New York Court of Appeals Applies “Business Judgment Rule” in Shareholder Suit Against Corporation

New York CityThe people in charge of a business entity, such as the directors of a corporation or the managers of a limited liability company (LLC), owe multiple fiduciary duties to the owners of the business. In a dispute between corporate shareholders and a corporation’s directors, the extent of scrutiny that a court will give to the directors’ decisions depends on the circumstances. A recent decision by the New York Court of Appeals considered whether to apply the “business judgment rule” (BJR) or the stricter “entire fairness standard” (EFS) in a shareholder lawsuit. The lawsuit involved a proposed “going-private merger,” in which a majority shareholder sought to buy all of its outstanding shares. The court chose the BJR, citing a Delaware Supreme Court decision that applied the BJR under similar circumstances. In re Kenneth Cole Prods., Inc., 2016 NY Slip Op 03545 (May 5, 2016); Kahn v. M&F Worldwide Corp., 88 A.3d 635 (Del. 2014). The court also noted, however, that the Delaware decision establishes multiple safeguards for minority shareholders that must be in place before the BJR may apply.

Under the BJR, courts defer to the judgment of a corporation’s directors, provided that the directors acted reasonably and rationally, and without conflicts of interest. The court’s decision in Kenneth Cole states that the directors must “exercise unbiased judgment in determining that certain actions will promote the corporation’s interests.” Kenneth Cole, slip op. at 6. The plaintiff has the burden of proving that one or more directors acted in bad faith, had an undisclosed conflict of interest, or otherwise behaved fraudulently or with gross negligence in order to overcome the deference afforded by the BJR.

The EFS sets a far stricter standard. It views a transaction in its entirety. Rather than requiring evidence of misconduct or negligence as a prerequisite for second-guessing directors’ decisions, the EFS essentially requires the directors to prove that they handled the subject of the dispute fairly. They must show that both the process of the transaction and the final price were fair, especially with regard “to independent directors and shareholders.” Id. at 8.

Kenneth Cole’s founder and namesake owned 46 percent of the company’s outstanding Class A shares and all of its outstanding Class B shares in early 2012. This gave him, according to the court, nearly 90 percent of the total shareholder voting power. He sought to purchase the remaining Class A shares, which would effectively turn the publicly traded company into a private one.

Multiple shareholders filed suit to enjoin the merger, claiming breach of fiduciary duty by Cole and other directors. The plaintiffs argued that the court should apply the EFS, while the defendants argued for the BJR. The trial court granted the defendants’ motion to dismiss the lawsuit, and the appellate court affirmed.

The Court of Appeals also affirmed, citing the Delaware Supreme Court’s decision in Kahn and noting that the defendants had taken appropriate precautions to protect the shareholders’ interests. Kahn held that the BJR applies to a going private merger if the deal is “conditioned upfront…on approval by both a properly empowered, independent committee and an informed, uncoerced majority-of-the-minority vote.” Id. at 10, quoting Kahn, 88 A.3d at 639.

Business merger attorney Samuel C. Berger represents businesses and business owners in the greater New York City and Northern New Jersey areas. Our fixed-fee legal-service packages cover a wide range of matters and provide our clients with the legal assistance they need to run and grow their businesses. To schedule a confidential consultation with a skilled and experienced business advocate, contact us today online, at (201) 587-1500, or at (212) 380-8117.

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Photo credit: Randy Pertiet (Flickr: New York City at Sunset in HDR) [CC BY 2.0], via Wikimedia Commons.