New York and Delaware Agree: Directing Should Be Left to Directors
With its recent decision in In Re Kenneth Cole,1 the New York Court of Appeals
expressly adopted the standard from Delaware's highest court in its 2014 Kahn v. M&F
Worldwide Corp. (MFW) decision,2 governing transactions in which a controlling
shareholder proposes to take a public company private.3 But perhaps not enough
attention has been paid to these two influential courts' having put the proverbial nail in
the coffin of the proposition that ad hoc judicial inquiry provides better protection of
shareholder rights than a properly run corporate process, overseen by independent
fiduciaries. (The authors represented the independent directors of Kenneth Cole
Productions in this case.)
For many years, attorneys, supported by influential academics and judges, have
criticized the deference to the business decisions made by corporate directors as poor
public policy and harmful to shareholders. Many claimed that application, and
expansion, of the business judgment rule was symptomatic of a "race to the bottom" in
corporate law. That theory, most famously asserted by William Cary, chairman of the
SEC from 1961 to 1964,4 posits that states introduce rules favoring managers that
permit the appropriation of the firm's surplus at the expense of the shareholders.
The Cole and MFW courts' adherence to the longstanding principle that courts should
strive to avoid interfering with the internal management of corporations, and their
rejection of policy arguments to the contrary, is a powerful reaffirmation that judicial
intervention in corporate decision-making should come from prescribing or judging
processes, not the results.
Cole and the earlier MFW decision from Delaware's highest court are notable because
they rejected judicial second-guessing urged by those in favor of a reflexive application
of the so-called "entire fairness" review, and instead were guided foremost by the
principle that courts should strive to avoid interference with the management of
business corporations.
There are several components to the historical policy arguments in favor of applying
entire fairness review, all of which are frequently articulated as support for a world view
in which courts are better suited to decide what is in the best interests of corporations
and shareholders than are directors or shareholders themselves. The Cole and MFW
decisions may be seen not only as express rejections of these arguments but also as
reaffirmations of several longstanding corporate principles.
Informed Shareholders Empowered With Veto Rights Will Act Rationally. First, the
high courts of New York and Delaware rejected the proposition that shareholders were
not faithful agents of their own best interests. MFW held that it "is consistent with the
central tradition of Delaware law" to defer to the decisions of impartial directors,
"especially when those decisions have been approved by the disinterested stockholders
on full information and without coercion." This language was quoted approvingly by the
New York Court of Appeals in Cole. If the courts instead had adopted the entire fairness
approach they would encourage shareholders to act through the courts and weaken the
legal force of their action in the marketplace.
The business judgment rule does not just protect directors from shareholders. It also
protects the corporation and its shareholders from other shareholders. If a disgruntled
shareholder can too easily access courts, the effect is to transfer power from directors
to shareholders or, more realistically, to a few shareholders whose interests conflict with
those of the larger body of shareholders who voted for the transaction.
There appears to be an insistence by those urging entire fairness review that
shareholders will not act in their own rational self-interest. Plaintiffs in these cases
sometimes assert that public shareholders empowered to accept or reject the buyout
will irrationally sell their shares at prices below the "fair price" or vote in favor of the
buyout even if they believe it is not in their best interest. In other words, the hypothesis
goes, where the controller proposes to buy out shareholders at a price the shareholders
identify as below the "fair price," shareholders empowered to vote against the buyout
will nonetheless act against their own self-interest by failing to reject the deal.
The more logical conclusion, however, is that the market (i) believes the controller's
offer price was higher than what the shares were worth and (ii) did not anticipate a
second, better offer by the controller or anyone else to be forthcoming. To follow the
interventionist theory would be to ignore market forces and how shareholders voted with
their own money at stake in favor of a judicially imposed assessment of "fair price."
Going-Private Transactions Are Not Inherently Abusive. Second, properly executed
going-private transactions are the product of market forces, and it would be improper to
presume that they are categorically unproductive or wasteful. Nonetheless, premised on
a distrust of market mechanisms, litigants and academics have urged courts to
conclude that going-private transactions are actually a net loss to companies and
society as a whole. This unsupported proposition is impossible to square with the reality
of interested parties with skin in the game reaching the perfectly rational conclusion that
taking a company private (or, from the perspective of the shareholder, taking cash in
exchange for shares and moving on to other investments) is the best available option.
The lesson of Cole and MFW for shareholder plaintiffs who are displeased with the
terms offered by a controller is to focus their criticism and litigation strategy on the
substance of the particular transaction, the information provided to shareholders, and
the core question of whether fiduciaries properly satisfied their duties. Broadside attacks
aimed at painting a picture of a rigged system in which controlling shareholders seize
assets from supposedly powerless shareholders are unlikely to carry the day.
Courts Are Ill-Equipped to Make Business Judgments. Third, these decisions are
consistent with the vision that the most suitable corporate law rules rely on systemic
processes and that intervention should come from prescribing or judging these
processes, rather than results.5 The business judgment rule places a premium upon the
process that directors follow to reach a decision, rather than the resulting decision itself.
As the New York Court of Appeals explained in its seminal decision Pollitz v. The
Wabash Railroad Company, 207 N.Y. 113 (1912): Business questions "are left solely to
[directors'] honest and unselfish decision," and "may not be questioned, although the
results show that what they did was unwise or inexpedient."
The Cole court reasoned that "courts are ill equipped to evaluate what are essentially
business judgments; there is no objective standard by which to measure the
correctness of many corporate decisions (which involve the weighing of various
considerations); and corporate directors are charged with the authority to make those
decisions."
The top-down approach to corporate governance favors intervention in the form of using
expertise to prescribe and judge results. The New York and Delaware high courts
instead have now underscored—consistent with the history and purpose of the business
judgment rule—a judicial trend in favor of assessing processes. By providing an
evaluation of institutional competence rather than an ad hoc assessment of results,
courts create the incentives for controlling shareholders to provide a structure "that is
most likely to protect the interests of minority shareholders, because when [procedural]
protections are in place, the situation replicates an arm's length transaction and
supports the integrity of the process."6
For example, the MFW court held that the "dual protection merger structure" achieves
the objective of an entire fairness standard of review, "fair price." It does so, however,
not through a post hoc substantive price analysis by judges but, rather, by "requir[ing]
two price-related pretrial determinations" in that "a fair price was achieved by an
empowered, independent committee that acted with care" and "a fully-informed,
uncoerced majority of the minority stockholders voted in favor of the price." Structuring
the buyout as an arm's-length transaction susceptible to business judgment review
ensures greater shareholder protection than entire fairness review by incentivizing
procedural protections that put shareholders in the best position to scrutinize the deal
for themselves and allowing courts to evaluate corporate compliance with procedural
protections rather than second-guessing business decisions on their merits. This trend
has broad implications for corporate law practitioners.
Entire Fairness Review Encourages Frivolous Lawsuits and May Deter Valuable
Transactions. Finally, the MFW and Cole decisions recognize that "entire fairness"
judicial review may deter buyout transactions that would be mutually beneficial for
controllers and public shareholders. An entire fairness review affects the controlling
shareholder's litigation costs, time to closing, and, of course, increases risk of an
adverse judgment. These additional costs and uncertainty likely would deter at least
some controllers from making an otherwise lucrative buyout offer for shares of minority
shareholders where the value of their publicly traded firm would be greater as a private
firm. This hurts public shareholders by denying them an opportunity to share in the
enterprise value created by taking a company private—for them, this would come in the
form of receiving a premium to the current market price for their shares.
There may be no more compelling example of the class action bar's overzealousness
than Cole, in which four putative class action lawsuits were filed just days after designer
Kenneth Cole's buyout offer—long before the independent directors ever took any
action. Empirical data on mergers shows that challenges by plaintiffs' firms are
increasingly common. One study found that from 1999 to 2001, only 18.4 percent of
mergers with deal values over $100 million were challenged by a shareholders classaction lawsuit.7 Whereas that figure was 44 percent in 2007, it increased to 90 percent
or more since then.8
Some evidence suggests a very recent reversal in this trend, but an important reason
appears to be new Delaware decisions criticizing attorney fee awards in disclosure-only
settlements—where plaintiffs' counsel seek significant attorney fees and release future
shareholder claims in exchange for the company making modest additional
disclosures.9
It will be important for practitioners going forward to watch these trends as they affect
both the deal-making process and the litigation that has seemingly invariably followed in
recent years. Will more controllers accept the added risk to completion of a transaction
by conditioning their bids on the shareholder protections that the New York and
Delaware courts have found so compelling? And will these influential courts continue to
show deference to the will of directors acting in good faith and shareholders making fully
informed, uncoerced decisions? Those who favor the free flow of information and
empowering owners of businesses to determine their own fates free of a "litigation tax"
are encouraged by recent developments.
Endnotes:
1. In re Kenneth Cole Prods., Inc., S'holder Litig., 2016 N.Y. Slip Op. 03545 (N.Y. May
5, 2016).
2. Kahn v. M & F Worldwide Corp., 88 A.3d 635 (Del. 2014).
3. If the controller conditions the going-private merger on certain procedural
protections—most important, approval by both a special committee of independent
directors and an informed vote of the majority of the minority shareholders—courts will
review shareholder challenges to the transaction under the deferential "business
judgment rule," not the stringent "entire fairness" standard.
4. William L. Cary, "Federalism and Corporate Law: Reflections Upon Delaware," 83
Yale L.J. 663 (1974).
5. M. Todd Henderson, "Two Visions of Corporate Law" (2009).
6. Cole, Slip Op. at 11 (citing MFW, 88 A.3d at 643).
7. Elliott J. Weiss and Lawrence J. White, "File Early, Then Free Ride: How Delaware
Law (Mis)Shapes Shareholder Class Actions," 57 Vand. L. Rev. 1797, 1825 (2004).
8. Cornerstone Research, Shareholder Litigation Involving Mergers and Acquisitions—
Review of 2014 M&A Litigation.
9. Liz Hoffman, "The Judge Who Shoots Down Merger Lawsuits," Wall Street Journal,
Jan. 10, 2016 (explaining recent trend, and reporting that only 34 percent of mergers
involving Delaware corporations since Oct. 1, 2015, were challenged); see also In re
Riverbed Tech., Inc. Stockholders Litig., No. 10484-VCG, 2015 WL 5458041 (Del. Ch.
Sept. 17, 2015) (explaining "perverse incentive" for plaintiffs' attorneys to settle for quick
attorney fees rather than pursue litigation that benefits shareholders, and awarding
reduced attorney fees because the "result is too modest a benefit to justify the fee
sought here").
Andrew W. Stern is a partner at Sidley Austin. Benjamin F. Burry is an associate at the
firm. They are based in the New York office and represented the independent directors
of Kenneth Cole Productions, Inc. in 'In Re Kenneth Cole Prods.,' which is discussed in
this article.
Reprinted with permission from the July 18, 2016 edition of the New York Law Journal©
2016 ALM Media Properties, LLC. All rights reserved.
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