditioned on approval by a committee of independent directors, and subsequently, by a majority of the public holders who were not affiliated with Mr. Cole.  In addition, Mr. Cole was careful to inform the KCP board that he would not be in favor of any other type of transaction, and if his proposal were rejected, his ongoing relationship with KCP would not be adversely affected.  After months of negotiation, the special committee approved a transaction at $15.25 per share, and 99.8% of the minority shareholders voted in favor of allowing Mr. Cole to squeeze them out.

Noting that this was an issue of first impression under New York law, the Court of Appeals closely followed the reasoning of the Delaware Supreme Court in MFW.  In particular, the New York court pointed out that while the entire fairness standard generally applies to transactions between a corporation and a controlling shareholder, in the context of a merger and in the absence of coercion by the controlling shareholder, certain procedural protections essentially replicate an arms’-length transaction.  The court noted that use of a committee of independent, well-advised directors with sufficient authority to negotiate (and, if they see fit, reject) the proposal is similar to board approval in a third-party transaction, and approval by a majority of unaffiliated shareholders replicates the approval of all shareholders in non-control transactions.  The court then quoted and adopted the MFW standard:

‘in 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.’[3]

The New York court also followed Delaware’s lead with respect to the standard to be used in considering whether a complaint in such a case should survive a motion to dismiss.  “According to the Delaware Supreme Court, for purposes of this rule … a complaint is sufficient to state a cause of action … if it alleges ‘a reasonably conceivable set of facts’ showing that any of the six enumerated shareholder-protective conditions did not exist.”[4]  Applying that standard, the court affirmed the dismissal of the complaint finding that the plaintiffs did little more than present insufficient “conclusory allegations” with respect to the power and freedom of the special committee, potential coercion by Mr. Cole, the committee members’ potential conflicts of interest, and the information presented to shareholders in advance of the vote.

Application of the business judgment rule in lieu of the entire fairness standard makes a protracted and expensive lawsuit less likely, but it is worth noting that following the teachings of MFW/Kenneth Cole is no guarantee that deal litigation will be avoided or if brought will be vanquished on the pleadings.  As both the New York and Delaware courts recognized, well-pled facts showing only that it is reasonably conceivable that any of the six prongs of the test have not been satisfied will result in plaintiffs’ survival of a motion to dismiss and propel the parties into discovery.  Moreover, before proceeding, transaction participants ought to consider carefully whether attempting to satisfy the six MFW/Kenneth Cole prongs will be worth the potential cost.  For instance, if ill-tempered hedge funds buy up the publicly traded shares, obtaining that majority of the minority vote may prove more difficult than a litigation under the entire fairness standard, and the fact that the majority of the minority condition must be non-waivable means there is no turning back for some period of time.  In short, MFW and Kenneth Cole provide a useful tool when planning a going-private merger, but buyers and their advisors are well advised to consider carefully whether it suits their particular situation.

[1] Kahn v. M&F Worldwide Corp., 88 A.3d 635 (Del. 2013) (“MFW”).

[2] In the Matter of Kenneth Cole Productions, Inc., Shareholder Litigation, slip op. (N.Y., May 5, 2016).

[3] Id. at 12 (quoting MFW, 88 A.3d at 645) (emphasis in original).

[4] Id. at 13 (quoting MFW, 88 A.3d at 645).