The Delaware Supreme Court recently issued an opinion, captioned Corwin v. KKR Financial Holdings LLC,1 that sheds further light on when a stockholder owning less than 50% of the voting power of a company may be deemed a controlling stockholder. In the opinion, the Delaware Supreme Court also clarified that the business judgment rule will be invoked as the standard of review in a post-closing damages action where a merger that is not subject to the entire fairness standard of review is approved by a fully informed, uncoerced majority of disinterested stockholders, even if the stockholder vote is required by statute. The decision affirms the Delaware Court of Chancery’s ruling in In re KKR Financial Holdings LLC Shareholder Litigation.2
The underlying Court of Chancery action arose out of the acquisition of KKR Financial Holdings LLC (KFN), a widely held, publicly traded, and externally managed specialty finance company at the time, by KKR & Co. L.P. (KKR), a widely held, publicly traded investment firm. As a result of the transaction, which was structured as a stock-for-stock merger, KFN became a wholly owned subsidiary of KKR and the stockholders of KFN received units representing limited partnership interests in KKR.3
Leading up to and at the time of the merger, KKR owned less than 1% of the shares of KFN, but an affiliate of KKR, KKR Financial Advisors LLC, served as KFN’s external manager. As is common in the asset management industry, the manager ran the day-to-day operations of KFN pursuant to a management agreement, subject to the oversight of KFN’s board of directors. KFN had no employees, and its executive officers were all employees of the manager or its affiliates.
From the outset of the transaction, KKR conditioned its proposal to acquire KFN on the transaction being approved by an independent KFN board committee and a majority of KFN’s common stockholders not affiliated with KKR. A special negotiating committee, consisting of six of the 12 directors on KFN’s board, was formed in response to the proposal and negotiated and approved the transaction, which was ultimately recommended to and approved by KFN’s full board (excluding two directors who held high-level positions at KKR). The merger agreement included several deal protections, including a termination fee equal to 1% of the transaction value, a no-shop provision with a fiduciary out, and a matching right that KKR could exercise in the event a competing proposal surfaced. The merger was subject to approval by the holders of a majority of KFN’s common stock; however, the merger agreement further required that the approval by KFN’s common stockholders include a majority of shares held by persons other than KKR and its affiliates.
After the transaction was announced, and in advance of the stockholder vote, certain KFN stockholders filed an action in the Court of Chancery asserting, among other things, that the members of KFN’s board of directors breached their fiduciary duties of care and loyalty by agreeing to the merger, and that KKR breached its fiduciary duty as a (purported) controlling stockholder by causing KFN to enter into the merger at an unfair price and following an unfair process. The defendants moved to dismiss the complaint for failure to state a claim.
During the pendency of the motion to dismiss, the KFN stockholders, including a majority of the outstanding common stock entitled to vote and not held by KKR or its affiliates, voted in favor of the merger, which closed thereafter. Notably, the plaintiffs did not challenge the disclosures in KFN’s proxy statement in advance of the stockholder vote and did not seek to enjoin the closing of the transaction.
The Court of Chancery Decision
In ruling on the motion to dismiss after the closing, Chancellor Andre Bouchard addressed a core, threshold issue: whether the plaintiffs pled facts sufficient to rebut the business judgment rule and to compel application of a higher standard of review, specifically enhanced scrutiny under Revlon4 or entire fairness. The court ruled out application of Revlon, which would have examined whether the directors acted reasonably to maximize the short-term value of KFN for its stockholders, on the ground thatRevlon’s enhanced scrutiny standard was “not implicated in this action because the stock-for-stock merger involved widely-held, publicly traded companies.”5 As a result, the court’s inquiry narrowed to whether the alleged facts warranted application of the entire fairness standard.
Seeking to invoke the Delaware Supreme Court’s decision in Kahn v. Lynch Communication Systems, Inc.,6 the plaintiffs argued that entire fairness should apply because KKR was a controlling stockholder of KFN and stood on both sides of the transaction. Among other things, the plaintiffs alleged that KKR, through its affiliates, was a stockholder of KFN and dominated and controlled KFN by virtue of the management agreement. In evaluating whether KKR was a controller, the Court of Chancery reviewed the two scenarios in which a stockholder becomes a controller under Delaware law: “where the stockholder (1) owns more than 50% of the voting power of a corporation or (2) owns less than 50% of the voting power of the corporation but ‘exercises control over the business affairs of the corporation.’”7Since KKR owned less than 1% of KFN, the question was whether KKR exercised actual control with regard to the transaction. The particular question before the court was novel because the controlling stockholder argument “really had nothing to do with the amount of voting power KKR held in KFN,” and rested on the unique management structure and reliance of KFN on KKR for its operations.8
The Court of Chancery declined to endorse such a novel argument and found that, based on the existing Delaware jurisprudence, the allegations in the complaint did not support a reasonable inference that KKR was a controlling stockholder of KFN. In particular, the court noted that the plaintiffs’ allegations that KKR’s affiliate managed the day-to-day affairs of KFN did not support a reasonable inference that KKR exercised actual control over the KFN board. There were no allegations, for example, that KKR had a contractual right to appoint any members of the KFN board, to dictate any action by the board, to veto any action of the board, or to prevent the board from hiring advisors and gathering information to be fully informed.9 In other words, there were no facts in the complaint suggesting that “KKR could prevent the KFN board from freely exercising its independent judgment in considering the proposed merger or, put differently, that KKR had the power to exact retribution by removing the KFN directors from their offices if they did not bend to KKR’s will in their consideration of the proposed merger.”10 For these reasons, the court dismissed the claim that KKR breached its fiduciary duty of loyalty in its capacity as a controlling stockholder.
The plaintiffs argued in the alternative that the business judgment rule should be rebutted, and entire fairness should apply, because a majority of the KFN board was not independent.11 The court, therefore, considered whether the plaintiffs pled facts supporting a reasonable inference that a majority of the directors who voted on the merger were beholden to a controlling person or so under the influence of a controlling person that they could not exercise discretion. Of the 10 directors who voted on the transaction (two KKR executives who were directors did not vote), the court found it reasonably conceivable that two of them would not be found independent. One director had long-standing ties to KKR and held positions at a KKR affiliate; the other director was dean of a business school that received a $100 million donation from KKR’s founder. But the plaintiffs failed to allege facts challenging the independence of the remaining eight directors who voted on the merger. As a result, the court determined that the plaintiffs had failed to rebut the business judgment rule by demonstrating that a majority of the directors were interested in the merger or not independent. For this reason, and the fact that the plaintiffs did not challenge the merger as being irrational or on the grounds of waste, they failed to state a claim that the directors breached their fiduciary duties in approving the merger.
Having determined that the plaintiffs failed to demonstrate that KKR was a controlling stockholder or that a majority of KFN’s board was not independent, the court nevertheless considered the effect of the stockholder vote on the merger. The Court noted that the defendants argued, and the plaintiffs did not disagree, that “the legal effect of a fully-informed stockholder vote of a transaction with a non-controlling stockholder is that the business judgment rule applies and insulates the transaction from all attacks other than on the grounds of waste, even if a majority of the board approving the transaction was not disinterested or independent.”12 Applying this principle, and finding that the plaintiffs failed to allege that the stockholder vote was not fully informed, the court concluded that “even if plaintiffs had pled facts from which it was reasonably inferable that a majority of KFN’s directors were not independent, the business judgment standard would still apply to the merger because it was approved by a majority of the shares held by disinterested stockholders of KFN in a vote that was fully informed.”13 For this independent reason, the court dismissed the claim that the directors breached their fiduciary duties in approving the merger.
The Delaware Supreme Court Decision
On appeal, the Delaware Supreme Court affirmed the Court of Chancery’s decision.14 In particular, with respect to the controlling stockholder question, the Delaware Supreme Court adopted the Court of Chancery’s reasoning and application of existing law, and declined to recognize the novel claim. The Delaware Supreme Court noted, for example, that Chancellor Bouchard properly “focused on the reality that in cases where a party that did not have majority control of the entity’s voting stock was found to be a controlling stockholder, the Court of Chancery, consistent with instructions of this Court, looked for a combination of potent voting power and management control such that the stockholder could be deemed to have effective control of the board without actually owning a majority of stock.”15 Citing to the Court of Chancery’s analysis, the Delaware Supreme Court affirmed its holding that “there were no well-plead facts from which it was reasonable to infer that KKR could prevent the KFN board from freely exercising its independent judgment in considering the proposed merger or, put differently, that KKR had the power to exact retribution by removing the KFN directors from their offices if they did not bend to KKR’s will in their consideration of the proposed merger.”16
The Delaware Supreme Court next addressed the effect of the KFN stockholder vote and the plaintiffs’ argument on appeal that, if the entire fairness standard did not apply, Revlon’s enhanced scrutiny did. The court declined to address whether the Court of Chancery properly determined that Revlon did not apply. The court noted that the plaintiffs arguably waived this challenge because they did not fairly pursue it in the trial court, but, ultimately, the court declined to reach the issue because a determination that Revlon applied would not have changed the analysis. Once the Court of Chancery determined that the transaction was not subject to entire fairness review, its analysis of the effect of the uncoerced, informed stockholder vote dictated the outcome. In the words of the Delaware Supreme Court, adopting the Court of Chancery’s holding, “the business judgment rule is invoked as the appropriate standard of review for a post-closing damages action where a merger that is not subject to the entire fairness standard of review has been approved by a fully informed, uncoerced majority of the disinterested stockholders,” even if the stockholder vote was statutorily required and even if Revlon applied.17
In adopting that holding, the Delaware Supreme Court rejected the plaintiffs’ argument on appeal that invoking the business judgment rule on the basis of a fully informed, uncoerced stockholder vote would impair the operation of Unocal18 and Revlon. Among other things, the Delaware Supreme Court noted that “Unocal and Revlon are primarily designed to give stockholders and the Court of Chancery the tool of injunctive relief to address important M&A decisions in real time, before closing,” and not to sustain post-closing damages claims.19 In addition, this principle applies only to fully informed, uncoerced stockholder votes. The business judgment rule would not be invoked, for example, if troubling facts regarding director behavior were not disclosed and would have been material to a voting stockholder.
The Delaware Supreme Court and Court of Chancery decisions provide corporations and practitioners with helpful guidance on the level of control necessary for a minority stockholder to be deemed a controller (and, therefore, a fiduciary), and on the potential cleansing effect of a fully informed, uncoerced stockholder vote. To summarize, here are a few takeaways:
- The test for determining that a minority stockholder is a controlling stockholder is difficult to satisfy and requires demonstrating a level of power and control over the board of directors that effectively prevents the directors from freely exercising their judgment or subjects them to threat of removal from office if the minority stockholder’s will is not carried out. When making this determination, Delaware courts will consider whether the minority stockholder possesses a combination of “potent voting power” and “management control,” or otherwise has a contractual right, that effectively allows the stockholder to control the board’s actions.
- For transactions outside of the controlling-stockholder entire-fairness context,20 a fully informed, uncoerced vote of a majority of disinterested stockholders can invoke and reestablish the business judgment standard of review in a post-closing damages action challenging the transaction, even if a majority of the board of directors approving the transaction was not both disinterested and independent (and even if the entire fairness standard would have applied on that basis).
- After KKR, Revlon and Unocal enhanced-scrutiny cases are likely to continue to focus on challenging the disclosures made to stockholders and enjoining the transaction before closing. If those claims are not adequately pursued before closing, and only a post-closing damages case remains, then, under KKR, the business judgment rule would be applied instead of enhanced scrutiny if the transaction is approved by a fully informed, uncoerced majority of the disinterested stockholders. The stockholder vote would have the effect of cleansing or extinguishing the Revlonand Unocal claims, leaving a challenger to argue waste or irrationality to otherwise rebut the business judgment rule.